Weird stuff in high frequency markets

On the left is a graph from a really neat paper, “Low-Latency Trading” by Joel Hasbrouck and Gideon Saar (2011). You’re looking at the flow of “messages”–limit orders placed or canceled–on the NASDAQ.  The x axis is time, modulo 10 seconds. So, you’re looking at the typical flow of messages over any 10 second time interval.

As you can see, there is a big crush of messages on the top of the second, which rapidly tails off in the milliseconds following the even second. There is a second surge between 500 and 600 milliseconds.

Evidently, lots of computer programs reach out and look at the markets once per second, or once per half second. The programs clocks are tightly synchronized to the exchange’s clock, so if you program a computer “go look once per second,” it’s likely to go look exactly on the second (or half second). The result is a flurry of activity on the even second.

 It’s likely the even-second traders are what Joel and Gideon call “Agency traders.” They’re trying to buy or sell a given quantity, but spread it out to avoid price impact. Their on-the-second activity spawns a flurry of responses from the high frequency traders, whose computers monitor markets constantly.

There’s a natural question: Is this an accident, or is there intentional “on the second” bunching? You can see that a programmer who didn’t think about it would check once per second, not realizing that means exactly on the top of the second. But sometimes there is more liquidity when we all agree to meet at the same time. Volume has always been higher at the open and close.  Joel and Gideon show the pattern lasted from 2007 to 2008, so was not an obvious short-term programming bug.  (Do notice the vertical scale however. The range is from 9 to 13, not 0 to 13.) I’d be curious to know if it’s still going on.

Here’s another one, found by one of my students on nanex.net here. (Teaching has many benefits when the students know more about markets than you do!).

You’re looking at bids, asks, and (white dot) trades in the natural gas futures markets. From nanex:

On June 8, 2011, starting at 19:39 Eastern Time, trade prices began oscillating almost harmonically along with the depth of book. However, prices rose as bid were executed, and prices declined when offers were executed …..price oscillates from low to high when trades are executing against the highest bid price level. After reaching a peak, prices then move down as trades execute against the highest ask price level. This is completely opposite of normal market behavior….It’s almost as if someone is executing a new algorithm that has it’s buying/selling signals crossed. Most disturbing to us is the high volume violent sell off that affects not only the natural gas market, but all the other trading instruments related to it.

I’m generally give efficient markets the benefit of doutbt, but it’s hard not to suspect that some programming bugs are working against each other here. It’s hard enough to debug a program to work alone, but when 17 programs work against each other all sorts of interesting weirdness can spill out. I am reminded of work in game theory in which computer programs fight out the prisoner’s dilemma and all sorts of weird stuff erupts. If so, this will settle down, but it may take a while.

The Economist reports an interesting related story.

ON FEBRUARY 3RD 2010, at 1.26.28 pm, an automated trading system operated by a high-frequency trader (HFT) called Infinium Capital Management malfunctioned. Over the next three seconds it entered 6,767 individual orders to buy light sweet crude oil futures… Enough of those orders were filled to send the market jolting upwards.

A NYMEX business-conduct panel investigated what happened that day…. Infinium had finished writing the algorithm only the day before it introduced it to the market, and had tested it for only a couple of hours in a simulated trading environment to see how it would perform. …. When the algorithm started its frenetic buying spree, the measures designed to shut it down automatically did not work. One was supposed to turn the system off if a maximum order size was breached, but because the machine was placing lots of small orders rather than a single big one the shut-down was not triggered. The other measure was meant to prevent Infinium from selling or buying more than a certain number of contracts, but because of an error in the way the rogue algorithm had been written, this, too, failed to spot a problem. ..

High frequency trading presents a lot of interesting puzzles. The Booth faculty lunchroom has hosted some interesting discussions: “what possible social use is it to have price discovery in a microsecond instead of a millisecond?” “I don’t know, but there’s a theorem that says if it’s profitable it’s socially beneficial.” “Not if there are externalities” “Ok, where’s the externality?” At which point we all agree we don’t know what the heck is going on.

There is also the more prosaic question whether high frequency traders “provide liquidity” and thus are in some sense beneficial to markets, or if they are somehow making markets worse. A question for another day (there is some interesting new research).

There are lots of reports of how profitable it is. But high frequency trading is a zero sum game. Anything you do in milliseconds can only talk to another computer. By definition, they can’t all be making money off each other.

Hope for Europe

A provocative Wall Street Journal OpEd by Donald Luskin and Lorcan Kelly gives me hope for Europe.

No, I’m not talking about Greece, and the latest bailout deal. That’s more of the usual charade. But in the end Greece is small. Europe can bail Greece out if they feel like it; or let it default.Or let it rot, which seems where they are headed. 

Italy and Spain are where the real issue lies. Italy and Spain are too big to bail.

Growth is the only hope for paying back large government debts. “Growth” to an economist means long-run growth, growth that lasts decades. Even the most hard-bitten Keynesian, if honest,  has to admit that “stimulus” does not produce long-run “growth."   Growth comes from more people or more productivity. Period. Italy and Spain can only grow if they free up their markets, clean up their tax systems, put themselves quite a few notches higher on the list of good places to do business.

Growth  is also essential for solving the more immediate debt problems. Italy and Spain need to roll over debts. Markets can be quick to do that, and even lend more, if they see countries have good long-run growth prospects. Markets will stay away as long as they do not see a coherent plan for long-term growth. ("Growth” is distinct from “austerity.” “Austerity” means high and distorting taxes, spending cuts but no liberalization of the economy. This quickly runs the economy into a death spiral as people and money leave.)

I had long thought that like the Greeks – or, increasingly, like the Americans – Italy, Spain and the rest of Europe (Belgium? France?) simply did not have the will to free their economies. If so, Europe seemed to me destined for a huge bout of inflation. The ECB is basically buying up the debt (via the banks); if the debt can’t be bailed out, defaulted on, or repaid, it must end up with inflation.

But, as Luskin and Kelly point out, I may have for once been too Grumpy. Mario Monti, Italy’s prime minister, is on a rampage of liberalization. They quote him, growth “will have to come from structural reforms or supply-side measures.” Spain’s prime minister Mariano Rajoy is headed in the same direction. Monti and Rajoy recognize that companies will only hire people if they can later fire them; that barriers to entry for all the professions (“from pharmacy and baking to taxi-driving”) just drag down the economy, that state industries don’t provide “jobs,” but instead suck the lifeblood out of growth.

Will they get there? Will they reestablish growth soon enough to get the bond markets to roll over debt, or pay back the ECB before it needs to unwind its purchases to avoid inflation? It will be dicey. There is a lot of entrenched opposition to liberalization – which is why obviously good ideas have such a hard time being implemented for decades. But, as my mayor once said, a crisis is a terrible thing to waste. Maybe Monti and Rajoy can achieve the needed “grand bargains.”

What is remarkable – what gives me hope –  is that they are even talking about “supply side” growth measures and liberalization at all!

The Conventional Wisdom makes no connection between stifling labor market regulations and a debt crisis. The debt crisis is about “confidence” and “contagion,” to be met with bailout funds, “firewalls,"  financial engineering,  and ECB debt schemes.

For example, in her most recent speech, IMF Director Christiane Lagarde recommends that "stronger growth"  come first of all from "additional and timely monetary easing.” Then, “raising [bank] capital levels” (Note the usual passive policy voice – who does this raising and how? Translation: taxpayers give money to banks.) Then, “maintaining orderly funding conditions” whatever that means. (Watch your wallet.)

She warns that “ On fiscal policy, resorting to.. budgetary cuts will only add to recessionary pressures…those with fiscal space should support the common effort by reconsidering the pace of adjustment planned for this year.” Translation: Economies with stratospheric debt/GDP ratios need just a little more fiscal stimulus. As St. Augustine lamented,  Lord give me frugality, but not quite yet.

The bond market?  She wants a  “larger firewall.… Adding substantial real resources..folding the EFSF into the ESM, increasing the size of the ESM,..” Then, “Action by the ECB to provide the necessary liquidity support to stabilize bank funding and sovereign debt markets would also be essential.” Translation: ECB to buy debt with printed Euros. 

Eventually, yes, “some countries still have much to do to boost their competitiveness and growth potential.” Some? What, most of Europe is right on its “growth potential? And finally, at the very end, ”..structural reforms are critical, however medium or long-term their impact might be. … fiscal sustainability depends, ultimately, on generating long-term growth.“ Four or five years down the line, maybe, meekly approach Italy’s unions and government-run industries with a request for "structural reforms.” Sure, that’s going to work. 

I don’t mean to pick on Lagarde. Her speech is just a good example of global bien-pensant policy Conventional Wisdom. I’m sure everyone murmurs this sort of thing at Davos.  Grumpy’s favorite columnist, Paul Krugman is, believe it or not, arguing for more spending and stimulus across Europe. I’m not exactly clear how he wants Italy, Spain, Portugal or Greece to borrow more money to spend it. Budget constraints are never the forte of Keynesian economics. He seems to saying that  multipliers are so large that spending is self-financing:  “Because spending cuts have deeply depressed their economies, undermining their tax bases to such an extent that the ratio of debt to G.D.P.” It’s either that or the Easter bunny: I don’t see bond markets ponying up more stimulus. But “growth,” tackling absurd regulations, unions, labor market rigidity denying employment to a generation of Italians and Spaniards… that’ s not even on his agenda.

In this noxious intellectual environment, it is remarkable and praiseworthy that Monti and Rajoy are putting “supply side growth” on the front burner at all; that they make a connection between a debt crisis and sclerotic microeconomics. This is a Reagan / Thatcher moment, when courageous politicians may seize the moment of crisis to jump to the long run; let their economies grow and pay off a mountain of debt, ignoring the Conventional Wisdom. It could happen. Or not, but at least there finally is hope.  

In bocca al lupo (“good luck” in Italian – and, literally, “into the mouth of the wolf,” an unusually apt expression) Signor Monti!

Taylor on Lehman and TARP

John Taylor took the trouble to respond to Paul Krugman’s latest outrage on the sources of the financial crisis.  Taylor’s post – along with the deeper analysis he points to – is well worth reading.

Krugman’s calumnies are so nonsensical I generally do not find it worth responding.

The idea that I now like stimulus is simply preposterous if you bother to read what I write about it. (Here, here and here.)  The idea that I or John Taylor don’t think there was a run is even more preposterous.  (One of many examples here, p. 7: “Why was there such a large fall in output? For once in macroeconomics we actually have a good idea what  the shock was—there was a ‘‘run’’ in the shadow banking system.”)

To top it off, Krugman writes “Anyone else have the impression that something happened in the second half of September 2008?” I mean really, accusing Taylor and myself of thinking that nothing happened in September 2008? Are Krugman’s readers such simpletons that they fall for such unvarnished falsehoods?

Taylor did us a service by taking the time to straighten this one out.

Yes there was a run.

Taylor’s detailed work shows what many of us sensed: That the run was not triggered by Lehman’s bankruptcy. Instead a good part of the run can be laid at the feet of Treasury Secretary Paulson, who showed up on national TV asking for 700 billion dollars, with three sheets of paper in front of him, no clear explanation of what he wanted to do with the money, and with a hastily-imposed short-sale ban on bank stocks. How to Cause A Run 101.

More importantly, Taylor’s work also puts to rest Krugman’s idea (last sentence) that Lehman caused or threatened a chain of bankruptcies. Ed Lazear puts it nicely: it wasn’t dominoes, it was popcorn.

That’s what a run is. When a piece of news comes out that banks may be in trouble,  people pull their money out of all the banks at the same time.  Krugman is being simply incoherent in first calling it a run and then a threatened chain of bankruptcies only saved by further bailouts.

In fact, the run is central to my view of the crisis and its lessons. I doubt Krugman has thought through the implications carefully, along with the distinction between dominoes and popcorn, as they run directly counter to his worldview.

Runs don’t have a single cause, they have a straw that broke the camel’s back. Ask yourself, would simply bailing out Lehman have avoided this whole mess? Obviously not.  People saw Lehman go under – and Paulson’s speech, plus short-sale ban, plus everything else going on at the time – and asked themselves, “gee, my bank was investing in the same things Lehman was. I wonder how they’re doing? I’d better pull my money out just to be safe.”   (“People” here means institutional investors in the shadow-banking system, i.e. prime-brokerage customers, repo investors, derivatives counterparties, asset-backed security investors.)

In the circumstances of Fall 2008, suppose that the government had announced a big Lehman bailout, especially along with Paulson’s speech. Well, you come to just about the same worries about your own bank, as if Lehman had not been rescued, don’t you? If they had to rescue Lehman, they must have been in real trouble. I wonder if my bank is in similar trouble?

Actually it would have been worse. such a bailout would have also come with a howl of protest, and it was clear that the bailouts would have to end somewhere, and the next one would be bigger.  AIG? Citigroup? Hmm, let’s take our money out extra special fast as a big blowup is coming this way.

The insight that it was a run is central to my view of  how to fix things. If it was a run, echoing, as Krugman says, Friedman and Schwartz’s view of the Great Depression, then some of Friedman and Schwartz’s conclusions are surely warranted! No, this was not some mysterious failure of  capitalism and we need to have the Fed run everything under Dodd-Frank. No, this does not require that we save every big institution and protect them from competition and failure forever. This was one run very like the many runs and panics we’ve seen throughout history.

Our run was in the shadow-banking system. I recommend Darrel Duffie’s “Failure mechanics of dealer banks,” the article  and the book  Once you read these, you naturally see simple ways in which we can fix bankruptcy law and run-prone assets in place of Dodd-Frank. How, exactly? That’s a subject for another post – actually a long series – coming up.

Yes it was a run. And that fact leads directly to some very un-Krugmanlike conclusions.

(If you want to read what I actually have written so far about this issue it’s all here. I’m teaching a class this week on financial crisis – we’re going to spend a lot of time on Duffie and Gary Gorton’s analysis of the run in repo markets.)

Fed Independence 2025

Headline: The Fed just  forced mortgage servicers  that got caught submitting “documents that were not properly notarized,” among other sins, to cough up money towards principal reduction, for people unaffected by the notarization scandal, as well as to fund “nonprofit housing counseling organizations” and other policy objectives. 

Deeper question: What will the Fed look like in 2025? How long can it stay independent as it takes on more and more power, and uses that power for these kinds of political policy actions?

Act 1:  Three recent news items add up to a scary picture.

Item 1: Led by the White House, the state Attorneys General announced their “settlement” with banks.

Here’s what happened. Suzie, Bob, and Joe each bought  $300,000 houses, that are now worth $200,000. Suzie stopped paying, and was foreclosed.  Bob borrowed $280,000, so he’s “underwater,” but he likes his house, doesn’t want to ruin his credit, and is still paying his mortgage.  Joe only borrowed $200,000 and is also still paying.

The banks got caught robo-signing Suzie’s paper work. The Administration and Attorneys General (with the laudable exception of Oklahoma) used the threat of prosecution to get the banks to lower Bob’s principal by $20,000. Suzie might get a small check. Joe gets nothing.

There is a story for doing this. Bob might decide to stop paying his mortgage, forcing the bank to foreclose. The foreclosure might lower the value of his neighbor’s property.

There are also costs. This money comes from somewhere – the mortgage investors, the bank equity holders, or eventually the taxpayers. Maybe they had better things to do with $20,000. Maybe banks and investors, seeing their contracts torn up ex-post by the government, are going to be a whole lot more careful about who they lend to in the future. We live in a time of 3.5% mortgages that nobody can seem to get. To say nothing of the blatant unfairness, and moral hazard, of giving Bob this little present for taking out a huge loan, or the larger moral hazard of using the threat of prosecution for procedural errors to force anyone to cough up money towards unrelated policy goals.

As you can guess, I think it’s a rotten idea. The Fed’s own White Paper on Housing puts the ineffectiveness of the policy and its costs better than I can, citing the relevant research. Look at the top of p. 21.

But that’s not important here. Even if you think it was a great idea, you have to admit it is a controversial policy, one on which there is likely a strong partisan divide. You also have to admit that the Administration threatened the banks with prosecutions to force them to finance a  policy goal having nothing to do with the actual legal case.

Ok, that’s the kind of tough hardball that the executive branch plays. Which is why, in our society,  they have to face the voters.

Item 2: The Federal Reserve thinks foreclosures and underwater mortgages are a big problem too, and has been cheering the Administration’s various mortgage-modification programs.  See Governor Elizabeth Duke’s Speech on September 1, or Ben Bernanke speech on February 10, titled “Rebalancing the Housing Market” – a new job for the Fed – or the Fed’s extensive White Paper on Housing. (Actually, reading this stuff, the Fed seems much more keen on “government-facilitated rent-to-own programs,” but that’s an intervention for another day.)

Item 3: In case you missed it, the Federal Reserve is taking on regulation of financial institutions at a very detailed level. I reviewed its massive plan to regulate large banks in an earlier oped and blog post The Fed just announced its plans to actually go forward and “designate” non-banks as “systemically important” and subject to its mercies as well. Together with the new “Consumer Financial Protection” bureau, located in the Fed, the Fed can and will tell large banks what to do at an amazingly detailed level.

Let’s put two and two together. How long will it be until the Fed starts acting like the Administration. “Nice bank you have there. Wouldn’t want anything to happen to it. Those consumer financial protection nerds can be a real pain in the butt, can’t they? To say nothing of those wonks down in the systemic risk department. Say, we notice you’re still sitting on a lot of reserves, and nobody’s lending to support the housing market in Detroit. Sure would be nice if you pitched in and helped a bit. And why aren’t you writing down mortgages instead of foreclosing on all those houses?”

I don’t mean to ascribe any bad motives here. The people I know at the Fed are all well-meaning and really smart.  The problem is the power. If you really believe that “the market is not functioning as it should.” (Elizabeth Duke, Sept 1), i.e. that the housing markets are impeding recovery, and that banks could do a lot about it;  if your institutional mandate includes micromanaging the state of the economy by watching individual markets, and detailed regulation of bank’s activities,  the outcome is inevitable: You will soon be using your regulatory power to force the banks to accomplish policy goals.

Act 2: It’s already happening

As I was writing this, I thought I was writing one of my usual doom-and-gloom worries about  the far-off future. Browsing the Fed’s website, it turns out it’s already happening.  For the Fed is a party to the Administration’s deal, and is using its banking supervision powers to force mortgage reductions.

The Fed announced its actions in a February 9 press release 

The Federal Reserve Board …has reached an agreement in principle with five banking organizations regarding the issuance of monetary sanctions against the organizations totaling $766.5 million. The monetary sanctions would be assessed for unsafe and unsound processes and practices in residential mortgage loans servicing and foreclosure processing.

… the Board is acting in conjunction with a comprehensive settlement agreed in principle between the five banking organizations, the state Attorneys General, and the Department of Justice on February 9, 2012 (“Settlement Agreement”). The Settlement Agreement requires these organizations to provide $25 billion in payments and other designated types of monetary assistance and remediation to residential mortgage borrowers. 

It’s right there in print:

1) The Fed is using its banking supervision powers, to call the robosigning scandals “unsafe and unsound” banking practices.

2) The Fed is acting in conjunction with the Administration – so much for independence and standing outside of politics.

3) The Fed is forcing the banks to write down mortgages and provide other “assistance,” policy goals unrelated to the actual “unsound processes and practices." 

The details, in the followup Feburary 13 press release are even more astonishing. Reading from the Ally Financial settlement,

WHEREAS, the Mortgage Servicing Companies [Ally Financial Subsidiaries], … allegedly:

(a) Filed or caused to be filed…numerous affidavits.. making various assertions, such as the ownership of the mortgage note and mortgage, the amount of principal and interest due, and the fees and expenses chargeable to the borrower, in which the affiant represented that the assertions in the affidavit were made based on personal knowledge or based on a review by the affiant of the relevant books and records, when, in many cases, they were not based on such knowledge or review;

(b) Filed or caused to be filed in courts… numerous affidavits and other mortgage-related documents that were not properly notarized,..

© Litigated foreclosure and bankruptcy proceedings… without always confirming that documentation of ownership was in order at the appropriate time, including confirming that the promissory note and mortgage document were properly endorsed or assigned and, if necessary, in the possession of the appropriate party…

Heavens, what a scandal…Documents not properly notarized! Notice it does not even "allege” that anyone was actually kicked out of a house who was paying their mortgage.

WHEREAS, as part of the Settlement Agreement the Ally Parties agreed to provide consumer relief, which may include mortgage principal reductions or refinancing, and other assistance to certain residential mortgage borrowers (the “Borrower Assistance”)

NOW, THEREFORE, ..and solely for the purpose of settling this matter without a formal proceeding being filed and without the necessity for protracted or extended hearings or testimony, it is hereby ORDERED by the Board of Governors,… that:

1. Ally Financial, ResCap, and the Mortgage Servicing Companies are hereby jointly and severally assessed a CMP [civil monetary penalty] in the amount of $207,000,000…

2. …the Board of Governors shall remit up to $207,000,000 of the CMP by an amount equivalent to the aggregate dollar value of the Borrower Assistance provided….

3. .. the Board of Governors shall also remit up to $207,000,000 of the CMP… by an amount equivalent to the aggregate amount funds expended by Ally Financial, ResCap, and the Mortgage Servicing Companies on funding for nonprofit housing counseling organizations, approved by the U.S. Department of Housing and Urban Development, to provide counseling to borrowers who are at risk of or are in default or foreclosure, or to provide assistance to borrowers in connection with the independent foreclosure reviews required by the Consent Order…

Again, right there in print:

1) Ally is to provide “relief” to borrowers, not victims of the lack of notarization.

2) They’re doing it to avoid the threat of huge legal bills.

3) Legally, the Fed can’t tell Ally to write people checks. So, the Fed is  going to levy a $207 million penalty because Ally’s lack of notarization is an “unsafe and unsound” practice. Then the Fed will “reduce the penalty” by exactly the amount that Ally spends on “borrower assistance.”

4) It’s not just writedowns,  but all the hilarious stuff in the last paragraph – “funding for nonprofit housing counseling organizations!” Stuff that the Administration wouldn’t dare put in a budget it sent to Congress.

It’s a bit puzzling that the Fed signed on to this agreement, actually. As above, the White Paper on Housing and Fed official’s speeches are pretty negative on mortgage writedowns. One sniffs a lot of pressure coming form the White House.

Which is the danger, for the Fed, of getting involved in these policies at all: Who knows what great ideas the Santorum Administration will have for the Fed to “support manufacturing,” or the Romney Administration will have for its idiotic “day 1” currency war with China?  Now we know what the Fed is,  it is only a matter of the price. It would be have been far better for the Fed to say, “as the price of our independence, we’re not allowed to do things like this.”
     
Act 3: Independence

The Fed is set up to be politically independent, and central bank independence is a cherished principle of monetary economists.

Academics typically think the Fed’s main job is to control short-term interest rates: too high and we get unemployment, too low and we get inflation. Fed "independence" helps it to make this decision without too much political interference. Such interference might skew the decision to temporary stimulus at the expense of long-term inflation.

Before the financial crisis, thinking around the world was moving towards the idea that the central bank’s job is really just to control inflation. Efforts to micromanage the economy  were largely seen as illusory.  This view was embodied in the ECB’s mandate and many “inflation-targeting” regimes. The whole banking supervision part of the Fed was a separate backwater, unrelated to the Fed’s macroeconomic policy roles.

That all seems so quaint now. The Fed is now the Gargantuan Financial Regulator, as well as Controller and Stimulator of the Macroeconomy.  Its macroeconomic role is increasingly the Supporter of Particular Markets and the Allocator of Credit. It’s also getting in to the business of running whole markets, i.e. the details of how mortgages are written and serviced. And it’s loudly cheering for particular Administration policies such as mortgage modifications. Monetary policy is way down the list.

The price of independence is limited power. Central banks that only try to control inflation, and only using one tool, such as purchases and sales of Treasury debt, can be walled off from the political process. As a country, we can decide that the price level will not be used for political purposes and assign its maintenance to technocrats.

The Fed was assigned great power after the financial crisis. It’s more competent than most of the other agencies, and as a result of its historic independence can act with great power. But this situation cannot last. The Federal Reserve cannot command that one group of voters cough up $20,000 checks to another group of voters, and not expect those voters to want a say in the matter. Locating financial regulation in the Fed may turn out to have been a terrible idea.

What to do? Good question. My preferred answer would be to save the independence, competence, and a-political nature of the Federal Reserve. That means breaking up its functions. Focus monetary policy on the price level, and stop pretending to micromanage activity. In any case, separate monetary policy from financial regulation – break the institution up so that financial regulation tools cannot be used to promote macroeconomic policy goals, except by direct political intervention, by politically accountable officials.

The alternative is to bring the whole of the Federal Reserve’s activities under much more direct control and accountability to elected officials. I have no more faith in the wisdom of elected officials than the next person, so I foresee a politicized Fed will be disastrous. But our society is not built on faith in the wisdom of an unaccountable aristocracy with huge power and no supervision. That will be even more disastrous. That’s where the Fed is going, and it cannot last.

Where your money goes

Two nice graphs from the New York Times 

Comment: Now, could we please stop talking about how we need more taxes to pay for roads and bridges or to help the poor? The main function of our government is to write checks to middle-class and wealthy voters. And that’s the reason its finances are in the toilet.

This means Elizabeth Warren, for example, who said a factory owner needs to pay more taxes because “you moved your goods to market on the roads the rest of us paid for; you hired workers the rest of us paid to educate; you were safe in your factory because of police forces and fire forces that the rest of us paid for.” Answer: you paid for that long ago. That’s not where the money is going.

This means  Robert Frank, whose NYT “Economics view” argued  for  “higher taxes needed for improved infrastructure” and claimed “when the anti-tax wealthy make campaign contributions, they are buying only the deeper potholes and dirtier air that inevitably result when tax revenue is low.” No, that’s not where the money is going either.

(Frank’s article is hilarious in another way. Higher taxes are fine, he says, because more money won’t make you feel better when everyone around you is wealthier too. Too much low-hanging fruit there, just go read it and have a laugh. Or shake your head in amazement. No, he’s not joking.)

The point, today, is not whether these checks are a good idea. The point is just this: let’s argue honestly about the actual issue. Ms Warren, Mr. Frank, and company: argue wholeheartedly that you want higher taxes to keep the checks coming and write more of them. Opponents: argue the opposite. But leave the roads, bridges, the poor and the environment out of the debate over higher taxes.

Nor am I being heartless. I think we should be doing more to help the genuinely poor, especially the mentally ill that wander the streets of Chicago. I like roads and bridges as much as the next guy (though I must note that building more highways is a very recent liberal priority!) But these priorties are just irrelevant to the current taxation and spending debate.

PS. Of course the Times article was trying to make the opposite point – that all these middle-class recipients of government largesse were being silly for not supporting politicians who promised to give them more money. The idea that these hearty middle class people were actually smarter than Times writers, and saw that the system would soon break down, did not occur to the Times.

Wallison on financial regulation

Peter Wallison has an important Op-Ed in the Wall Street Journal last week (AEI link) titled “Dodd-Frank and the Myth of Interconnectedness”

The chain of bankruptcies is one of the central myths of the financial crisis. A owes money to B,  B owes money to C, C owes money to D. If A fails, it wil result in a chain of bankruptcies where B, C,  and D fail too.

As Peter points out, it simply did not happen. We had a run, not a chain of bankruptcies.
A (L actually!) failed, investors noticed that B, C and D were invested in many of the same things, and stopped lending to B, C and D; B, C  and D also stopped lending to each other. Everyone tried to buy Treasuries. Since the banks were funding themselves by overnight debt, they were supremely exposed to such a run.  

Getting it wrong matters. To produce a sensible regulation of the financial system, it helps to have a vaguely coherent idea of what happened – and what did not happen. The Dodd-Frank/Fed approach seems to be “we don’t know what happened, really, so we’ll just regulate everything that moves.”

On the chain of bankruptcies theory, and as directed by Dodd-Frank, the Fed is getting ready to monitor and regulate all links between “systemically important” institutions, and implement regulatory limits on their cross-exposures. I reviewed  this in an earlier WSJ oped, and pointed out how fairly hopeless the effort is.

The central idea of Dodd Frank, which the Fed is now endorsing and implementing, comes down to this:  no “large,” “systemically important,” “interconnected,” or whatever (nobody knows what these words mean) will be allowed to fail. The Fed will be looking over their shoulders the whole time.

That approach will necessarily mean protecting them from competition. How else do you make sure they’re “strong,” and will never get in trouble? And it’s only a matter of time that “policy goals” get enmeshed with “regulation.” See last week’s agreement whereby banks agreed to lower principal amounts on one group of homeowners, as “settlement” against their paperwork problems with another completely unrelated group. The Fed is pushing hard for banks to “do more” for housing… you can see where this will go fast. 

If, instead, we had a run, as I and Peter believe, that sends you thinking in a completely opposite direction. In my view, it means we need to get rid of the institutional focus – protecting specific “systemically important” institutions – and instead focus on the run-prone assets. Peter seems to lean more to the “common shock” problem. But either line of thought is a long way from what’s going on in the dungeons of the Fed.

The Real Trouble With the Birth-Control Mandate

(This is a Wall Street Journal Op-Ed. If you don’t subscribe, there is a pdf on my webpage.)

When the administration affirmed last month that church-affiliated employers must buy health insurance that covers birth control, the outcry was instant. Critics complained that certain institutions should be exempt as a matter of religious freedom. Although the ruling was meant to be final, presidential advisers said this week that the administration might look for a compromise.

Critics are missing the larger point. Why should the Department of Health and Human Services (HHS) decree that any of us must pay for “insurance” that covers contraceptives?

I put “insurance” in quotes for a reason. Insurance is supposed to mean a contract, by which a company pays for large, unanticipated expenses in return for a premium: expenses like your house burning down, your car getting stolen or a big medical bill.

Insurance is a bad idea for small, regular and predictable expenses. There are good reasons that your car insurance company doesn’t add $100 per year to your premium and then cover oil changes, and that your health insurance doesn’t charge $50 more per year and cover toothpaste. You’d have to fill out mountains of paperwork, the oil-change and toothpaste markets would become much less competitive, and you’d end up spending more.

How did we get to this point? It all leads back to the elephant in the room: the tax deductibility of employer-provided group insurance. 

If your employer pays you $100 less in salary and buys $100 of group insurance for you, you don’t pay taxes on that amount. Hence, the more insurance costs and covers, the less in taxes you seem to pay. (Even that savings is an illusion: The government still needs money and raises overall tax rates to make up the difference.)

To add insult to injury, this tax deduction does not apply to portable, guaranteed-renewable individual insurance. You don’t get the tax break if your employer gives you the $100 and you buy a policy—a policy that will stay with you if you get sick, leave employment or get divorced. The pre-existing conditions crisis is largely a creature of tax law. You don’t lose your car insurance when you change jobs.

Why did HHS add this birth-control insurance mandate—along with “well-woman visits, breast-feeding support and domestic-violence screening,” and “all without charging a co-payment, co-insurance or a deductible"—to its implementation of a provision of the new health-care reform law? "Because it promotes maternal and child health by allowing women to space their pregnancies,” says the HHS advisory panel. Because these “historic new guidelines” will make sure “women have access to a full range of recommended preventive services,” says the original HHS announcement. To “increase access to important preventive services,” echoes White House Press Secretary Jay Carney.

Notice the doublespeak confusion of “access” and “cost.” I have “access” to toothpaste because I have two bucks in my pocket and a competitive supplier. Anyone who can afford a cell phone can afford pills or condoms.

Poor women who can’t afford birth control are a red herring in this debate. HHS isn’t limiting this mandate to the poor. We all have to pay. The very poor typically don’t have employer-provided health insurance in the first place.

“Allowing women to space their pregnancies”? Was there some sort of federal ban on birth control before this?

It’s not about “access” and it’s not about “insurance.” It’s because Americans, when paying even modest co-payments, choose to spend their money on other things. They prefer a new iPod to a “wellness visit” to the doctor. As the HHS unwittingly admits: “Often because of cost, Americans used preventive services at about half the recommended rate.”

Remember, we’re supposed to be worrying about skyrocketing health-care expenses. Doubling the number of wellness visits and free pills sounds great, but who’s going to pay for it? There is a liberal dream that by mandating coverage the government can make something free.

Sorry. Every increase in coverage means an increase in premiums. If your employer is paying for your health insurance, he could be paying you more in salary instead. Or, he could be lowering prices and selling his product to you and all consumers more cheaply. Someone is paying. Not even HHS tries to claim that these “recommended preventive services” will lower overall costs.

Here’s a good mandate: Let’s mandate that every time a government official says that the government is going to “help” some category of voter, he or she has to say who they are going to hurt in the same sentence. Because it has to be someone.

But what about the fact, you may ask, that unwanted children are a burden on society as well as to their mothers? Perhaps there is a social interest in subsidizing birth control? Perhaps there is—but if so, this is an awful way to do it.

If pills are “free,” under insurance, the incentive for drug companies to come up with cheaper versions vanishes. So does their incentive to develop safer, more convenient, male-centered or nonprescription birth control. And by making pills free but not condoms, the government may inadvertently be contributing to an increase in sexually transmitted diseases.

The taxes and spending we argue about are the tip of the iceberg. Salting mandated health insurance with birth control is exactly the same as a tax—on employers, on Catholics, on gay men and women, on couples trying to have children and on the elderly—to subsidize one form of birth control.

If the government wants to subsidize birth control, OK, pass an explicit tax, and sensibly subsidize all birth control. And face the voters on it. The tax rate and spending debates that occupy the media are a small part of the effective taxes and spending that the government achieves by these regulatory mandates.

There is also the issue of religious freedom. Our nation is divided on social issues. The natural compromise is simple: Birth control, abortion and other contentious practices are permitted. But those who object don’t have to pay for them. The federal takeover of medicine prevents us from reaching these natural compromises and needlessly divides our society.

The critics fell for a trap. By focusing on an exemption for church-related institutions, critics effectively admit that it is right for the rest of us to be subjected to this sort of mandate. They accept the horribly misnamed Patient Protection and Affordable Care Act, and they resign themselves to chipping away at its edges. No, we should throw it out, and fix the terrible distortions in the health-insurance and health-care markets.

Sure, churches should be exempt. We should all be exempt.

(All health-insurance artilcles and opeds)

Taylor's graphs

John Taylor wrote a very nice blog post, “Reassessing the recovery”. He made two graphs, reproduced here. On the top you see the current recession and recovery. On the bottom you see the typical pattern, exemplified by the biggest previous postwar recession in 1982.

We usually bounce back to the trend line. Now, we’re not.

The difference betwen “levels” and “growth rates” accounts for a lot of confusion in popular discussions. “Recessions” are pretty much defined as times in which GDP is declining – negative growth rates, the level is going down. GDP stopped going down in early 2009.

Yet, as many commentators point out, if the recession is over, why does it feel so glum out there? Answer: because prosperity is measured in levels. Employment responsds to levels. 

The big macroeconoimc question for our time is this: Just why are we stuck at a much lower level? What do we need to do to get back to the trend line? Or is that trend line illusory?

There are two stories – and I use that word advisedly.

1) “Demand.” We’re about a trillion dollars below trend, so the government needs to borrow an additional $750 billion a year (I’m usuing the Keynesian 1.5 multiplier) and blow it on whatever is handy; Solyndras, high speed rail, windmills, any old rathole will do so long as it’s “spent.” (Sorry, I’m not doing a very good job of expounding this position. Not my job.) Or just let it be stolen, as thieves have high marginal propensities to consume. The problem is the intractable thriftiness of American consumers, so the government just needs to spend more, or borrow or tax money and give it to people who will.

Monetary policy is close to powerless now, but promising zero percent interest rates for a decade helps; those 3.5% mortgages that are strangling credit could be brought down to 3.4%.

2) “Supply." Companies are skittish about using incredibly low rates to build new houses or factories. Over-regulation, uncertainty, fear of political interference, labor-market mismatches are holding us back. (Steve Davis, Scott Barker and Nick Bloom have a nice paper that tries to quantify this story.) Boeing’s efforts to start a factory in South Carolia writ large. As a little recent example, the collected attorneys general of several states have got the banks to cave and send foreclosed homeonwers big checks. The banks are certainly going to learn to be much more careful about who they lend to in the future, which has something to do with 3.5% mortgages that nobody seems to qualify for.  There are also stories about housing problems spilling over to the real economy, which I don’t agree with, but are still basically "supply” stories.

The uniting features of “supply” stories is that, even if you think fiscal/monetary stimulus works in general, they won’t work now.
  
In short, is our problem “micro” or “macro,” “supply” or “demand,” a mysteriously lingering business cycle, or the outbreak of a long-term growth slowdown?  I lean to “supply,” but the stories are not really quantified let alone easy to distinguish. Hence the repeated “micro vs. macro” thoughts on this blog.

This matters for all sorts of reasons. All of the projections that show our fiscal problems getting better in the near term before the entitlement bomb hits rely on our quickly closing the gap. If we don’t close the gap, we never make progress on the deficit, and our future looks like Greece a lot sooner.

Monetary policy might help “gaps” but it can’t fight “trends” or “supply.” Jim Bullard, President of the St. Louis Fed, gave an interesting  speech  in Chicago yesterday pointing this out. Though I disagree with his analysis of why we might never get back to trend (housing prices as a “wealth shock”), his basic point is deeper: If the “trend” is illusory, if it represents “supply” that the Fed can do nothing about, then we are in danger of repeating the mistakes of the 1970s, in which the Fed kept chasing optimistic “potential” calculations that were in fact unrealizable by monetary policy.

And of course it matters for people. 5 percent of everybody’s income is a lot of prospertity; 10 more years of slow growth adds up to a lot of lost prosperity.

Sargent on debt and defaults

Tom Sargent’s Wall Street Journal oped is well worth reading closely. It’s a very short summary of his Nobel prize speech

As readers of this blog will probably know, I think Europe should stop bailing out bondholders of Greek and other debt. (See the Euro collection and Euro tags to the right.)

“What about Alexander Hamilton?” has always been a nagging doubt.


Hamilton famously brokered the deal by which the Federal Government assumed state debts. By doing so, he created a group of citizens with a strong interest in the success of the Federal Government. But it was a bailout of the states; it was a bailout of their creditors, many who had bought up debts cheaply. It was explicitly a case of greater “fiscal union."  Perhaps this is Europe’s Hamilton moment?

As Tom points out, there are some important differences. The states had borrowed money to fight the revolutionary war, not to import Porsches or build cozy crony economies and fat welfare states. U.S. Taxation was low everywhere. Even the new Federal taxes were only tariffs, amounting to 2% of GDP, not 50% and up taxation in the Eurozone.  The Federal debt ("Eurobonds”) was backed by directly levied Federal taxes, not by voluntary contributions or even by remittances from member states. And those direct taxes were to be legislated by a directly-elected legislature, not Brussels technocrats.

Tom points to a second episode: the state defaults of the 1830s and 1840s. Here, many states had borrowed a lot to finance infrastructure projects (“canals to nowhere?”) that were not generating enough revenue to pay back the debt. 

Reputation, pre-commitment and moral hazard are big in Tom’s thinking and his account of the sophisticated thinking of our ancestors. The US chose to pay off its revolutionary war debt, according to Tom, to enhance its reputation and credibility as a serious nation and future borrower. But this decision led to moral hazard: states and their creditors believed the US would always bail them out. The US chose not to bail out the states (really, their creditors) the second time around. It suffered a financial crisis as a result, but put state overborrowing and default off the table for a hundred and fifty years.  (When Tom talks about reputation and pre-commitment, he’s not blowing smoke; he understands the equations.)

This second episode strikes Tom as a better antecedent to the Eurozone. Let Greece and the others default precisely to save the euro and European union.  Now is the time to clarify that the no-bailout clause is real, and that the euro will not be inflated. A crisis is the price of not having been clear about that moral hazard up front. But the union project is too important to abandon.

There are lots more  little gems in Tom’s paper. The interaction of monetary and fiscal policy is one; the fact that framers spent all their time on fiscal policy, and money was, as in the constitution, considered just part of the definition of weights and units.

This post is a bit interpretive, and I’m sure I put some words in Tom’s mouth here and there. He’s always scholarly, informative and precise. If so, well, there’s no substitute for the original. 

Important Note: The comments section is running off the rails. Please be polite and stay on topic. You’re welcome to disagree, or point out flaws in my arguments or facts – actually I like that, as I learn something. But if you want to spew venom, go back to Krugman and DeLong’s blogs. I’m going to turn off comments if this doesn’t end asap.

Negative stimulus, 1946

I ran across a fascinating article, “A Post-Mortem on Transition Predictions of National Product,”  in the 1946 Journal of Political Economy, by Lawrence Klein. Klein, who would go on to create the main macroeconomic forecasting models and a Nobel Prize, was  confronting one of the first great failures of Keynesian economics:

We all recall clearly the headlines in last Autumn’s press, declaring that “Government economists predict 8 million unemployed by 1946.” …We now find ourselves in the first half of 1946 with about three million unemployed and facing one of the greatest inflationary pressures that we have ever experienced. The economists who were warning us of a deflationary danger during the early months of the postwar transition period should have been stressing precisely opposite economic policy

Yes indeed. Government spending, or “stimulus” in the modern lingo, was certainly going to fall like a stone at the end of the war. 8.5 million young men would be dumped on the labor market. With a Keynesian mindset the forecast was obvious: we’re going right back to the depression. Instead, we got sharp inflation and a boom.Where did they go wrong? This event has been covered in more depth, but let’s keep reading Klein’s analysis…

The customary model for prediction can be called the simplest Keynesian model…The model can be written as GNP=C(GNP)+I, where GNP = gross antional product, the function C(GNP) is the consumption schedule, and I = autonomous investment….

It is immediately obvious where this forecast failed-in the prediction of consumer expenditures,…The order of magnitude of the error involved is great, and, what is more serious, it is great enough to lead to disastrous policy recommendations. The predicted GNP of $164.5 billion should call for an inflationary policy, but this is just the opposite of the policy that was needed…

Most critics will agree that the consumption function is incorrect…At least as important as the statistical errors, however, are the errors of economic theory…[the consumption function].may be incorrect from an economic theoretical point of view and from a statistical point of view.

And after this poor Klein dithers around with statistics, the special effects of  “bottlenecks,” wartime, liquidity and so on. With the benfit of hindsight you can see him circling around the elephant in the room, the permanent income theory of consumption.  No, returning soldiers did not follow some “schedule” relating this year’s consumption to this year’s income. He’s so close, he can smell the elephant, but he never quite touches it. That would wait 15 years and Milton Friedman’s permanent income, to be followed by Lucas, Sargent and the others who tore apart this Keynesian castle.

Why are we reading this? It’s fun to go back and see how really smart people understood things at the time. Maybe it should give us some humility – so much policy debate seems based on the idea that we know everything so well. If we understood things as well as we now see Klein understood things, would we still want to spend trillions on our best guesses? Klein is happy that the Government didn’t follow the widely-recommended “inflationary” or stimulative policy advocated in 1945! If you were transported back to to 1790 and got sick, would you want to be treated by the best doctors of the day?

On the other hand, many of Tom Sargent’s writings suggest our ancestors understood nuances of policy even better than we do – or at least before the brief interlude in which  Keynesians forgot everythng their ancestors knew. (Start with Tom’s Nobel Prize speech. The point is not that hard to see between the lines.)

As a research economists, it’s a bit frightening. There are surely such elephants in our room that we’re missing, and we will kick ourselves for not really noticing them. Try not to get so close and miss the big point!

I got to Klein on a different mission. 1946 is a great data point to understand – the great negative stimulus which coincided with a boom and inflation. I also got to this paper while digging in to the long set of historical writings that found budget constraints missing in Keynesian models. This is a big point in my writings about stimulus, but I’m not the first to notice that. More later…

Notice a Journal of Political Economy article published in August 1946 about how summer 1945 forecasts for 1946 turned out!   That could never happen now, in any academic journal.

Update: David Henderson and Russ Roberts on the postwar depression that wasn’t, with good Samuelson quotes.