Krugman on stimulus

I usually don’t respond to Paul Krugman’s blog posts. But last week he wrote about Stimulus and Ricardian Equivalence. The post gives a revealing view of his ideas, so it’s worth making an exception.

Paul explains:

…think about what happens when a family buys a house with a 30-year mortgage.

Suppose that the family takes out a $100,000 home loan …. If the house is newly built, that’s $100,000 of spending that takes place in the economy. But the family has also taken on debt, and will presumably spend less because it knows that it has to pay off that debt.

But the debt won’t be paid off all at once — and there’s no reason to expect the family to cut its spending right now by $100,000. Its annual mortgage payment will be something like $6,000, so maybe you would expect a fall in spending by $6000; that offsets only a small fraction of the debt-financed purchase.

So, according to Paul, “Ricardian Equivalence,” which is the theorem that stimulus does not work in a well-functioning economy, fails, because it predicts that a family who takes out a mortgage to buy a $100,000 house would reduce consumption by $100,000 in that very year.

How could anyone who thought about this for even a minute — let alone someone with an economics training — get this wrong?

How indeed?

The answer is, we didn’t, and Paul got this one wrong.


We all agree that “Ricardian Equivalence” is how the economy would and should work, if there were no “frictions,” or other problems.  Yes, even Paul, who writes

It [Ricardian Equivalence] is a dubious doctrine even done right; many people are liquidity constrained, and very few people have the knowledge or inclination to estimate the impact of current government budgets on their lifetime tax liability.

Read that carefully for admission of the converse: if the economy is functioning right, if people are not “liquidity constrained,” if people are smart enough to recognize that today’s deficits mean tomorrow’s taxes, then Ricardian equivalence does hold and stimulus doesn’t work. (More careful discussion with a few more ifs  here, here and here.)

So according to Paul, the prediction of a properly functioning economy is that people who take out a $100,000 mortgage consume $100,000 less in the first year; that they do not do so is proof stimulus works.

But of course it is not!  People who take out a $100,000 mortgage with $6,000 payments per year should spend about … $6,000 per year less on other things. Much of that $6,000 comes out of rent they are no longer paying on the house or apartment they moved out of, so there is not necessarily any change in their consumption of housing services. Some of the $6,000 goes to principal payments, which are a form of saving, allowing the household to put less in the bank. So, in fact they need not change consumption or saving at all!

In fact the classic view predicts exactly what common sense predicts: No, the family does not make radical $100,000 changes in its consumption plans thank you very much.

But what about the extra $100,000 of “spending”? Doesn’t the new house contribute to “aggregate demand?” What, in the classic view, goes down by $100,000?

The question is not the family’s spending, but where did the $100,000 come from, and what were they going to do with the money?

Most likely, someone was saving money, and put it in a bank. If this family didn’t take out the loan, another family would have (perhaps at an infinitesimally lower interest rate) done so, and the economy would have built a different house. Or perhaps the money came from an investor in mortgage-backed securities, who would have built a factory instead. These are where the $100,000 offset in aggregate demand comes from, and why the family’s decision to take out the mortgage need have no effect on aggregate demand.

Can something go wrong in that process?  Sure. That’s what real analyses of stimulus think about. But those like myself who, reading theory and evidence, come to the conclusion that stimulus doesn’t work well, do not come to that conclusion because we think the family will spend $100,000 less!

To me, this example illustrates beautifully how Krugman “got this wrong.” He never asked where the $100,000 loan came from!  In his analysis of  government borrowing and spending, he does not ask, who lent the money to the government, and what were they planning to do with it otherwise.  People “with an economics training” are supposed to remember lesson one – follow the money and pay attention to budget constraints. His stimulus is manna from heaven, not borrowed money.

Good advice to anyone: If you get up one morning with the brilliant insight, “Bob Lucas thinks that a family who takes out a $100,000 mortgage will reduce consumption by $100,000,” have a cup of coffee, settle down and think, “Wait, Bob’s a pretty smart guy. Did I get this wrong somehow?” before hurling insults Bob’s way in the New York Times’ blog section.

(Note, this is about Krugman’s analysis, not stimulus in general. There are plenty of serious analyses of fiscal stimulus that do not make simple logical errors. The plausibility of their assumptions and how they fit the data is an interesting topic. For another day.)

PS: Why is it my new year’s resolution not to respond to Krugman blog posts?

Really, what do you do with a guy who insults fellow economists, while admitting in writing that he doesn’t even read the opeds and blog posts that are the cause for his insults (let alone their actual academic work, where ideas can be documented and defended)?  He often doesn’t even link or name the articles he’s criticizing so his readers can decide for themselves!

If you don’t believe me, look here , here, here, here and… well, I could go on. Just search his column for anyone he disagrees with. (And dear New York Times, is there anyone left in the journalistic ethics or fact-checking department?)

The best answer to that sort of thing is silence. Which I resolve to maintain, along with that diet and hitting the gym….

The Fed's Mission Impossible

A Wall Street Journal Op-Ed  reviewing the latest  Fed’s proposal (press release) to regulate big banks – and, soon, everyone else. Here’s the much more fun introduction, which we had to cut for space,

Imagine that your brother-in-law and his 5 buddies are heading for Las Vegas. Again. You already cosigned the refi on his house, and it was only a last-minute wire to the bail bondsman that got him out of the slammer last time.

So, you’re going to have another little kitchen-table talk about “the rules.” This time, no lending to your buddies (“limits on credit exposure”). No buying rounds of drinks (“limit dividend payouts and bonuses”). And for God’s sake, don’t lose it all on one silly bet (“stress test”). Keep some cash for the flight home (“liquidity provisions.”) No pawning the wife’s engagement ring for one last double-or-nothing (“leverage limits”). And if I hear there’s trouble, I’m going to come out myself and make sure you don’t overdo it. (“Early remediation”)

Sure, he says, with a twinkle in his eye. Because you both know he’s got your credit card, and you’re not going to let your sister live in poverty (“systemically important”). And you can’t talk about her dumping this lug (“breaking up the big banks”), or at least stopping these Vegas trips (“Volker Rule”), not unless you want to sleep on the couch for a month (“Dodd Frank”).

On to the real oped:

The Fed’s Mission Impossible

The Federal Reserve last week announced its new “Enhanced Prudential Standards and Early Remediation Requirements” for big banks, as required by the Dodd-Frank law. You have to pity the poor Fed because it faces an impossible task.

The Fed’s proposal opens with an eloquent ode to the evils of too-big-to-fail and moral hazard. And then it spends 168 pages describing exactly how it’s going to stop any large financial institution from ever failing again.



More capital is at least a step in the right direction. But the Fed’s capital proposals don’t go nearly far enough. Putting less than one investor dollar at risk for every 10 borrowed dollars seems laughably low when we’re guaranteeing the debts. With a 50-50 chance of a banking tsunami coming across the Atlantic from Europe, you wonder why the Fed is allowing any dividends at all.

But there’s nothing here to solve the deeper problems. The last generation of smart MBAs got around capital requirements by pooling risky assets into “AAA” securities that had lower risk weights, and then putting those securities in special-purpose vehicles with off-balance-sheet credit guarantees. Voilà! Same risk, no capital. I can’t wait to see what they come up with this time. Diligently following risk weights, European banks built capital ratios by selling good loans and keeping “risk-free” sovereign debt.

The Fed’s proposed “credit limits” are a revealing mess. They seem simple and obvious—big banks can’t bet more than 10% of their equity on a single counterparty.

But on second thought, it’s not so obvious. This wasn’t the problem we had in 2008. Banks didn’t fail because they lent to other banks. We had a classic run: Investors pulled money from banks that lost a lot on mortgage-backed securities. Yes, banks take too much risk. But they have no incentive to take stupid undiversified counterparty risk.

Credit limits are not so simple either. Suppose you buy a $100 Bank of America bond. OK, you have $100 at risk, though usually there is some recovery in default. But what if they give you $102 of collateral, yet that collateral might be hard to sell or stuck in court for a while? How does a regulator measure that risk? Or what if loans from A to B are funneled through shell company C using derivatives? Ten percent of equity is less than 1% of assets, and a tiny fraction of gross exposures, so measuring it right will matter a lot.
How does the Fed address these problems? Read the 22 pages of overview with 39 separate explicit questions. Translation: Help! We have no idea how to measure and regulate “credit exposure” for modern banks.

The Fed’s proposed “triggers” for “early remediation” are interesting attempts to regulate the Fed, not the banks. The Fed recognizes that last time “while supervisors had the discretion to act more quickly, they did not consistently do so.” Triggers will force the machinery to action.

Or will they? You’re a regulator facing a bank in trouble. If you label it in trouble, you will start a panic in markets. This is the inherent contradiction—your job is to prop up banks, not cause runs. We’ll see.
The Fed goes on to a chilling list of “corporate governance” rules, gems such as: “The covered company’s board of directors (or the risk committee) must oversee the covered company’s liquidity risk management processes … [and] determine whether each line or product has created any unanticipated liquidity risk.” Well, duh, isn’t that what boards do? Why must this be written into federal regulations, with force and penalty of law?

The Fed’s proposal exemplifies what a recent editorial in these pages described as Washington’s “badly written bad rules.” Everything under the sun gets regulated, with no attempt to measure benefits or costs. Sure, as the Fed make clear, Dodd-Frank is to blame, but it could fight back just a bit.

Big picture time. Is any of this going to work?

For 70 years, our government has sought to stop crises by guaranteeing more and more debts, explicitly with deposit insurance, or informally with predictable too-big-to-fail bailouts. Guaranteeing debts gives obvious incentives to gamble at taxpayer expense, so we try to limit risks with regulation. But big banks still have every incentive to avoid, evade and financial-engineer their way around the rules, and they have lots of lawyers, lobbyists and ex-politicians to pressure regulators to use their wide discretion. The government has lost this arms race time and time again. Will this new round of rules, and greater discretionary supervision, finally stop too big to fail?

The depressing scenario is that the six big banks will use this massive regulation as an anticompetitive fortress. We will have the same six big banks 30 years from now, spurred to even greater size with continuing subsidies, cheap Fed-provided financing, the government guarantee, and occasional bailouts. And a financial system as innovative as the phone company, circa 1965.

The only hope I see is that nimble, new small-enough-to-fail competitors will spring up and rebuild the financial system. But this is faint hope in the face of the vast discretionary powers in last year’s Dodd-Frank financial legislation and the Fed’s rules, which allow the government to step in whenever they decide that a financial risk is “systemically important.”

What is not “systemically important?” How I can I build a new financial company that demonstrably causes no “systemic” danger—and is therefore not subject to the Fed’s onslaught of regulation, discretionary supervision and “remediation”? How can I assure my creditors that they will receive the legal protections of bankruptcy court, and not be dragged into some arbitrary and politicized “resolution”?

The Dodd-Frank legislation never defines “systemic” or, more importantly, its absence. Under the law, the Financial Stability Council can just “determine” that any company might have “serious adverse effects on financial stability.” They can consider any “factors that the Council deems appropriate.” The Fed proposes to subject any company to “other requirements or restrictions” if it thinks existing rules do not “sufficiently mitigate risks to U.S. financial stability.”

There is nothing to say that a risk to “financial stability” can’t be, for example, taking profits away from the big six, or a failure that takes money away from an influential voting bloc. Don’t laugh: Life insurance companies were bailed out in 2009 at least in part so they could keep up payments on guaranteed-return retirement products.

The Fed does not propose any such limit to its powers or describe how it will encourage a financial system free of too-big-to-fail firms. The Fed’s report has instead a searching inquiry on how it can expand its powers, and how it can begin “designating” and regulating companies beyond the big banks.

If we are going to get out of the guarantee-regulate-bailout trap, we must legally define what is not too big, and what can, will and must—by absence of legal authority—fail. If the government won’t break up too-big-to-fail banks, we must at least allow competition to do it.

Health economics by anecdote

In a big-think post  “Is capitalism sustainable” on Project Syndicate, Ken Rogoff put in this little zinger

A third problem is the provision and distribution of medical care, a market that fails to satisfy several of the basic requirements necessary for the price mechanism to produce economic efficiency, beginning with the difficulty that consumers have in assessing the quality of their treatment.

Ok, a difficulty of the blogging/oped medium is that you have to keep things short, and I too hate to be quoted for little snippets out of context…But, really, Et tu Ken?

It’s hard to know if the car mechanic is doing a good job. Get ready for the Federal takeover of the car industry. I can’t tell B grade exterior from A grade interior plywood, so we need a Federal takeover of home rehab. Vets and dentists operate outside of the mass of stifling health care and insurance regulation, so I guess they’re in for the treatment next.

Is it really that much harder to assess the quality of treatment for all health care than the other services we receive? For all medical care, not just extreme cases? Actually, my doctor complains that everyone who comes in has spent a week on the internet and knows too much about treatment options. The internet is ushering in a grand era of star ratings and consumer information.

Where is the evidence? Just this sort of armchair argument has been used for centuries (remember the guilds?) to justify competition-stifling regulation of all sorts of businesses.  Milton Friedman’s PhD thesis showed that licensing doctors was good for raising doctor’s salaries, but didn’t do much for the quality of health care. (His later essay on health economics is still a classic.)

And as always, the real argument for the free market is not that the market is perfect, but that the government is usually far worse. Do we have any evidence that government regulators assess the quality of care better than the people whose lives and money are at stake? Is there any vaguely plausible way that the small asymmetric information in health care justifies the monstrous system we have constructed?

Rant over. But really, there is a lot of harm passing around anecdotes like these as if they are agreed-on economic facts, representing both documentation and a serious cost-benefit tradeoff of viable alternatives. 

(I’ve written a bit more on free-market heath insurance here. ) 

All the world's troubles in 10 minutes

Last month, John Taylor asked me to give some  lunch-time remarks at a conference on “Restoring Economic Growth” at the Hoover institution. “Oh,” said John, “Just talk about what’s going on in Europe and how to fix the U.S. economy. Keep it to about 10 minutes.” As any economist knows, it’s easy to talk for an hour and nearly impossible to talk for 10 minutes. Then I looked at my fellow panelists, who turned out to be George Schultz and Alan Greenspan. Heady company, I feel like a kid again.

The euro crisis,some emerging thoughts on how to create a run-free financial system, a review of why everything on the current policy agenda does not have a prayer of working, and a note of cation to economists'  collective habit of jumping from bright idea to policy. (There is a permanent version on my webpage)

In case you’re not reading the papers, we’re in financial crisis 3.0, a run on European banks stemming from their sovereign debt losses.

This is not high finance. European banks have been failing on sovereign debt since Edward III stiffed the Perruzzi in 1353. This is not a “multiple equilibrium,” a run of self-confirming expectations. People are simply getting out of the way of sovereign default, since it’s pretty clear that governments are at the end of the bailout rope.

By dutiful application of bad ideas and wishful thinking, the Europeans have turned a simple sovereign restructuring into a currency crisis, a fiscal crisis, a banking crisis, and now a political crisis. They could have had a lovely currency union without fiscal union. The meter in Paris measures length. The Euro in Frankfurt measures value. And sovereigns default, just like companies. They could do what George Schulz beautifully called the “simple obvious” things, and return to the kind of strong growth that would let them pay off large debts. Alas, the ECB is full in, both buying debt and lending to banks who buy debt, so now a sharp euro inflation – which is just a more damaging and wider sovereign default – seems like the most likely outcome.

How did we get here? Financial crises are runs. No run, no “crisis.” People just lose money as in the tech bust. (Let me quickly plug here Darrell Duffie’s “Failure Mechanics of Dealer Banks.” This wonderful article explains exactly how our financial crisis was a run in dealer banks.)

For nearly 100 years we have tried to stop runs with government guarantees – deposit insurance, generous lender of last resort, and bailouts. That stops runs, but leads to huge moral hazard. Giving a banker a bailout guarantee is like giving a teenager keys to the car and a case of whisky. So, we appoint regulators who are supposed to stop the banks from taking risks, in a hopeless arms race against smart MBAs, lawyers and lobbyists who try to get around the regulation, and though we allow – nay, we encourage and subsidize –expansion of run-prone assets.

In Dodd-Frank, the US simply doubled down our bets on this regime. The colossal failure of Europe’s regulators to deal with something so simple and transparent as looming sovereign risk hints how well it will work. (European banks have all along been allowed to hold sovereign debt at face value, with zero capital requirement. It’s perfectly safe, right?)

The guarantee – regulate - bailout regime ends eventually, when the needed bailouts exceed governments’ fiscal resources. That’s where Europe is now. And the US is not immune. Sooner or later markets will question the tens of trillions of our government’s guarantees, on top of already unsustainable deficits.

What financial system will we reconstruct from the ashes? The only possible answer seems to me, to go back to the beginning. We’ll have to reconstruct a financial system purged of run-prone assets, and the pretense that nobody holds risk. Don’t subsidize short-term debt with a tax shield and regulatory preference; tax it; or ban it for anything close to “too big to fail.” Fix the contractual flaws that make shadow-bank liabilities prone to runs.

Here we are in a golden moment, because technology can circumvent the standard objections. It is said that people need liquid assets, and banks must borrow short and lend long to provide such assets. But now, you could pay for coffee with an electronic transfer of mutual fund shares. The fund could hold stocks, or mortgage backed securities. Nobody ever ran on a (floating-NAV) mutual fund. With instant communication, liquidity need no longer coincide with fixed value and first-come first-serve guarantees. We also now have interest-paying reserves. The government can supply as many liquid assets as anyone wants with no inflation. We can live the Friedman rule.

Short-term debt is the key to government crises as well. Greece is not in trouble because it can’t borrow one year’s deficits. It’s in trouble because it can’t roll over existing debt. Governments can be financed by coupon-only bonds with no principal repayment, thereby eliminating rollover risk and crises. The new European treaty, along with wishing governments would mend their spending ways, should at least insist on long-maturity debt.

You may say this is radical. But the guarantee – regulate – bailout regime will soon be gone. There really is no choice. The only reason to keep the old regime is to keep the subsidies and bailouts coming. Which of course is what the banks want.

On to the US: Why are we stagnating? I don’t know. I don’t think anyone knows, really. That’s why we’re here at this fascinating conference.

Nothing on the conventional macro policy agenda reflects a clue why we’re stagnating. Score policy by whether its implicit diagnosis of the problem makes any sense: The “jobs” bill. Even if there were a ghost of a chance of building new roads and schools in less than two years, do we have 9% unemployment because we stopped spending on roads & schools? No. Do we have 9% unemployment because we fired lots of state workers? No.

Taxing the rich is the new hot idea. But do we have 9% unemployment – of anything but tax lawyers and lobbyists – because the capital gains rate is too low? Besides, in this room we know that total marginal rates matter, not just average Federal income taxes of Warren Buffet. Greg Mankiw figured his marginal tax rate at 93% including Federal, state, local, and estate taxes. And even he forgot about sales, excise, and corporate taxes. Is 93% too low, and the cause of unemployment?

The Fed is debating QE3. Or is it 5? And promising zero interest rates all the way to the third year of the Malia Obama administration. All to lower long rates 10 basis points through some segmented-market magic. But do we really have 9% unemployment because 3% mortgages with 3% inflation are strangling the economy from lack of credit? Or because the market is screaming for 3 year bonds, but Treasury issued at 10 years instead? Or because 1.5 trillion of excess reserves aren’t enough to mediate transactions?

I posed this question to a somewhat dovish Federal Reserve Bank president recently. He answered succinctly, “Aggregate demand is inadequate. We fill it. ” Really? That’s at least coherent. I read the same model as an undergraduate. But as a diagnosis, it seems an awfully simplistic uni-causal, uni-dimensional view of prosperity. Medieval doctors had four humors, not just one.

Of course in some sense we are still suffering the impact of the 2008 financial crisis. Reinhart and Rogoff are endlessly quoted that recessions following financial crises are longer. But why? That observation could just mean that policy responses to financial crises are particularly wrongheaded.

In sum, the patient is having a heart attack. The doctors are debating whether to give him a double espresso or a nip of brandy. And most likely, the espresso is decaf and the brandy watered.

So what if this really is not a “macro” problem? What if this is Lee Ohanian’s 1937 – not about money, short term interest rates, taxes, inadequately stimulating (!) deficits, but a disease of tax rates, social programs that pay people not to work, and a “war on business.” Perhaps this is the beginning of eurosclerosis. (See Bob Lucas’s brilliant Millman lecture for a chilling exposition of this view).

If so, the problem is heart disease. If so, macro tools cannot help. If so, the answer is “Get out of the way.”

People hate this answer. They want to know “what would you do?” What’s the bold new plan? What’s the big new idea? Where is the new Keynes? They want FDR, jutting his chin out, leading us from the fear of fear itself. Alas, the microeconomy is a garden, not an army. It grows with property rights, rule of law, simple and non-distorting taxes, transparent rules-based regulations, a functional education system; all of George’s “simple obvious steps,” not the Big Plan for the political campaign of a Great Leader.

You need to weed a garden, not just pour on the latest fertilizer. Our garden is full of weeds. Yes, it was full of weeds before, but at least we know that pulling the weeds helps.

Or maybe not. This conference, and our fellow economists, are chock full of brilliant new ideas both macro and micro. But how do we apply new ideas? Here I think we economists are often a bit arrogant. The step from “wow my last paper is cool” to “the government should spend a trillion dollars on my idea” seems to take about 15 minutes. 10 in Cambridge.

Compare the scientific evidence on fiscal stimulus to that on global warming . Even if you’re a skeptic, compared to global warming, our evidence for stimulus – including coherent theory and decisive empirical work – is on the level of “hey, it’s pretty hot outside.” And compared to mortgage modification plans, strange “unconventional” monetary policy, the latest creative fix-the-banks plan, and huge labor market interventions, even stimulus is well-documented.

There are new ideas and great new ideas. But there are also bad new ideas, lots of warmed over bad old ideas, and good ideas that happen to be wrong. We don’t know which is which. If we apply anything like the standards we would demand of anyone else’s trillion-dollar government policy to our new ideas, the result for policy, now, must again be, stick with what works and the stuff we know is broken and get out of the way.

But keep working on those new ideas!

How to destroy the middle class

In a splendid recent editorial piece, The New York Times  distilled every bad idea floating around the liberal policy agenda.

A few choice moments:

“Economic growth alone, … would not be enough to restore the middle class”…“To lift wages requires generous tax credits for low earners, a higher minimum wage, and guaranteed health care” … “Job training efforts" 

That is, after all, how our ancestors got off the farm.

”…the [jobs] bill recently filibustered by Republicans would have created an estimated 1.9 million jobs in 2012.“

I didn’t know the tooth fairy was making economic "estimates” these days.

…“unrelenting political pressure for principal write-downs of underwater loans, expanded refinancings for borrowers in high-rate loans, and forbearance for unemployed homeowners." 

Econ 101 quiz. What happens to the unemployment rate if you don’t have to pay your mortgage so long as you don’t get a job?

”..all forms of income to be taxed at the same rates"

That means dividends and capital gains at the 39.5%  rate. Well, at least it’s consistent. If you don’t believe in saving and investment, taxing the heck out of them should do the trick.  

 "a financial transactions tax.“…"high-end tax increases.. to control the deficit”.…  “public education, Social Security, unions, child care, affirmative action and, not least, campaign finance reform”

Read on, (how to destroy the) “Middle Class Agenda” at the New York Times

A continent of bad ideas

Why does noone see that Europe can have a nice currency union without fiscal union? I tried to put together this and some of the other bad ideas that I think are clouding the euro crisis debate in this post on the IGM/Bloomberg “business class” blog.

By artful application of bad ideas, Europe has taken a plain-vanilla sovereign restructuring and turned it into a banking crisis, a currency crisis, a fiscal crisis, and now a political crisis..

Read more here