After the ACA -- Crafting an Alternative to Obamacare

I gave a talk at Hoover, encouraging those of us who are less than fans to speak up and outline the alternative to Obamacare. Podcast here.

Repeal and status quo is not enough. We need to listen, and point out how a radically freed and competitive system will address the genuine concerns that motivate many to support the law despite its flaws – preexisting conditions, health care for the poor, outrageous cost and so forth.

The essay “After the ACA” lays it out in some detail.  The talk is a lighter discussion of where we are, but emphasizes how sitting back and letting the ACA unravel will just lead to an even more expensive and incorherent system. Stand up and state the alternative.

A limited central bank

Philadelphia Fed president Charles Plosser gave a noteworthy speech, “A limited central bank.” It’s especially noteworthy in the context of Janet Yellen’s nomination, discussion between Congress and Fed about how the Fed should be run, the Fed’s focus on unemployment, and the current state of the hawks vs. doves debate.

We find out what he thinks of micromanaging the taper based on monthly employment reports:

The active pursuit of employment objectives has been and continues to be problematic for the Fed. Most economists are dubious of the ability of monetary policy to predictably and precisely control employment in the short run, and there is a strong consensus that, in the long run, monetary policy cannot determine employment….

When I talk to Fed types about this, the usual answer is a version of “well, yes, we don’t really have that much effect on employment, but employment is in the toilet, we have to do what we can, no?”

Charlie has a good answer to that, along the way blasting his colleagues who want the Fed to continue to fiddle with long term bond markets, mortgage rates, credit spreads, credit “availability” and perceived bubbles:

When establishing the longer-term goals and objectives for any organization, and particularly one that serves the public, it is important that the goals be achievable. Assigning unachievable goals to organizations is a recipe for failure. …

…We have assigned an ever-expanding role for monetary policy, and we expect our central bank to solve all manner of economic woes for which it is ill-suited to address. We need to better align the expectations of monetary policy with what it is actually capable of achieving.

…Even though the [Fed’s] 2012 statement of objectives acknowledged that it is inappropriate to set a fixed goal for employment and that maximum employment is influenced by many factors, the FOMC’s recent policy statements have increasingly given the impression that it wants to achieve an employment goal as quickly as possible.

What should the Fed do?

I have concluded that it would be appropriate to redefine the Fed’s monetary policy goals to focus solely, or at least primarily, on price stability.

The speech is very thoughtful about independence. In a democracy, an agency can only be independent if it has limited powers. An agency that writes checks to voters, allocates credit to favored businesses and industries, cannot be politically independent.

The current deal for independence is written in part in the Federal Reserve act which sets up the current “dual mandate,” but

The act doesn’t talk about managing short-term credit allocation across sectors; it doesn’t mention inflating housing prices or other asset prices. It also doesn’t mention reducing short-term fluctuations in employment.

You’re getting a sense of what genies Charlie would like to put back in their bottles. It’s a bit remarkable for a Fed president to essentially say that Fed policy is not only unwise, but stretching the Fed’s legal authority.  Yet independence is a good thing:

Even with a narrow mandate to focus on price stability, the institution must be well designed if it is to be successful. To meet even this narrow mandate, the central bank must have a fair amount of independence from the political process so that it can set policy for the long run without the pressure to print money as a substitute for tough fiscal choices

Such independence in a democracy also necessitates that the central bank remain accountable. Its activities also need to be constrained in a manner that limits its discretionary authority. 

… in exchange for such independence, the central bank should be constrained from conducting fiscal policy… [yet] the Fed has ventured into the realm of fiscal policy by its purchase programs of assets that target specific industries and individual firms.

What would Charlie do to draw some lines in the sand? One, by reinstating traditional limits on what assets the Fed can buy:

One way to circumscribe the range of activities a central bank can undertake is to limit the assets it can buy and hold. My preference would be to limit Fed purchases to Treasury securities and return the Fed’s balance sheet to an all-Treasury portfolio. This would limit the ability of the Fed to engage in credit policies that target specific industries.

Rules are important,

A third way to constrain central bank actions is to direct the monetary authority to conduct policy in a systematic, rule-like manner. It is often difficult for policymakers to choose a systematic rule-like approach that would tie their hands and thus limit their discretionary authority.  

And for more reasons than usual: if the bank is following a rule, it’s much less open to political criticism and able to preserve its independence:

Systematic policy can also help preserve a central bank’s independence. When the public has a better understanding of policymakers’ intentions, it is able to hold the central bank more accountable for its actions. And the rule-like behavior helps to keep policy focused on the central bank’s objectives, limiting discretionary actions that may wander toward other agendas and goals

…assigning multiple objectives for the central bank opens the door to highly discretionary policies, which can be justified by shifting the focus or rationale for action from goal to goal.

Charlie agrees: you can’t have effective forward guidance without precommitment, and you can’t have precommitment and discretion. Here is the slam at how taper talk roiled bond markets

My sense is that the recent difficulty the Fed has faced in trying to offer clear and transparent guidance on its current and future policy path stems from the fact that policymakers still desire to maintain discretion in setting monetary policy. Effective forward guidance, however, requires commitment to behave in a particular way in the future. But discretion is the antithesis of commitment and undermines the effectiveness of forward guidance. Given this tension, few should be surprised that the Fed has struggled with its communications.

In some sense, arguing about the dual mandate is the last war. The Fed is now the Gargantuan Financial Regulator, and the “mandate” includes “financial stability,” and detailed discretionary direction of credit flows. Charlie:

Some have even called for an expansion of the monetary policy mandate to include an explicit goal for financial stability. I think this would be a mistake.

The Fed plays an important role as the lender of last resort…. the role of lender of last resort is not to prop up insolvent institutions. However, in some cases during the crisis, the Fed played a role in the resolution of particular insolvent firms that were deemed systemically important financial firms. .. by taking these actions, the Fed has created expectations — perhaps unrealistic ones — about what the Fed can and should do to combat financial instability.

In fact, the bigger the fire house, the more the chance of fires:

I can think of three ways in which central bank policies can increase the risks of financial instability. First, by rescuing firms or creating the expectation that creditors will be rescued, policymakers either implicitly or explicitly create moral hazard and excessive risking-taking by financial firms. For this moral hazard to exist, it doesn’t matter if the taxpayer or the private sector provides the funds. What matters is that creditors are protected, in part, if not entirely.

Second, by running credit policies, such as buying huge volumes of mortgage-backed securities that distort market signals or the allocation of capital, policymakers can sow the seeds of financial instability because of the distortions that they create, which in time must be corrected.

I would add, if you prop up prices in bad times, you kill the incentive for people to keep some cash around to buy in the next “fire sale.”

And third, by taking a highly discretionary approach to monetary policy, policymakers increase the risks of financial instability by making monetary policy uncertain. Such uncertainty can lead markets to make unwise investment decisions — witness the complaints of those who took positions expecting the Fed to follow through with the taper decision in September of this year.

“You can keep your bonds if you like them?”

The whole speech is good, I hope my excerpts get you to go to the real thing.

New vs. Old Keynesian Stimulus

While fiddling with a recent paper, “The New-Keynesian Liquidity Trap” (blog post), a simple insight dawned on me on the utter and fundamental difference between New-Keynesian and Old-Keynesian models of stimulus.

Old-Keynesian. The “Keynesian cross” is the most basic mechanism. (If you are worried that I’m making this up, see Greg Mankiw’s Macroeconomics, p. 308 eighth edition, “Fiscal policy and the multiplier: Government Purchases.”)

Consumption follows a “consumption function.” If people get more income Y, they consume more C

C = a + m Y.

Output Y is determined by consumption C investment I and government spending G

Y = C+ I + G.

Put the two together and equilibrium output is

Y = a + mY + I + G
Y = (a + I + G)/(1-m).

So, if the marginal propensity to consume m=0.6, then each dollar of government spending G generates not just one dollar of output Y (first equation), but $2.5 dollars of additional output.

This model captures a satisfying story. More government spending, even if on completely useless projects, “puts money in people’s pockets.” Those people in turn go out and spend, providing more income for others, who go out and spend, and so on. We pull ourselves up by our bootstraps. Saving is the enemy, as it lowers the marginal propensity to consume and reduces this multiplier.

New-Keynesian. The heart of the New-Keynesian model is a completely different view of consumption. In its simplest version

Here consumption C, relative to trend, equals the sum of all future real interest rates i less inflation π i.e. all future real interest rates. The parameter σ measures how resistant people are to consuming less today and more tomorrow when offered a higher interest rate.

(This is just the integrated version of the standard first order condition, in discrete time

People in this model think about the future when deciding how much to consume and allocate consumption today vs. tomorrow looking at the real interest rate. I’ve simplified a lot, leaving out trends, the level and variation of the “natural rate” and so on.)

In this model too, totally wasted government spending can raise consumption and hence output, but by a radically different mechanism.  Government spending raises inflation π . (How is not important here, that’s in the Phillips curve.) Holding nominal interest rates i fixed, either at the zero bound or with Fed cooperation, more inflation π means lower real interest rates. It induces consumers to spend their money today rather than in the future, before that money loses value.

Now, lowering consumption growth is normally a bad thing. But new-Keynesian modelers assume that the economy reverts to trend, so lowering growth rates is good, and raises the level of consumption today with no ill effects tomorrow. (More in a previous post here)

Comparing stories

This new-Keynesian model is an utterly and completely different mechanism and story. The heart of the New-Keynesian model is Milton Friedman’s permanent income theory of consumption, against which old-Keynesians fought so long and hard! Actually, it’s more radical than Friedman: The marginal propensity to consume is exactly and precisely zero in the new-Keynesian model.  There is no income at all on the right hand side. Why? By holding expected future consumption constant, i.e. by assuming the economy reverts to trend and no more, there is no such thing as a permanent increase in consumption.

The old-Keynesian model is driven completely by an income effect with no substitution effect. Consumers don’t think about today vs. the future at all. The new-Keynesian model based on the intertemporal substitution effect with no income effect at all.

Models and stories

Now, why is Grumpy grumpy?

Many Keynesian commentators have been arguing for much more stimulus.  They like to write the nice story, how we put money in people’s pockets, and then they go and spend, and that puts more money in other people’s pockets, and so on.

But, alas, the old-Keynesian model of that story is wrong. It’s just not economics. A 40 year quest for “microfoundations” came up with nothing. How many Nobel prizes have they given for demolishing the old-Keynesian model? At least Friedman, Lucas, Prescott, Kydland, Sargent and Sims. Since about 1980, if you send a paper with this model to any half respectable journal, they will reject it instantly.

But people love the story. Policy makers love the story.  Most of Washington loves the story. Most of Washington policy analysis uses Keynesian models or Keynesian thinking. This is really curious. Our whole policy establishment uses a model that cannot be published in a peer-reviewed journal. Imagine if the climate scientists were telling us to spend a trillion dollars on carbon dioxide mitigation – but they had not been able to publish any of their models in peer-reviewed journals for 35 years.

What to do? Part of the fashion is to say that all of academic economics is nuts and just abandoned the eternal verities of Keynes 35 years ago, even if nobody ever really did get the foundations right. But they know that such anti-intellectualism is not totally convincing, so it’s also fashionable to use new-Keynesian models as holy water. Something like “well, I didn’t read all the equations, but Woodford’s book sprinkles all the right Lucas-Sargent-Prescott holy water on it and makes this all respectable again.” Cognitive dissonance allows one to make these contradictory arguments simultaneously.

Except new-Keynesian economics does no such thing, as I think this example makes clear. If you want to use new-Keynesian models to defend stimulus, do it forthrightly: “The government should spend money, even if on totally wasted projects, because that will cause inflation, inflation will lower real interest rates, lower real interest rates will induce people to consume today rather than tomorrow, we believe tomorrow’s consumption will revert to trend anyway, so this step will increase demand. We disclaim any income-based "multiplier,” sorry, our new models have no such effect, and we’ll stand up in public and tell any politician who uses this argument that it’s wrong.“

That, at least, would be honest. If not particularly effective!

You may disagree with all of this, but that reinforces another important lesson. In macroeconomics, the step of crafting a story from the equations, figuring out what our little quantitative parables mean for policy, and understanding and explaining the mechanisms, is really hard, even when the equations are very simple. And it’s important. Nobody trusts black boxes. The Chicago-Minnesota equilibrium school never really got people to understand what was in the black box and trust the answers. The DSGE new Keynesian black box has some very unexpected stories in it, and is very very far from providing justification for old-Keynesian intuition.

The Work Behind the Prize: Video and Text

This is a link to the “Work Behind the Prize” event from Monday Nov 4. Our charge was, explain to the community of scholars at the University of Chicago, what Lars Hansen and Gene Fama’s research was that won them Nobel Prizes. Jim Heckman and John Heaton talk about Lars Hansen’s work, Toby Moskowitz and I talk about Gene Fama. 10 minutes each. I start at 33:50.

Here is the text of my remarks. (Faithful blog readers will note some recycling. Let’s call it “refining.”) A pdf with embedded pictures is here. The video on youtube is here

Eugene Fama: Efficient markets, risk premiums, and the Nobel Prize

In 1970, Gene Fama defined a market to be “informationally efficient” if prices at each moment incorporate available information about future values.

A market in which prices always `fully reflect’ available information is called `efficient.’” - Fama (1970)

If there is a signal that future values will be high, competitive traders will try to buy. They bid prices up, until prices reflect the new information, as I have indicated in the little picture. “Efficient markets” just says that prices in a competitive asset market should not be predictable.


“Efficient markets” is not a complex theory. Think Darwin, not Einstein. Efficiency is a simple principle, like evolution by natural selection, which organizes and gives purpose to a vast empirical project.

That empirical work is not easy. The efficient market hypothesis has many subtle implications, most of them counterintuitive to practitioners, especially those who are selling you something.

For example, efficiency implies that trading rules – “buy when the market went up yesterday”– should not work. The surprising result is that, when examined scientifically, trading rules, technical systems, market newsletters, and so on have essentially no power beyond that of luck to forecast stock prices. This is not a theorem, an axiom, a philosophy, or a religion: it is an empirical prediction that could easily have come out the other way, and sometimes does.

Efficiency implies that professional managers should do no better than monkeys with darts. This prediction too bears out in the data. It too could have come out the other way. It should have come out the other way! In any other field of human endeavor, seasoned professionals systematically outperform amateurs. But other fields are not as ruthlessly competitive as financial markets.

43 years later, “efficiency” remains contentious.

Some of that contention reflects a simple misunderstanding of what social scientists do. What about Warren Buffet? What about Joe here, who predicted the market crash in his blog? Well, “data” is not the plural of “anecdote.” These are no more useful questions to social science than “how did Grandpa get to be so old even though he smokes” is to medicine. Empirical finance looks at all the managers, and all their predictions, tries to separate luck from ex-ante measures of skill, and collects clean data.

Another part of that contention reflects simple ignorance of the definition of informational “efficiency.” Every field of scholarly research develops a technical terminology, often appropriating common words. But people who don’t know those definitions can say and write nonsense about the academic work.

An informationally-efficient market can suffer economically inefficient runs and crashes – so long as those crashes are not predictable. An informationally efficient market can have very badly regulated banks. People who say “the crash proves markets are inefficient” or “efficient market finance is junk, you did not foresee the crash” just don’t know what the word “efficiency” means. The main prediction of efficient markets is exactly that price movements should be unpredictable! Steady profits without risk would be a clear rejection.

I once told a reporter that I thought markets were pretty “efficient.” He quoted me as saying that markets are “self-regulating.” Sadly, even famous academics say things like this all the time.

There is a fascinating story here, worth study by historians and philosophers of science and its rhetoric. What would have happened had Gene used another word? What if he had called it the “reflective” markets hypothesis, that prices “reflect” information? Would we still be arguing at all?

Starting in the mid 1970s, Gene started looking at long-run return forecasts. Lo and behold, you can forecast stock returns at long horizons.

The blue line is the ratio of dividends to prices. Think of it as prices upside down. It goes down in the big price booms, such as the 1960s and 1990s, and goes up in the big busts such as the 1970s. It also wiggles with business cycles. You see the astounding volatility of stock valuations, which Bob Shiller shares the Nobel Prize for pointing out.

The red line is the average return for the 7 following years. So, times of high prices, relative to dividends are reliably followed by 7 years of low returns. Times of low prices are reliably followed by high returns. This pattern is pervasive across markets – stocks, bonds, foreign exchange, real estate.

Even more surprising are the dogs that don’t bark: Times of high prices are not followed by higher dividends, earnings or profits.

Does this fact imply that markets are inefficient? No.

“The theory only has empirical content, however, within the context of a more specific model of market equilibrium,…” [Fama (1970)]

Gene’s 1970 article emphasized that you can get better returns, by shouldering more risk, and the reward for bearing risk can vary over time and across assets, and that’s how he interprets these facts. Discounted prices should be unpredictable. So how you measure discount rates is crucial. 

For example, in December 2008, prices fell and expected stock returns rose. In this view, typical investors answered: “Yes, I see it’s a bit of a buying opportunity. But stocks are still risky, and the economy is falling to pieces. I just can’t take risks right now. I’m selling.” Many university endowments did just that.

The facts still imply a huge revision of our world view: Business-cycle related variations in the risk premium, rather than variation in expected cashflows, account entirely for the volatility of stock valuations. This view changes everything we do in finance and related fields from accounting to macroeconomics. [“Discount rates” is an essay on this point.]

There is another possibility: perhaps people were irrationally optimistic in the booms, and irrationally pessimistic in the busts.

And a third more recent challenge: perhaps the institutional mechanics of financial intermediation cause variation in the risk premium. When leveraged hedge funds lose money, they sell. If not enough buyers are around, prices fall.

These views agree on the facts so far. So how do we tell them apart? Answer: we need “models of market equilibrium.” We are not here to tell stories. We need economic models, psychological models, or institutional models, that tie price fluctuations to more facts, in a non-tautological way. And, that is exactly what a generation of researchers like myself spend a lot of its time doing, a sure sign of how influential these facts are.

Financial economics is a live field, asking all sorts of interesting and important questions. Is the finance industry too large or too small? Why do people continue to pay active managers so much? What accounts for the monstrous amount of trading? How is it, exactly, that information becomes reflected in prices through the trading process? Do millisecond traders help or hurt? How prevalent are runs? Are banks regulated correctly? The ideas, facts and empirical methods of informational efficiency continue to guide these important investigations.

Gene’s bottom line is always: Look at the facts. Collect the data. Test the theory. Every time we look, the world surprises us totally. And it will again.

The Work Behind the Prize

This afternoon (Monday November 4) a panel of four will try to explain the research that Gene Fama and Lars Hansen did to win the Nobel Prize for the University of Chicago community.

This is classic University of Chicago, community of scholars stuff: Yes, we’ve congratulated you.  Now, let’s talk seriously about the ideas and the research.

My job: Explain efficiency, long run returns and volatility in 10 minutes flat. Wish me luck. John Heaton and Jim Heckman will describe Lars Hansen’s work, and Toby Moskowitz will join me on the Fama panel.  Gary Becker will moderate

The announcement is here; RSVP if you want to attend as seating is limited. The event will be web-cast here