Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Friday, November 6, 2009

Fiscal Multipliers in War and in Peace

It truly is breathtaking how certain some people are of what they know to be true about the way a macroeconomy operates. The Krugmans and DeLongs of this world really make it sound like everything we really need to know has been settled long ago. Yes, the science is "settled" (where have we heard this before?).

I recently came across this piece by Brad DeLong: A Guide for the Perplexed. Consider the following quote:
But when fiscal boost was tried on a large enough scale, it certainly did the job. And it is reasonable to infer (with all the caveats provided by the CBO) that what is true in the very large will be true in the merely large as well. Eugene Fama says that it is theoretically impossible for fiscal stimulus to boost output: World War II proves him wrong. Robert Barro says that the multiplier is zero: World War II proves him wrong. Benn Steil says that Jacques Rueff in 1947 conclusively proved that fiscal policy could not boost employment: World War II proves him wrong.

Implication: a WWII style fiscal stimulus will "do the job" in a peacetime recession. WWII "proves" it. does he know this? Why do I not feel as confident that this is the case? Am I truly that dense? (an invite to some rather rude comments, I'm sure!)

In any case, I decided to gather my thoughts on the subject and post them here for public review and criticism. The piece is a bit too long for a blog posting; so if you're interested, please click here. Looking forward to any comments.

Wednesday, September 30, 2009

And the New Minneapolis Fed President is...

Narayana Kocherlakota; see here.

Hmm...his biography says that he was born in Baltimore. I seem to recall him mentioning that he was born in Winnipeg. Is he Canadian, or isn't he? Someone enlighten me!

In any case, he is an excellent choice. NK is a consummate academic: clear-thinking, articulate, and persuasive. Does he have what it takes to be a successful/influential Fed president? Yes, I believe so. Apart from his academic credentials, he has a very easy manner; not many people are likely to find him a boor. He has the gift of skewering lame-brained ideas to the wall, and then making you feel good that you've learned something useful (at least, this has been my experience).

Congratulations to NK...and good luck!

Tuesday, September 22, 2009

Kocherlakota on the State of Macro

A very nice piece by NK here. Unfortunately, you won't see something like this published in the NYT. But naturally, we can rely on DeLong to make a comment; see here: Narayana Leaves Me Puzzled. Consider this DeLong quote:
The models thus tell us that downturns are either the result of a great forgetting of technological and organizational knowledge, a great vacation as workers develop a sudden extra taste for leisure, or a great rusting as the speed with which oxygen in the air corrodes speeds up and so reduces the value of large things made out of metal.

This is exactly how I would expect a first-year undergraduate to interpret a model that they've seen for the first time. And DeLong claims that he has a PhD in economics. Let me help the poor lad along.

Some macro models incorporate "news shocks." A news shock is the random arrival of information that leads people to (rationally) revise their forecasts of future events. These forecasts may be made, for example, over future productivity, future riskiness of investments, future policies, etc. These news shocks do not seem like an implausible impulse mechanism; unexpected news arrives every day.

Investment demand today depends on forecasted productivity of investment. These forecasts will change with news; leading to variations in investment that an econometrician might identify as "aggregate demand shocks." As the investment matures and comes online, its actual productivity may be higher or lower than originally forecast; its realization constitutes another "shock."

There is no need to appeal to DeLong's childish "great forgetting" interpretation of a negative technology shock. A negative technology shock occurs when the realized return on investment is lower than expected. The return on an important class of investments may turn out to be terrible (think of all the fibre optic cable planted across the world's oceans in anticipation of a demand that never materialized). And as Fisher Black has stressed, these types of errors are typically correlated across agents. In short, recessions may be explained, in part, by collective mistakes on investments made in the past.

In any case, what DeLong fails to offer us what he might propose instead as the ultimate source of the business cycle? I am guessing that he might say something like "animal spirits." So why did the recession occur? Because people thought that it would. Why did that boom occur? Because people believed that it would.

There may be an element of truth to the animal spirit hypothesis; but then, there do appear to be competing interpretations as well. If DeLong would spend less time writing his blog and more time reading the literature, he might one day be less puzzled with Narayana's observations.

Thursday, August 27, 2009

Why the Growing Level of U.S. Debt May Not be Inflationary

History shows that high levels of government debt are frequently associated with inflation. The reason for this seems clear enough. At some point, maturing debt needs to paid back. At high enough levels of debt, rolling the debt over is no longer feasible. Cutting back government spending and raising taxes is politically difficult. The easy way out is simply to print new money. As the money supply expands, inflation resuts.

The rough logic described above would seem to fit the experience of many smaller economies that find themselves under fiscal pressure. But things may not work so simply for a select few dominant economies. Japan appears to be one example; and the U.S. another.

Let us consider the U.S. Unlike most other economies, there appears to be a huge worldwide demand for U.S. Treasuries and U.S. dollars (which can be thought of as zero-interest Treasuries). A large scale increase in the supply of these government debt instruments need not lead to a depreciate in their value if there is a correspondingly large scale increase in the worldwide demand for these objects. What is the evidence that this may be happening?

Foreigners Snap Up Treasuries Even as US Debt Keeps Rising

But why should this be so? What accounts for what appears to be an insatiable demand for US debt, especially in the wake of the recent financial crisis?

Ricardo Caballero of MIT offers some hints in a very interesting piece entitled: On the Macroeconomics of Asset Shortages. After reading this paper, I started thinking in the following way. Tell me what you think.

There is a high and growing demand for low-risk assets, both as a store of value, and as collateral objects in payment systems (e.g., repo and credit derivatives markets). This growth has exploded over the last 20 years or so; and stems from the demand from emerging economies and innovations in the financial sector. There is a worldwide "shortage" of good quality (low-risk) assets, like U.S. Treasuries (which explains their relatively low yield). Indeed, many of the innovations in the financial sector can be interpreted as the private sector's response to this shortage: the creation of "low-risk" tranches of MBSs allowing these objects to substitute for U.S. Treasuries as collateral in the rapidly expanding repo market.

The recent financial crisis was centered in the repo market. Very suddenly, agents in the repo market were no longer willing to accept MBS as collateral (or if they did, at very large "haircuts"). The demand for U.S. Treasuries exploded (I seem to recall a day when their yields actually went negative). At the same time, there was a worldwide "flight to quality;" which again, manifested itself as large increase in the demand for (relatively safe) U.S. Treasuries.

If this is more or less true, then the implication is this: The massive increase in the supply U.S. Treasury debt may very be "socially optimal" in the sense that the U.S. government is simply supplying the world with an asset that is in very high demand (which, in turn, means that the demanders obvious find some value in the existence of such an asset). To the extent that this "new demand regime" remains stable, the added supply of U.S. Treasuries will impose no financial burden on the U.S. (indeed, they make off like bandits, as the Treasuries are ultimately purchased by exporting goods and services to the U.S.).

The million dollar question, of course, is whether the high world demand for U.S. debt will persist long into the future (and whether the U.S. government will "overissue" debt beyond what is called for by this new high-demand regime). Who knows what will happen. But it appears to me that IF the U.S. government plays its cards right, it may very well enjoy its higher debt levels without the prospect of inflation. U.S. citizens will benefit (from the sales of Treasuries for goods) and the world will be grateful to hold a stable asset.

Well, maybe. But that was a big IF. What could possibly go wrong?

Wednesday, August 26, 2009

William Poole on Ben Bernanke

For those of you who may not know, I have recently joined the Federal Reserve Bank of St. Louis as a VP in the research division. Will keep you posted on things that I learn (and am allowed to reveal).

We were recently asked to comment on an article written by Bill Poole, former president and CEO of the Fed here in St. Louis. He asks the question: Should President Obama reappoint Fed Chairman Bernanke? See here. His conclusion is "no." (too late, it appears).

So what's his beef? Essentially, that some of the new policies initiated by Bernanke have violated stipulations in the Federal Reserve Act (FRA) and that, in doing so, he has comprised the Fed's political independence. The relevant stipulations are section 13(3) and section 14(b).

Poole grants Bernanke some leeway in terms of the emergency measures adopted in March 2008 (Bear Stearns) and September 2008 (AIG). But he believes that the Fed's Commercial Paper Funding Facility (CPFF) violates section 13(3). He may have a point here; but there is not much a leg for him to stand on as the term "exigent" is not precisely defined.

Poole also believes that the Fed's buying program for Mortgage Backed Securities (MBS) is not authorized under Section 14(b). I beg to differ. As far as I can tell, the act does allow for purchases of assets that are guaranteed by the U.S. government. The MBS purchased by the Fed are fully insured by the Treasury (and indeed, they are generating a very nice return).

Poole makes some very good points about distancing the Fed from politics as much as possible. But I do not believe that he makes a compelling case against reappointment. Among other things, he does not propose alternative candidates (many of the apparent frontrunners would likely view Bernanke's interventions as too conservative). Bill should be careful what he wishes for.

In any case, it looks like Bernanke will be reappointed (after a good grilling in front of the Senate). Considering the alternatives, I think this was the right choice.

Wednesday, April 22, 2009

Against Intellectual Property

I have long suspected that there was something fishy about the economic defense for property rights in knowledge. My first attempt at questioning the wisdom of such a policy at a conference at NYU in 1994 was met with harsh criticism (especially from the late great Fisher Black, bless his libetarian soul). I was never able to fully recover from that experience, and so I meekly let that research program die.

But I am now very pleased to see that Michele Boldrin and David Levine have taken up the cause. Levine was kind enough to visit SFU on March 20, 2009 where he delivered a public lecture entitled "Against Intellectual Property." The lecture, if you are interested, is now available online here.

There is much food for thought here. The logic of his argument and the evidence he provides is quite persuasive, in my view. But if you see any holes in his arguments that have escaped me, please let me know.

Sunday, March 29, 2009

King Solomon's Dilemma and Behavioral Economics

When the tale of King Solomon's dilemma was first told to me as a kid, I was (like most people, no doubt) left marvelling at Solomon's brilliant solution to a rather difficult predicament.

But then I grew up and made the unfortunate choice of pursuing a graduate degree in economics. My mind was left rotted to the point where I could no longer appreciate what most other people continued to believe was the self-evident wisdom of Solomon.

The problem with Solomon's "solution" is that it adopts what in modern parlance would be labeled a "behavioral approach." In other words, the solution relies heavily on the assumption that people are "irrational" in a particular sense. It turns out to be easy to be a wise philosopher king when one assumes that everyone else is irrational. Perhaps this is why so many aspiring philosopher kings today want to replace conventional economic theory with what they call "behavioral economics."

Let's think about this. The "mechanism" (game) designed by Solomon proposes to split the baby in two (sounds "fair" at least). One women screams out "No! Let the other have the whole baby instead." The other woman coldly agrees to the solution. The real mother is revealed in the obvious manner. What is not so obvious is why the false mother could not have anticipated this outcome; a more clever woman would have simply mimicked the behavior of the true mother. Instead, the false mother fails to make this calculation (and instead adopts a simple "behavioral" strategy; which is just a fancy label for irrational behavior).

Now, perhaps there really are "irrational" people like the false mother. But would you be willing to stake a baby's life on this assumption? Even if this mechanism worked out one time, could we reasonably expect it to work in the future (would people not learn from the outcome and tailor their strategies accordingly?). If you believe that people are fundamentally irrational in this sense, then you will make a fine behavioral economist (and a poor philosopher king).

So what is the solution to Solomon's dilemma?

One approach might be to adopt the Coase theorem, which states that if transaction costs are zero, then an arbitrary assignment of property rights will lead to the efficient solution. That is, Solomon could just have assigned the baby at random to one or the other woman. If it fell into the hands of the false mother, the true mother (who presumably values the baby more) could then purchase the baby (from the one who values it less). In other words, if there are gains to trade (as would obviously exist in this case), then these gains will be realized--if transaction costs are zero.

The problem with this approach is that transaction costs are obviously not zero (these costs could arise, for example, if the true value of the baby by both women is private information). Moreover, this "solution" violates what most people would consider to be a principle of "fairness" (why should the true mother pay for her own baby?). The Coase theorem is a fascinating theorem, but it should not be applied as a solution to the problem at hand; the theorem simply states what one could expect to happen IF transaction costs are zero. In fact, the Coase theorem should be interpreted as explaining precisely why various institutions emerge to handle the problem of resource allocation in a world where transaction costs are not zero.

One such solution was offered by Solomon. But I have already highlighted the problem with his proposed institution (or mechanism). Another possible solution was offered by William Vickery: a sealed-bid second-price auction (or a Vickery auction). Assume, as seems reasonable in this case, that only the two mothers know the true value they attach to the baby. A Vickery auction would have both mothers submitting sealed bids for the baby. The woman with the highest bid would then win the auction, but pay the second-highest bid.

This solution is clever because the amount that either woman expects to pay is independent of their actual bid. Accordingly, neither one of them have an incentive to misrepresent how much they really value the baby. If the true mother values the baby more, she will win the auction (it would not be rational for the false mother to bid more than what the baby is worth to her).

Clever indeed. But there is still a problem associated with this solution. In particular, it requires that the true mother actually pay for her baby. Leaving issues of "fairness" aside, a more relevant problem may be that this mother does not have the resources to make the requisite payment. (It is absolutely critical that the payment be forthcoming; if Solomon could not credibly commit to collecting the payment, then rational players will understand this limitation and alter their strategies accordingly).

One solution might be to let the women offer themselves as indentured servants. This sounds feasible and has the desirable property that the true mother gets her baby (she would presumably be happy to offer herself as Solomon's servant, if it means getting her baby). While this solution has its drawbacks, it seems to dominate Solomon's solution--something that risks having the baby split in two.

But is it possible to design a mechanism that "does the right thing" without any cost to the true mother? Several solutions have been proposed in the literature; but each with its own peculiar drawbacks. But I recently came across one proposed solution that seems quite clever; see Bid and Guess: A Nested Solution to King Solomon's Dilemma, by Cheng-Zhong Qin of UC Santa Barbara.

The idea as presented in Qin's paper seems a little more complicated than it needs to be (but I could be wrong). The basic idea, as I see it, is to have the women play a "participation game" just before playing a standard Vickery auction. We could set up the mechanism as follows.

First, Solomon informs the women of the Vickery auction that will be used to allocate the baby. Second, he informs each woman that the price of participating in the Vickery auction will be a half-life of servitude in some miserable occupation. The women are then asked to submit envelopes with ballots that are marked "yes" or "no" (yes, I am willing to participate; no I am not). If both women submit "yes," then the Vickery auction is played. If only one woman submits "yes," then the baby is allocated to her for free (the auction is not played). If neither woman submits "yes," then the baby is disposed of in some manner (perhaps in the King's service).

Now, put yourself in the place of first, the true mother and second, the false mother. How would you play the game? Would you say "yes" or "no?"

Theory suggests that the true mother will say "yes" to the participation game (she knows that she will get the baby if the auction is played; she will pay one half-life of servitude for participation, and the other half-life in payment for the baby). Likewise, the false mother will say "no." Why submit to a half-life of servitude when she knows that she will inevitably lose the subsequent auction? The false mother will rationally bow out of the bidding; she will choose not to participate. And the baby is allocated for free to the true mother.

Of course, this assumes that the people playing this game are "rational" in the sense that they understand the rules of the game and in the sense that they can anticipate how others are likely to play it. One of the great strengths of assuming rationality in this form is that the assumption can be applied as a general condition that prevails in any resource allocation problem. Its weakness is that people may not always possess this assumed degree of rationality.

But the alternative--the "behavioral approach"--suffers from an even greater problem. In particular, the policymaker must be aware of precisely how people are irrational in each and every given circumstance (a great loss in generality). There are an infinite number of ways in which people might be irrational; and the behavioral theorist is forced to choose among an infinite number of "behavioral rules" that he or she believes captures this irrationality in a plausible manner. The only hope that a behavioral theorist has for developing a general theory is in discovering that people are irrational in some systematic manner. But if the theorist can identify this systematic pattern of irrationality, it seems hard to know why people cannot discover it for themselves too. But then, it seems clearly in the interest of aspiring philosopher kings prefer to think of themselves as being systematically more rational than the subjects they study.

Wednesday, March 25, 2009

Larry Summers on Fear and Greed

I used to think that Larry Summers was a reasonable sort of fellow. By here is some evidence proving that spending too much time in administration and politics can rot even the best mind; see White House: Greed Will Help. Here are some quotes:

"In the past few years, we’ve seen too much greed and too little fear; too much spending and not enough saving; too much borrowing and not enough worrying," Summers said Friday in a speech to the Brookings Institution. "Today, however, our problem is exactly the opposite."

Borrowing, you see, is evidently linked to greed; especially if one borrows too much. I am reminded of university students who mindlessly accumulate too much student debt. The greedy bastards. Or of poor people mindlessly borrowing to finance a home purchase. The greedy SOBs. There is too much borrowing; too much spending; there is too much greed.

Saving, on the other hand, is evidently linked to fear. Fear is a virture (as in the fear of God). As when all those virtuous savers bid up the NASDAQ to 5000. Whoops; this doesn't sound right. Perhaps he means saving in virtuous assets, like government treasuries (backed by virtuous/coercive taxation; rather than the prospect of future cash flow from a successful enterprise). Yes, fear is a virture...unless there is too much fear. Then fear is bad.

To summarize then: greed is vice; fear is a virtue. Unless there is too much fear, which is not a virtue. Not enough greed is a virtue; but not a good virtue...which is to say it is a vice. I am getting confused. Let me consult the article again.
"While greed is no virtue, entrepreneurship and the search for opportunity is what we need today."

OK, this clears things up. Make no mistake: greed is no virtue. But we do need more of it at a time like this. So to sum up, greed (borrowing) is bad and fear (saving) is bad (unless there is not enough of either). In the world economy (a closed system), we know that borrowing = saving. And this proves that greed is always balanced by fear. Wait a second, I am confused again. Perhaps what we need is a "new generation" IS-PC-TR like model to help policymakers confront the difficult economic choices they face in balancing fear and greed.

Assume that the policymaker has a quadratic loss function in deviations of actual fear and greed around some socially optimal level of fear and greed (we will let Woodford provide the microfoundations for this social welfare function). Accordingly, let us write this loss function as,

L(t) = 0.5(f(t) - f)^(1/2) + 0.5(g(t) - g)^(1/2)

Here, (f,g) are the socially optimal levels of fear and greed. f(t) and g(t) are the prevailing levels of fear and greed at date t. The policymaker wishes to minimize the fluctuations in fear and greed around their socially optimal levels.

We need more restrictions. Let's see. It seems natural to suppose that fear is influenced in some manner by endogenous variables and an exogenous shock; let's say

f(t) = a*f(t-1) - b*y(t) + e(t)

where y(t) is the output gap; and e(t) is the shock (like a "fear" markup shock in New Keynesian models).

Greed, on the other hand, is influenced by the interest rate and exogenous factors; e.g.,

g(t) = c*g(t-1) - d*r(t) + u(t)

where r(t) is the interest rate, set by monetary policy. Lowering r(t), the way Greenspan did, results in an increase in greed. Seems right.

Now, the policymaker wishes to choose an interest rate rule that miminizes the loss function, given the stochastic processes (estimated as the residuals from a mindless OLS or VAR) governing the fear and greed shocks.

Yes, I can see how the New Keynesian model, so widely used by central banks to justify the policies they follow, will no doubt be replaced by my formalization of Summer's hypothesis. The implications for policy design are likely to prove equally enlightening. Anyone care to coauthor this paper with me? Fame (or notoriety) is virtually guaranteed!

Friday, March 20, 2009

CDO Squared, Anyone?

Along with Martin Hellwig, I think that the other bright light in the field of finance is Gary Gorton of Yale. He has published several very interesting papers on historical banking panic episodes; see here. He gives a detailed account of the subprime mortgage market and the financial innovations associated with it in his paper entitled "The Panic of 2007."

In this paper, he describes the nuances of subprime mortgages; in particular, how their particular design made them very sensitive to the underlying asset price (unlike conventional mortgages). Evidently, this was by design (there was no other way for creditors to make money servicing this particular demographic).

He goes on to describe how these subprime mortgages were packaged into mortgage backed securities (MBS). This is a common form of securitization (although, the design of these also differed in a subtle, but important manner, from standard securitizations). As with other securitizations, mortgages were pooled and then tranches were formed; e.g., a senior tranche, a mezzanine tranche, and an equity tranche.

This type of securitization has an economic rationale. Higher rated tranches can be sold to insurance companies and pension funds (whose liabilities are longer term in nature). In principle, the originator of the MBS should could then hold on to the junior (equity) tranche. This gives the originator the incentive to construct a sound MBS; as the originator is the first in line to potential losses.

What I do not understand is what followed. These MBS were then used as backing for new securities, called Collateralized Debt Obligations (CDOs). For example, the mezzanine tranche of the MBS (rated BBB) would then be divided into senior, mezzanine, and junior tranches. The mezzanine tranche of this CDO would then be divided again into senior, mezzanine, and junior tranches (a CDO squared). The senior tranches of the CDO squareds would be assigned AAA ratings!

I do not understand the economic rationale for this further subdivision of the original MBS. I presume that there must be one (perhaps to get around some government regulations?). Is there an expert in finance out there that can help me out? I have had little luck in finding anything that explains the motivation for why CDOs exist.

Monday, March 16, 2009

Martin Hellwig on the Financial Crisis

Tired of all that sanctimonious drivel spewing from the likes of Dani Rodrik and Willem Buiter? Head aching from the cacophony of shrill voices rejoicing at the end of the world?

Then consult the good doctor Martin Hellwig; see here.

He also has a very nice article entitled "International Contagion: The Result of Information or Rhetoric?" that is well worth reading.

Would be interested to hear what people think.

Saturday, March 7, 2009

Multiplier Mischief

The current debate over the size of the "government spending mulitiplier" is a perfect measure of the sway that conventional economic theorizing continues to grip the minds of people who should know better.

At the center of the theorizing is the income-expenditure identity: Y = C + I + G. This identity is not a theory; it is something that is true by definition. The theory comes in by way of behavioral assumptions that are imposed on C and I. All that is left is to determine how an exogenous change in G manifests itself as a change in Y. The government spending multiplier is dY/dG. Now all economic historians have left to do is to try to estimate the size of dY/dG. They frequently "discover" that dY/dG > 1. That is, it appears that for every dollar the government spends, the national income appears to increase by more than a dollar. Conclusion: Obama's stimulus package is a good idea.

There you have it. The only puzzle remaining is why it takes 4 full years of training to receive a PhD in macroeconomic theory; and why it should take a further 6 years to become a tenured professional by publishing papers examining what we all know to be the self-evident truth embedded in this "really useful ad hoc model."

Unfortunately, I am apparently one of few who have trouble absorbing this simple theory. But perhaps there is still some hope for me. I just need a few questions answered.

[1] What does this theory predict concerning the optimal level of Y? Is more Y always to be preferred to less? When Y was expanding rapidly above trend during WW2, were people really made materially better off? Were people made happier by their long hours employed in military manufacture and European adventures? Did people really enjoy the rationing of foodstuffs and gasoline associated with the increase in G? Was the general destruction of capital (both physical and human) during WW2 really associated with increasing wealth levels?

[2] Do *measured* increases in Y associated with increases in G correspond in any meaningful way to *true* increases in Y? Do we not know that when the government pays for something, the "value" of this purchase is measured by cost (instead of market-value) by the National Income and Product accountants? Is this not a serious problem in assessing the "true" value of an increase in G? Are measured government spending multipliers simply a figment of this questionable accounting exercise?

[3] What are we to make of multiplier estimates that are above unity? Is this a linear approximation? Does it represent the value of the marginal dollar spent? (If it does not, then is the implication that the entire economy should simply be nationalized?).

[3] Do the "microeconomic" details concerning the added G not matter at all? Does it matter, for example, that almost $100 million in "stimulus" money is being directed to the Milwaukee Public School system to construct new schools (a district that has been closing schools as a result of declining attendance; see here)? Are people still willing to argue that "digging up holes and filling them in" is a wise use of economic resources?

[4] What does this simple theory identify as the "cause" of recession? An exogenous decline in private sector "sentiment?" What does this mean? Is this purely pyschological? Can we not expect private sector agents to make estimates of the future based on the best information available? Does the government have better information? If so, why does it not make it available? Can declining consumer and business sector "confidence" not be reasonably interpreted as a symptom, rather than a cause, of any economic downturn? How can we know, one way or the other? What evidence can be brought to bear on the idea that recessions are "inefficient?" Is the arrival of a harsh winter that freezes construction to a halt also inefficient? Should the government promote construction activity during a freezing winter?

[5] What is the government spending multiplier in Japan since 2000?

[6] Should we follow Christina Romer's advice and take employment as a metric of economic welfare? Has she not studied economic theory? (Actually, I know the answer to this last question--it is no). I recall reading an article from the TASS news agency, published in 1957 that "the unemployment rate in the Soviet Union, as in previous years, was equal to zero." Should we seek "full employment" along the old Soviet model? Is this how we are to measure success?

I have many more questions, but these will do for now. Of course, some of these questions are rhetorical in nature. But many are not; I genuinely do not know the answers to them. Evidently, the likes of Romer, DeLong and Krugman do know the answers to them. But perhaps this is because none of these esteemed academics are macro theorists. They likely view my ignorance on these matters as evidence supporting their proposition that too much macroeconomic theory distorts the mind. Thank goodness we have these clear-thinking folk around to set me straight!

Monday, March 2, 2009

Our "Deregulated" Financial System?

I used to love watching "60 Minutes" as a kid. Unlike "60 Minutes," however, I eventually grew up (although, not everyone around me agrees). Perhaps you have seen their recent report that places the blame for the current financial market turmoil squarely on those that "deregulated" the U.S. financial market; see here.

Is the U.S. financial system really an example of laissez-faire capitalism run amok? This certainly appears to be the bill of goods being marketed by the religious left and other clear-thinking people. It is unfortunate, as far as this view is concerned, that it contradicts reality so violently. The truth of the matter is that the financial market is by far the most heavily regulated sector in any “well-developed” economy.

If you already knew this, there is no need to read further. But for those of you who may be surprised by this, let me document just some of the federal agencies that play a major role in the U.S. financial market. Of course, I don't expect anyone to read what follows carefully: it is far too long to keep anyone's attention for any length of time. But I suppose that this is precisely the point that I am trying to make. Take a deep breath now...

The U.S. Department of the Treasury

Naturally, I begin with the U.S. Treasury. Here is their mission statement:

Serve the American people and strengthen national security by managing the U.S. Government’s finances effectively, promoting economic growth and stability, and ensuring safety, soundness, and security of the U.S. and international financial systems.

Again, in their own words,

The Department of the Treasury's mission highlights its role as the steward of U.S. economic and financial systems, and as an influential participant in the global economy.

If we are to take this seriously, I suppose it implies that the U.S. Treasury takes responsibility for the current global financial crisis.

The Treasury currently consists of 12 bureaus. I highlight the 5 here that have a direct bearing on the financial system. See:

[1] Bureau of the Public Debt

These are the guys responsible for selling and redeeming U.S. government bonds. They are also useful bean counters. If you visit their website, you’ll see that they keep a precise measure of the outstanding dollar value of the U.S. federal debt (to the penny). As of this writing, this debt amounts to $10,877,144,501,237.52. This is almost 11 trillion dollars; or roughly $36,000 per American.

Who is backing this debt? The American taxpayer of course. And of course, not all Americans pay taxes. Children do not pay taxes. Drug dealers and the unemployed do not pay taxes. According to the IRS, almost 33% of tax filers in 2004 did not pay taxes. You get the picture. It is probably not unreasonable to guess that each American taxpayer is on the hook for $100,000. And this does not include “off balance sheet” items, like social security.
Fortunately, the Bureau of Public Debt has a mechanism in place to help deal with this burden. On one of their webpages, they answer the question: “How do you make a contribution to reduce the debt?” Here is the answer:

Make your check payable to the Bureau of the Public Debt, and in the memo section, notate that it is a Gift to reduce the Debt Held by the Public. Mail your check to: Attn Dept GBureau of the Public DebtP. O. Box 2188Parkersburg, WV 26106-2188

[2] Community Development Financial Institutions Fund

Here is their mission statement:

Through monetary awards and the allocation of tax credits, the CDFI Fund helps promote access to capital and local economic growth in urban and rural low-income communities across the nation.

Through its various programs, the CDFI Fund enables locally based organizations to further goals such as: economic development (job creation, business development, and commercial real estate development); affordable housing (housing development and homeownership); and community development financial services (provision of basic banking services to underserved communities and financial literacy training).

In short, this federal department extends credit to low-income high-risk individuals. Where have we heard this before? This department is also responsible for implementing President Obama’s American Recovery and Reinvestment Act of 2009 (Recovery Act). According to their website:

It is an unprecedented effort to jumpstart our economy, create or save millions of jobs, and put a down payment on addressing long-neglected challenges so our country can thrive in the 21st century. The Act is an extraordinary response to a crisis unlike any since the Great Depression, and includes measures to modernize our nation’s infrastructure, enhance energy independence, expand educational opportunities, preserve and improve affordable health care, provide tax relief, and protect those in greatest need.

[3] The Inspector General

Conducts independent audits, investigations and reviews to help the Treasury Department accomplish its mission; improve its programs and operations; promote economy, efficiency and effectiveness; and prevent and detect fraud and abuse.

In short, this department does nothing.

[4] Office of the Comptroller of the Currency (OCC)

The Office of the Comptroller of the Currency (OCC) charters, regulates, and supervises all national banks. It also supervises the federal branches and agencies of foreign banks. Headquartered in Washington, D.C., the OCC has four district offices plus an office in London to supervise the international activities of national banks.

The OCC was established in 1863 as a bureau of the U.S. Department of the Treasury. The OCC is headed by the
Comptroller , who is appointed by the President, with the advice and consent of the Senate, for a five-year term. The Comptroller also serves as a director of the Federal Deposit Insurance Corporation (FDIC) and a director of the Neighborhood Reinvestment Corporation.

The OCC's nationwide staff of examiners conducts on-site reviews of national banks and provides sustained supervision of bank operations. The agency issues rules, legal interpretations, and corporate decisions concerning banking, bank investments, bank community development activities, and other aspects of bank operations.

National bank examiners supervise domestic and international activities of national banks and perform corporate analyses. Examiners analyze a bank's loan and investment portfolios, funds management, capital, earnings, liquidity, sensitivity to market risk, and compliance with consumer banking laws, including the Community Reinvestment Act. They review the bank's internal controls, internal and external audit, and compliance with law. They also evaluate bank management's ability to identify and control risk.

In regulating national banks, the OCC has the power to:

Examine the banks.
Approve or deny applications for new charters, branches, capital, or other changes in corporate or banking structure.
Take supervisory actions against banks that do not comply with laws and regulations or that otherwise engage in unsound banking practices. The agency can remove officers and directors, negotiate agreements to change banking practices, and issue cease and desist orders as well as civil money penalties.
Issue rules and regulations governing bank investments, lending, and other practices.

The OCC's Objectives

The OCC's activities are predicated on four objectives that support the OCC's mission to ensure a stable and competitive national banking system. The four objectives are:

To ensure the safety and soundness of the national banking system.
To foster competition by allowing banks to offer new products and services.
To improve the efficiency and effectiveness of OCC supervision, including reducing regulatory burden.
To ensure fair and equal access to financial services for all Americans.

So you see, how could we expect to see anything to wrong with such extensive government oversight?

[5] Office of Thrift Administration (OTS)

The OTS supervises a national thrift industry that is built on the bedrock of the American dream of homeownership—supplying affordable home financing for Americans from all walks of life.

The industry has a long history dating back to 1831 with the establishment of the first savings association, the Oxford Provident Building Association, which made home loans and offered savings accounts. Today, the charter is a vibrant, sophisticated model for running a retail financial services business.

Home mortgages remain a staple of the thrift industry. However, the array of financial products and services offered by many institutions and their holding companies paint a modern-day portrait of great diversification within the industry based on size, complexity, and business strategy.

Three unique advantages of the federal thrift charter foster this diversification:

Preemption – The federal thrift charter operates under a comprehensive framework of federal regulations that supersede state and local laws on lending and deposit taking activities. This provides a uniform national standard for lending and deposit taking, thereby reducing regulatory burden and increasing the efficiency of operations at thrift institution. This authority supports the delivery of low-cost credit and other services to the public, while maintaining consumer protections and promoting the safety and soundness of federal thrifts and the nation’s financial industry.

Branching – Federal thrifts enjoy the distinctive ability to establish branches nationwide, seamlessly and without restriction, under a single charter and a single regulator.

Single Supervisor – Savings and loan holding companies, and their thrift subsidiaries and affiliates, operate under the consolidated supervision of a single federal regulator, the OTS.
The thrift charter is employed by some of the largest financial enterprises in the world, as well as small, one-office savings associations. Financial institutions from across the nation and a number of international financial firms have found that the thrift charter and the experienced, responsive workforce of the OTS provide an ideal framework for conducting retail banking operations and related financial services activities. The charter enables these institutions to meet the needs of their customers and to innovate effectively, compete, and prosper in today’s fast-paced financial marketplace.

Today’s “fast-paced” financial marketplace indeed!

Other Government Regulatory Agencies

[1] U.S. Commodity Futures Trading Commission (CFTC)

Congress created the Commodity Futures Trading Commission (CFTC) in 1974 as an independent agency with the mandate to regulate commodity futures and option markets in the United States. The agency's mandate has been renewed and expanded several times since then, most recently by the Commodity Futures Modernization Act of 2000.

[2] Federal Deposit Insurance Corporation (FDIC)

The Federal Deposit Insurance Corporation (FDIC) is an independent agency created by the Congress that maintains the stability and public confidence in the nation’s financial system by insuring deposits, examining and supervising financial institutions, and managing receiverships.

[3] National Credit Union Association

The National Credit Union Administration (NCUA) is the independent federal agency that charters and supervises federal credit unions. NCUA, backed of the full faith and credit of the U.S. government, operates the NCUSIF insuring the savings of 80 million account holders in all federal credit unions and many state-chartered credit unions.

[4] Federal Reserve Board

Here you go: another fine example of laissez-faire capitalism (a government legislated monopoly on the paper money supply and sweeping regulatory powers). For details, see: