Tuesday, August 30, 2011

The Housing Bust, Deleveraging, and Zero

If the housing bust was the proximate cause of our Great Recession, why didn't the economy begin contracting until a year and a half after housing prices began to decline -- and well after the economy began shedding construction jobs? Indeed, Ryan Avent observes:
[T]he story in which the housing bust gave us the recession, because America suddenly had lots of houses and workers it couldn't use doesn't appear to fit the data. The economy muddled on despite the housing bust for two years, at which point, for some reason, all sectors suddenly decided that the outlook for growth was much worse than they'd previously believed.
But what about the story where the housing bust gave us the recession, because households underwater on their mortgages suddenly upped their savings rates, which was enough of a hit to aggregate demand to cause other households to save more out of fear as well? In short: the collapse of housing prices, rather than the collapse in demand from the housing sector, drove the recession.

The data certainly seems to conform with this general narrative. Here are owners' housing equity (blue) plotted against home mortgage liabilities (red) and the personal savings rate (green).

The now familiar tale of the financial calamity of the bubble decade emerges from this picture. The savings rate evaporated at the height of the boom as homeowners alternatively tapped home equity loans or counted on asset appreciation as a form of de facto savings. This reversed a bit when housing prices began to decline in the second half of 2006, but, still, personal savings only nudged up a modest amount.  Indeed, it was not until shortly after the value of outstanding mortgage debt surpassed owners' household equity in August 2007 -- a first for the post-war period -- that the savings rate began to spike. This deserves special consideration.

There is a peculiar psychology to zero, at least when it comes to net wealth. Karl Smith recently pondered the irrationality of our fixation with the number, but the reality remains: there is a fundamental aversion to going below it. That mortgage debt eclipsed household equity in late 3Q2007 does not, of course, tell us the exact percentage of households underwater, but it is a decent proxy for the widespread state of disrepair of household balance sheets -- a sad fact that has significant implications. Households (or corporations) whose chief financial asset and piece of collateral has pushed their net worth below zero drastically change their habits. It may be that no rate of interest can induce them to borrow more; they prefer to pay down debts instead in an effort to erase their financial holes. This was infamously the case during Japan's Lost Decade, when corporations deleveraged apace despite the ready availability of literally free money. 

Even so, why should increased savings from paying down debts act as a drag on aggregate demand? After all, basic economics tells us that banks and other financial intermediaries should recycle savings back into the economy via loans. Unfortunately, the wholesale mistrust that ruled financial markets, and the subsequent credit crunch, that was endemic from August 2007 onwards prevented this mechanism from functioning correctly. 

Banking problems reinforced three interrelated negative feedback loops, with the end result economic armageddon. The first among these related to foreclosures: when one (former) homeowner defaults on a mortgage, this depresses the value of their neighbors' homes. If these neighbors are left with negative equity, they are then unable to refinance their mortgages, and have a reduced incentive to not walk away. Put more clearly, foreclosures are contagious. Increased savings in response to this collapse in housing values was the second feedback loop. As first subprime and then prime borrowers set aside more money to pay their mortgages, this effectively sucked cash out of the economy due to banks not lending the money back out. Businesses reacted to this lessening of demand by slowly cutting back, which caused fear to spread, and savings to rise among workers. Finally, asset values kept falling as these forces worked their way through the economy, further impairing banks' capital. With banks looking to de-risk, they became even more reticent about lending. And so on, and so on.

Thankfully, the government (finally) moved to arrest this downward cycle. But could the Fed have mitigated the slump with aggressive, pre-emptive action? Almost certainly. If the Fed had eased to accommodate the excess demand for money that arose due to the collapse of subprime securities and other seemingly safe cashlike assets in late 2007, the panic in the financial sector would almost certainly not have been quite as acute. This is not to say, however, that there would have been no recession. Instead of  a precipitous decline in late 2008, perhaps there would have been a gradual one, as households continued deleveraging in response to falling house prices. Nothing short of a sustained burst of inflation that would simultaneously erode the real value of debts and, more importantly, reflate housing values would change this dynamic. Theoretically, the Fed could engineer such above-trend inflation over the medium-term if it was willing to embrace radical enough policies. A combination of institutional and political concerns make it difficult for the Fed to credibly commit to such a program. This is deeply unsatisfying, but no less true.

The lesson of our Great Recession is not only that central banks need to shed their discomfort in engaging in unconventional policies, but also that asset prices -- particularly those used as collateral -- are central to the economy. Ignore them, and their affect on private sector balance sheets, at our economic peril.

Saturday, August 27, 2011

Obama, Recess Appointments, and the Fed

Ben Bernanke could use some friends. Not just within the Republican party from which he has become... ahem, estranged (to put it a bit more diplomatically than Rick Perry would), but also on the Federal Open Market Committee (FOMC).

There are still two vacant seats on the Federal Reserve Board. The governing structure of the Fed is a bit abstruse, but what this means is that Bernanke has two fewer allies on the FOMC -- which votes to set monetary policy -- than would normally be the case. Maddeningly, Senator Richard Shelby (R-Ala.) has blocked President Obama's efforts to fill the empty seats on the Federal Reserve Board -- with the laughable excuse that Obama nominee and recent Nobel prize winner Peter Diamond is not enough of an expert in monetary policy.

It's not clear how much of Shelby's obstructionism is payback for the Democrats blocking conservative favorite Randy Kroszner's appointment to the FOMC during the Bush years, and how much is a matter of ideology. Nor is it clear if anybody would be acceptable to Shelby today. Indeed, part of Shelby's stated opposition to Diamond came from the latter's public support of QE2 -- which Mike Konczal points out would rule out Shelby voting for even Kroszner today. Already, one of Obama's two most recent appointees has dropped from consideration. It seems unlikely the spots will be filled in the near future.

Why does this matter?

The FOMC usually tries to reach a consensus in its policy decisions. Its last meeting was an outlier, with three dissenters opposing the mild change in communications that the Fed expects economic conditions to warrant keeping short-term rates at zero through mid-2013. Unfortunately, these dissenters subscribe to what I like to call Don Quixote economics: waging war against imaginary problems while actual ones persist. Indeed, with the ten-year implied inflation at just 2% -- and falling -- worries about potential stagflation are profoundly misguided, particularly given that the civilian employment-population ratio is worsening. This bloc of self-styled inflation hawks have succeeded in stymieing more expansionary policy, only relenting when inflation expectations fall below the Fed's tacit 2% target -- which, thankfully, averts complete collapse, but regrettably does little to promote robust recovery.

Two more dovish votes on the FOMC would obviously give Bernanke more latitude to push for unconventional policies, without having to worry as much about losing a vote to the inflation hawk camp. And clearly, the case for further monetary easing is made more urgent by Congressional Republicans not only blocking further fiscal stimulus, but also actually pushing for mild austerity. 

Of course, Obama could end this confirmation charade, if he wanted to. Indeed, I just want to say two words to the president, just two words: recess appointments. Senate Republicans have, predictably, attempted to prevent Obama from even going this route by holding pro forma sessions every three days during their recess, but as Think Progress points out, this is a legally dubious tactic. In a similar case in 2004, the Eleventh Circuit court ruled that there is no minimum time Congress must be out of session before the President can use a recess appointment. So why isn't Obama filling the vacancies on the Fed that urgently need to be filled?

There are no good reasons. The most plausible is that Obama is wary of appearing too partisan and damaging his brand as the most reasonable person inside the Beltway. This is a mistake. The only issue voters know less about than the FOMC itself is how its members are appointed. Republicans might score a few political points on Obama's "overreach" for a news cycle or two, but 14 months from now that will be irrelevant. What will be relevant is the state of the economy -- and with fiscal policy on the sidelines, the Fed is the last, best chance of generating faster growth.

Obama's re-election chances could very well hinge on whether he gets religion on monetary policy. Does anybody in the White House realize this?

Thursday, August 25, 2011

Behavioral Economics, Tax Cuts, and the Stimulus

Did the Obama administration outsmart itself when it came to the tax cuts in the 2009 stimulus?

Recall that the debate at the time centered on how much of the recovery act would be composed of spending programs versus tax cuts. Liberals argued that the ARRA should have been weighted more towards government spending, such as infrastructure, because it was more stimulative than tax cuts that would likely be saved instead of spent. However, a combination of practical (a dearth of shovel-ready projects) and political (wooing enough moderate Republicans to break the filibuster) concerns ultimately led to roughly 37% of the stimulus coming in tax cuts -- but there was a twist.

Tapping the insights of behavioral economics, the Obama administration tried to structure the tax rebates such that households would be more likely to spend them. Here is James Surowiecki explicating this strategy:
You might think that handing people a big chunk of change is a perfect way to get them to spend it. But it isn’t, because people don’t treat all windfalls as found money. Instead, in the words of the behavioral economist Richard Thaler, people put different windfalls in different “mental accounts,” which in turn influences what they do with the money. [....] 
The key factor in these kinds of distinctions, Thaler’s work suggests, is whether people think of a windfall as wealth or as income. If they think of it as wealth, they’re more likely to save it, and if they think of it as income they’re more likely to spend it. [....] 
So what does this mean for making a rebate work? If you want people to spend the money, you don’t want to give them one big check, because that makes it more likely that they’ll think of it as an increase in their wealth and save it. Instead, you want to give them small amounts over time. And you want the rebate to show up as an increase in people’s take-home pay, because an increase in steady income is more likely to translate into an increase in spending. What can accomplish both of these goals? Reducing people’s withholding payments.
Unfortunately, this may have been too clever by half. Politically, designing a tax cut so that households will not notice they are receiving it was a predictable disaster. Indeed, shortly before the 2010 midterm elections, polls showed that only one in ten respondents knew that Obama had actually reduced taxes for 95% of Americans. But there is an argument that this was perhaps a misguided economic policy as well.

One interpretation of our economic malaise is that we are still suffering from a debt overhang among households. The nominal shock of the housing bubble collapsing left many households underwater on their mortgages, and consequently drove them to begin paying down debt. Even with short-term interest rates parked up against the zero bound, there is a dearth of borrowers among households -- which also depresses business investment, since there are not as many profitable opportunities in an environment where consumers are retrenching. This economic weakness will persist until the private sector is finished deleveraging. The best the government can do is to simply avert complete collapse by borrowing the excess of desired savings over investment. This is Richard Koo's theory of the "balance sheet recession" (there is a counter-argument that if the Fed embraced more unconventional policies, it could stabilize nominal spending and end the slump, but that is for another post).

The data on household debt certainly supports the view that this time, the recession really is different. Indeed, for the first time in the post-war period, households have actually begun reducing the amount of debt on their balance sheets.

If the balance sheet recession view of our slump is correct, however, doesn't that suggest that it is better for households to save tax cuts rather than to spend them? Indeed, if growth will remain subpar as long as the private sector is deleveraging, then the quickest way to get past subpar growth is to accelerate the deleveraging process. There are three strategies for doing so. First, policymakers could simply write down the value of underwater mortgages to their current face value -- but this would necessitate recapitalizing banks as well, which is an obvious political non-starter. Second, the Federal Reserve could try to engineer above-trend inflation over the short-term to erode the real value of debts. Unfortunately, there is little support among the FOMC for such a proposition (not to mention that successfully orchestrating higher inflation would probably require such radical policies that even the most dovish FOMC members would be reluctant to try).

That leaves tax rebates. At the risk of sounding tautological, giving households money to pay down debts obviously speeds up the process of paying down those debts. The sums involved from the ARRA were not very large -- $400 for single-earner households; $800 for couples -- but the notion that it would have been a "waste" if households did not spend those checks misses the point of the balance sheet recession. Sending out lump sum tax rebates might have been the more efficient policy over the longer-term, since that presumably would have led to households putting themselves on firmer financial footing faster than they otherwise did.

To be sure, the government needed to spend money to provide a stream of income to the private sector so that it could save. But the Obama administration might have been better served thinking of the tax cuts as a means to hasten the rebuilding of household balance sheets, and of public spending as a means to set a floor under the economy, rather than conceiving of both as the latter.

The great irony is that an unconventional recession perhaps called for a conventional response on taxes.

Conservatives Do Not Care About Deficits

The greatest trick the Republican party ever pulled was convincing the world that they care about deficits. They plainly do not. Rather, the GOP cares about the size of government. Hence, their rigid insistence that any debt ceiling deal be composed entirely of spending cuts. And their lockstep opposition to a value-added tax (VAT).

The VAT is essentially a national sales tax. It is a hallmark of European welfare states given that is an efficient (if regressive) as well as politically palatable method to raise tax revenue. It is for precisely these reasons that the VAT is such a bogeyman for the Wall Street Journal editorial page crowd. Consider this latest broadside against the specter of a VAT:
We estimate that each percentage point of a U.S. VAT would provide Washington over 10 years with approximately $981 billion with which to launch new spending. So even a small VAT might help reduce the debt-to-GDP ratio. But by making reforms to entitlement spending less likely, VAT revenues would also lead to a permanent increase in spending to 24% or more of GDP (compared to the historic average of 20%). [...]
Translation: a modest VAT could reverse our medium-term budget problems, but conservatives prefer to "starve-the-beast" instead to justify rolling back Social Security and Medicare. There is nothing "conservative", in a Burkean sense, about this strategy. Indeed, this is pure Leninism: the worse, the better.

That the Republicans claim the mantle of fiscal conservatism after a generation of running up the debt on tax cuts for the wealthy not only demonstrates the post-modern nature of our politics, but also the milquetoast disposition of the Democrats. It's well past due for Obama to highlight the glaring hypocrisy of the GOP: conservatives do not care about deficits at all.

Wednesday, August 24, 2011

The Least Persuasive Tax Argument Ever

Who among us has bought a gift for a grandchild -- or any loved one, for that matter -- and not pondered the profound unfairness of not being able to count it as a tax deduction? It's galling. Forget that private equity managers only pay a 15% tax rate on the majority of their income -- this is the real injustice in our tax code.

Anyone who found themselves nodding at the above might have a future writing for the Wall Street Journal editorial page. The conservative temper tantrum over Warren Buffett's call for higher effective tax rates on the rich reached its apotheosis with the totally specious argument that taxes had actually increased on the wealthy in the last decade; the latest effort in the Wall Street Journal by former American Express CEO Harvey Golub is merely the least persuasive entry in this genre.

The usual canards get recycled fairly quickly. Golub begins with the de rigueur conservative talking point that Buffett should just pay higher taxes himself if he thinks his taxes are too low (which, of course, ignores Buffett's point about the broader unfairness of the loopholes that let the super-rich pay less as a percentage of their income than the middle class does).

This whirlwind tour of hackery makes its next stop at the Wall Street Journal's preferred three-card monte tax argument: that only those who pay federal income taxes have a "stake" in how the government spends money. It is certainly true that nearly half of all taxpayers do not pay federal income tax -- but that is only because this "lucky" majority is too poor to afford to pay much more after accounting for state, local and payroll taxes. Consider that in 2009 -- the last year before the temporary payroll tax cut -- that Social Security taxes raised 97% of the revenue that federal incomes taxes did. And the payroll tax is regressive. Indeed, is it fair that Warren Buffett pays exactly the same amount in payroll taxes as someone making $120,000 does?

Golub concludes with a rant against an assortment of spending programs, tax expenditures and some true head-scratchers (such as the aforementioned lament that donations to charities are tax deductible, but gifts to grandchildren are not). None of this vitiates Buffett's argument that the super-rich are "coddled" when it comes to taxes. Nor is it persuasive on its own merits. Golub's argument that his taxes should not go up until programs he disapproves of are eliminated or made more efficient is a weak dodge. Imagine the democratic dysfunction such a rule would invite if adopted as a categorical imperative.

Is this really the best the Wall Street Journal can do?

Tuesday, August 23, 2011

Subprime, Shadow Banking and Liquidity Shocks: Lessons of the Great Recession

Why did relatively trivial losses in AAA mortgage bonds nearly vaporize the world economy in 2008? It seems absurd on its face. After all, despite the financial carnage in the U.S. housing market, the losses only amounted to a small proportion of global assets and GDP. Ben Bernanke's assurances that subprime would be "contained" almost seem plausible. Of course, this ignores the role credit default swaps (CDS) played in not only magnifying the aforementioned losses, but also in obfuscating them: the labyrinthine web of such opaque, over-the-counter contracts left banks unsure of what both they and their counterparties were on the hook for. It's no wonder the interbank market froze.

The destruction of seemingly safe, cashlike assets -- and the resulting surge in the liquidity premium -- is the other part of the story. The past few decades have been marked by the rise of the so-called shadow banking system: securitization largely replaced traditional lending, while investors clamored to maximize returns on the putatively safe (but uninsured) holdings the unregulated system created. This was the great irony of the post-tech bubble economy: the juxtaposition of brazen, unhinged risk-taking among lenders with the extreme risk-aversion of investors. The financial alchemy of securitization and tranching (and sometimes re-tranching) reconciled -- indeed, facilitated -- these divergent aims for a time, before reality intruded.

Here is Steve Randy Waldman's incisive description of this dynamic:
[There was] a “giant pool of money”, specifically sovereign and institutional money, that was seeking out ultra-safe, “Triple A” investment, and sometimes agitating for yield within that category.... The investors in question weren’t, in fact, investors at all in an informational sense. To a first approximation, they paid no attention at all to the real projects in which they were investing. They were simply trying to put money in the bank, and competitively shopping for good rates on investments they could defend as broadly equivalent to a savings account.
What type of assets made up these quasi-savings accounts? Chief among them were AAA mortgage bonds, auction rate securities, commercial paper, and repo. Money-market funds that invested in these assets let retail investors get in the game too. The obvious appeal of these assets was that they were supposed to be as safe and as liquid as the cashlike assets that exist under the aegis of the regulated financial system -- i.e., T-bills and checking deposits (at least up to the FDIC-insured limit) -- while offering more yield. Unfortunately, this was a fantasy.

Losses and illiquidity migrated up the proverbial food chain of cashlike assets due to financial linkages and panic. This was an old-fashioned, albeit slow-motion, bank run on our modern financial system. The implosion of the AAA mortgage bond market first turned auction rate securities illiquid, as investors scrambled to sell the latter to make up for losses on the former. There were no buyers. The exposure of the banking system to its own subprime CDO dreck was the next accelerator. Worries about Lehman Brothers' solvency due to its toxic mortgage portfolio ultimately caused its funding in the repo market to evaporate -- and with it, nearly the remainder of cashlike assets in the economy.

Money-market funds were the next casualty. A few days after Lehman's bankruptcy, the Reserve Primary fund infamously "broke the buck" due to its holdings of short-term Lehman debt. A run ensued on money-market funds. Only a temporary government guarantee quelled the panic. The commercial paper market seized up next. This time, the Fed stepped in to lend directly to corporations. The ultimate fear -- that depositors might start a 1930s-style run on bank accounts above the $100,000 FDIC-limit -- led to accounts being insured up to $250,000 instead.

This wholesale demolition of cashlike assets naturally sent the premium for any remaining such assets through the roof -- or, in the case of Treasuries, to negative yields. This had disastrous implications. As Matt Rognlie points out, when the Fed Funds rate hits zero, the liquidity premium replaces T-bills as the effective benchmark for every interest rate in the economy. Hence, the yields on corporate bonds rose to ruinous levels in late 2008 despite the Fed's efforts to ease policy. The abyss beckoned.

Thankfully, policymakers managed to arrest the collapse. Capital injections into the banking system ended the run on cashlike assets. The Fed's credit easing program, i.e., QE1, pushed the liquidity premium down to normal levels by trading cash for illiquid assets like mortgage bonds. And the much-maligned ARRA not only put people to work and money in their pockets, but financing it also necessitated creating new cashlike assets: more T-bills. Recovery, however, remains elusive. The civilian employment-population ratio has not shown any sustained improvement since the recession technically ended in June 2009. Our economic hole is as deep as ever.

Could it happen again? In the short-term, it's difficult to see how another run on cashlike assets could develop given that the securitization machine is still idle. Treasuries are now essentially the only destination for investors to park their piles of cash -- which explains why yields continue to push down to historic lows. Of course, in the long-term, another panic in the shadow banking system is too possible considering that its basic financial architecture remains unchanged.

The rise of the "giant pool of money" has overwhelmed our financial system. Consider that in 1990 these piles of cash held by corporations and asset managers amounted to just $100 billion; today that sum has multiplied to $2-4 trillion. Any story purporting to explain why this has occurred certainly involves a fair amount of hand-waving. Some of the usual suspects include the move towards defined contribution pension plans; globalization and the subsequent decreasing share of revenue going to labor; the liberalization of markets as the Iron Curtain came down; and the centralization of financial institutions (note this does not even include the neo-mercantalist policies of the China bloc recycling their trade surpluses into dollar-assets). These gargantuan sums were simply too big for our insured financial system. Even with the recent move by the FDIC to permanently lift its limit to $250,000, only 33% of this money is held in deposit.

Deregulation and a stance of malign neglect allowed the shadow banking system to develop a seemingly safe place for these vast sums. Now that the illusion of liquidity has been broken, it is clear that right now the government must run mega-deficits to replenish the supply of safe financial assets for the private sector, and that some kind of reform is necessary to make our unregulated financial system safer.

As policymakers responded to the banking crises of the 1930s with deposit insurance, so must we too respond to our shadow banking crisis with some equivalent of the FDIC.

Saturday, August 20, 2011

Why Does John Mauldin Still Hate QE2?

John Mauldin has a sixth sense: he sees stagflation. Everywhere. Hence, his vociferous opposition to QE2. Never mind that the Fed was undershooting its tacit 2% inflation target back in August 2010 with implied ten-year inflation at 1.5% -- John Mauldin just knows that further monetary easing means the 1970s are right around the corner. And has apparently never heard of interest on excess reserves.

Mauldin recently reiterated his antipathy to QE2 with a substantive defense of Rick Perry calling Ben Bernanke "treasonous", while, of course, disavowing the Texas governor's belligerent tone. This is neither unexpected nor interesting. What is interesting is the chart Mauldin produces in the same note that purports to signal when the economy is entering recession. Compiling Fed surveys, along with a host of national economic indicators, Mauldin shows that recession warning signs are currently flashing bright red -- and that QE1 and QE2 not only turned things around before, but that their conclusion marked the beginning of economic weakening.

Simultaneously believing in this chart's predictive value and that QE2 was an unwise policy would seem to require a Herculean display of cognitive dissonance. Unless Mauldin simply subscribes to Mellon-esque liquidationism.

Still, it would be edifying if Mauldin would acknowledge the apparent tradeoff between 2-4% inflation and complete economic collapse, rather than ranting about the imminent return of problems that do not plague us. If we are to get past this muddle, we must cast aside Don Quixote economics.

Friday, August 19, 2011

The Limits of Keynesianism?

Is an age of austerity unavoidable? That is the question James McDonald asks in a thought-provoking piece that outlines the policy response to the financial crisis, and the problems that high levels of private debt pose to recovery.

Felix Salmon approvingly flags down this passage:
The markets have highlighted a fundamental shortcoming in Keynes' ideas: He assumed that governments would always be able to borrow. If they cannot, then Keynesian economics is dead in the water.
It is worth considering why a government might find itself unable to borrow in the private markets. Consider the examples McDonald cites: the PIIGS. Here is McDonald on Europe's seemingly atypical debt crisis:
Indeed, one of the most striking aspects of the eurozone crisis is that bond markets have not discriminated between causes of excessive debt.... What we are seeing, in other words, is a wholesale revision of the rules about debt that have held true for decades.
It is certainly true that the PIIGS evoke Tolstoy's description of unhappy families, but do their mutual yet disparate problems really portend a dramatic break with the rules that have governed debt in the post-war period? After all, McDonald omits the most salient point: all of the PIIGS are members of the Euro. It should not surprise us that a fixed exchange rate system calls the debts of high debt and low growth countries into question. By forfeiting monetary sovereignty, the PIIGS were left vulnerable to nominal shocks -- such as the financial crisis -- without the usual buffers of monetary easing or devaluing. Like the Gold Standard in the 1930s, the Euro has forced the PIIGS to adopt deflationary policies at precisely the wrong moment. Unfortunately, austerity is self-defeating here since it depresses growth; the denominator of the debt-to-GDP ratio shrinks in tandem with the numerator. This is Fisher's debt deflation on a sovereign level.

Fixed exchange rate systems merely substitute default risk for exchange rate risk. Debts that would otherwise be sustainable suddenly catch the ire of bond vigilantes who (legitimately) doubt the prospects for growth under the exchange rate regime. The same was true, of course, for Argentina in 2002 -- although in that case the culprit was not monetary union, but rather a currency peg. Insofar as this offers any lessons about the supposed practical limits of Keynesian stimulus, it would seem to be: do not surrender monetary sovereignty by joining a fixed exchange rate system.

There is another way for a government to get shut out of the bond markets: high inflation. If a country's central bank lacks credibility in promoting price stability and inflation reaches some critical point, private lenders will demand prohibitively high interest rates. Of course, this risks spiraling out of control: the inability to finance deficits in the international markets creates the temptation to monetize them instead. Inflation accelerates, making bond markets even more wary of lending money. In the worst case, this ends with Zimbabwe-style hyperinflation. But given that most advanced economies are still stuck in a liquidity trap, this is not terribly relevant right now.

As long as a country remains in the Goldilocks territory of controlling its own currency (especially if it can denominate debt in that currency) without letting inflation run too high, it should be able to engage in counter-cyclical Keynesian policy. Indeed, Salmon notes that the U.S. can happily still borrow at historically low rates, although the political winds are blowing the other way towards fiscal consolidation. But then comes this somewhat puzzling passage:
[W]e’re in the final innings of the Keynesian game. If you look at the history of sovereign debt, we started with countries borrowing large sums of money from rich private-sector individuals like the Rothschilds. When those sums weren’t enough, the era of big publicly-owned banks began, and borrowing capacity rose sharply. Then we moved into domestic capital markets, and eventually international capital markets. Each move increased the amount of money available for lending to sovereigns. Finally, when sovereigns get tapped out, they can try to appeal to super-sovereigns: the ECB, the EFSF, the IMF and the like. But those funds are limited, and don’t last long. Hence the move to austerity — the only other option.
The problem is not a dearth of private capital willing to lend to sovereigns; the problem is the lack of growth prospects for the PIIGS makes private capital unwilling to lend to them at affordable rates due to worries about eventual default. Hence, the necessary interventions of the ECB, EFSF, and the IMF. The irony is that we still suffer from a surfeit of savings: China et. al. have trade surpluses to recycle, and increased savings in the West are still eagerly seeking safe, liquid investments. That the 10-year Treasury bond recently yielded less than two percent and gilts touched lows not seen since the 1890s shows that the markets are desperate for debt from sovereigns that can credibly promise NGDP growth.

If the "Keynesian game" is indeed over, it is because of the misguided choices of politicians in countries that can still borrow to pursue austerity instead, while the PIIGS suffer under a renewed version of that old barbarous relic. And that is what makes this all so tragic. With a little bit of clear thinking and political will, a double dip would be preventable. Alas, we seem determined to forget our history.

The Most Specious Tax Argument Ever

Conservatives are in a tizzy because Warren Buffett had the temerity to once again suggest that he should pay a higher percentage of his income in taxes than his secretary does. The gall!

The GOP response has been as predictable as it is unpersuasive: Buffett is a hypocrite for not promoting a wealth tax instead, and just wants to keep the merely rich from reaching his status; the armies of lawyers and accountants the super-rich employ will insulate them from any tax hikes; and, if Buffett wants to pay higher taxes, why not just do it himself?

But Investors Business Daily wins the award for chutzpah with their Orwellian argument that the tax burden for top earners has actually increased in the last decade:
Nor is it true, as Buffett claims, that the rich have been "coddled." Indeed, the top 0.1% of income earners — the millionaires and billionaires Buffett says have made out like bandits — paid a third more in federal income taxes in 2008 than they did in 2001. 
The richest 400 paid almost two-thirds more. And the share of federal income taxes paid by the rich climbed after the Bush tax cuts went into effect.
There's a lot of dishonesty to unpack here. First, comparing absolute tax returns -- the metric they cite -- is essentially meaningless. The reductio ad absurdum version of this argument is that since the richest 0.1% paid more in taxes in nominal dollars in 2008 than they did in 1954 -- when top marginal rates were 91% -- that the rich are taxed more heavily now than then. Clearly, this tells us nothing. Between inflation and rising real incomes (at least for the top of the income distribution) this is what we would expect; higher nominal incomes should translate to higher nominal tax returns. The same is true for the 2008 versus 2001 comparison, albeit to a much lesser degree.

Let's inject some facts into this debate, courtesy of Emmanuel Saez. In 2001, the top 0.1% of earners accounted for 8.37% of all income and took home an average of $4.58 million (in 2008 dollars); in 2008 the top 0.1% of earners accounted for 10.4% of all income and took home an average of $5.65 million (in 2008 dollars). That amounts to a 23% increase in real incomes over eight years. What explains this prodigious jump? The top 0.1% of earners derive a large proportion of their income from capital gains, so they are more sensitive than most to the markets. In other words, their incomes are more pro-cyclical than those of a typical worker. The tech bubble wiped out a large chunk of wealth for the top 0.1% in 2001, which the housing bubble promptly restored in 2008 (tax returns for 2008 came in before Lehman went bust, so even though markets were off their October 2007 highs, they had not fallen too far).

It gets worse. The price level increased roughly 20% between 2001 and 2008. Factoring that rise in with the 23% bump in real incomes for the top 0.1% gives them a 48% increase in nominal incomes over the period. Remember how the top 0.1% paying 33% more in taxes in 2008 than in 2001 was supposed to prove how they hadn't been "coddled"? Oops. The same, of course, applies to the top 400 tax filers. The IRS data clearly shows that the effective tax rate for the top 400 filers fell significantly between 2001 and 2008.

Investors Business Daily does manage to get one fact right. The share of federal incomes taxes paid by the rich has increased since the Bush tax cuts became law. But that merely reflects the reality that increasing numbers of households are simply too poor to pay much after accounting for state, local and payroll taxes -- the last of which is regressive and raised 97% of the revenue that federal income taxes did in 2009.

Conservatives react to the undeniable reality that the richest members of our society benefit from egregious loopholes like carried interest with the equivalent of a temper tantrum. They know the wealthy are taxed too much, facts be damned! No, increasing taxes on the super-rich will not come close to filling our structural deficit, but it would not be insignificant either: perhaps $1 trillion over a decade. And it would go a long way towards reducing the blatant unfairness in our tax code.

The most specious tax argument ever does not change this.

Wednesday, August 17, 2011

Does Alan Blinder Want to End the Liquidity Trap?

Some rather puzzling comments from former Fed Vice Chairman Alan Blinder. Here is what Blinder had to say about the Fed's recent statement that it anticipates keeping short-term rates near zero through mid-2013:
In doing so, the Fed violated one of the most revered canons of central banking: Always keep your options open. No one knows what might happen between now and June 2013 -- not you, not me, and not the FOMC. A booming economy by, say, Christmas 2012 doesn't look too likely right now, but it could happen. And if it does, the Fed won't want to keep the federal-funds rate near zero. So why risk the loss of credibility?  
The answer is that the FOMC was so concerned about the health of our economy that they felt they had a duty to offer some support some support to the frail economy and soothe the nearly panicked financial markets. But they had used up all their good ammunition long ago.
While it is undoubtedly true that monetary policy is more difficult at the zero bound, that does not mean the Fed is out of proverbial bullets. Indeed, the Fed could still announce an interest rate target for 10-year bonds that would amount to open-ended QE3. Or the Fed could start buying other assets. Eliminating interest on excess reserves is another possibility. There are options.

But the most perplexing aspect of Blinder's piece is his attitude towards the Fed's change in communications. The Fed didn't actually say what Blinder says it did. And that's too bad. The Fed only said that it expects short-term rates to stay parked near the zero bound till mid-2013; it did not promise to keep them there. Here is the relevant passage from the latest FOMC statement:
The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.
This is certainly a more dovish statement, but it is not a commitment: it is making the Fed's own economic forecasts more transparent. If growth suddenly picked up around Christmas 2012, as Blinder imagines, nothing in this statement would preclude the Fed from hiking rates to check inflation. That's a problem.

Absent an explicit level target, a period of "responsible irresponsibility" is perhaps the Fed's best tactic for getting the economy out of a liquidity trap. After all, if markets think the Fed will react to any future above-trend inflation by raising rates, inflation expectations today will remain subdued -- and the economy will stay stuck. As Paul Krugman first suggested and Eggertsson and Woodford later expanded on, the reverse is true as well. If central banks credibly commit to maintaining expansionary policies for a prolonged period -- presumably longer than warranted -- then future inflation expectations should rise, causing real interest rates to fall and demand to pick up. Blinder's concern about the Fed boxing itself in to low rates ill-suited for future conditions is precisely the point of the policy.

Unfortunately, as long as economists remain more concerned with maintaining the Fed's future credibility as an inflation-fighter than with the devastating consequences of long-term unemployment, we will not get out of this muddle. We have enough real problems that we do not need to invent new ones.

Monday, August 15, 2011

What HFT Hedge Funds Tell Us About Carried Interest

Warren Buffett's recent New York Times op-ed calling for higher taxes on the super-rich has brought the issue of carried interest back into relief.  For the uninitiated, carried interest is the tax loophole that lets private partnerships -- venture capitalists along with private equity, hedge fund and real estate managers -- get taxed at the long-term capital gains rate rather than at the ordinary income rate. That is why a billionaire fund manager like Buffett recently had a tax bill that amounted to only 17.4% of his income.

Carried interest is actually a bit more complicated. Members of private partnerships are typically compensated along a 2/20 model: they earn a management fee equal to 2% of the size of their fund, and receive a performance fee of 20% of any profits. The 2% management fee is taxed at the ordinary income rate -- i.e., 35% -- but the 20% of profits are taxed at the capital gains rate of 15%, despite the fact that fund managers ordinarily do not risk much of their own capital. There's a final wrinkle. Managers must hold on to a position for a year to qualify for the long-term capitals gain rate of 15%; if they do not, profits are taxed as ordinary income.

Megan McArdle considers these facts and lays out her strongest counter-argument for maintaining the carried interest exemption:
The arguments for the carried interest are farily compelling: without it, the partners who contributed ideas and talent end up being taxed much more heavily on their earnings than partners who contributed financial assets. This is not only sort of unfair, and impedes the ability of talented people with few financial resources to move into the moneyed class, but also might have implications for economic growth: if your gains are going to be taxed at ordinary income rates, why quit that safe job and risk all on an untried venture?
Short answer: because the returns on these "untried ventures" are the most lucrative in our society. It's difficult to imagine someone choosing not to work at a private equity fund because carried interest was eliminated, given that it would be nearly impossible to find an equally well-paying job (none of which would enjoy tax subsidies either). Indeed, McArdle herself reaches the same conclusion -- albeit, rather tentatively.

But this is less a hypothetical question than an empirical one. Consider the case of high-frequency trading (HFT) hedge funds. As previously mentioned, a fund must hold a position for one year to qualify for the 15% capital gains rate. Venture capital, private equity and real estate trusts make multi-year investments, so this does not affect them. But many hedge funds, particularly the automated HFT crowd, hold very short-term positions. Consequently, those hedge funds have their entire income taxed at the ordinary rate. This has not seemed to much affect their staffing. Indeed, if there have been stories about HFT hedge funds having trouble hiring due to prospective employees worrying about their tax statuses, I have certainly missed them.

The proliferation of HFT funds the past few years shows that the marginal supply of hedge funders is relatively inelastic to the carried interest loophole, due to the inability to substitute a higher-paying job. Pretending otherwise is simply searching for a justification for an unjustifiable policy.

Saturday, August 13, 2011

The Don Quixote Economics of the Fed Dissenters

Aside from rumblings in Richard Fisher's gut, what are the best arguments Fed dissenters have against further easing? Here's Minneapolis Fed governor Narayana Kocherlakota giving his rationale for opposing the recent change in the Fed's communication strategy:

How about a reality check. Let's take a look at the percent change in PCE from the previous year, starting in November 2010.

See the "notable rise" in PCE inflation? Try squinting. Of course, Kocherlakota hedges a bit by claiming that the increase occurred during the first half of 2011, which conveniently ignores the subsequent decline (both of which were mainly driven by oil prices). The argument that PCE minus food and gas prices have also increased is equally hyperbolic -- unless a move from 1% to 1.3% inflation is worrisome.

What about unemployment? Given that it has come down from 9.8% in November 2010 to 9.1% in July 2011, perhaps further action is unwarranted. Unfortunately, this statistic is misleading. The U3 measure of unemployment ignores discouraged workers; the civilian employment-population ratio gives us a more accurate assessment of the labor market.

See the fall in unemployment now? If the economy is not already back in recession, it is certainly stuck in a "growth recession", where not enough jobs are being created to keep up with population growth. The output gap is steadily widening.

Confronted with subdued inflation expectations and a deteriorating jobs market, the Fed dissenters insist that the reverse is true. This is Don Quixote economics: waging war on imaginary problems while real ones persist unabated. It reflects little more than irrational angst over unconventional monetary policy, coupled with a misplaced conviction that any uptick in inflation augurs the return of stagflation. Regrettably, empirical evidence will not convince the inflation hawks that it is not 1980, nor will the continuing jobs crisis move them to act. As long as inflation runs between 1-2%, they consider it mission accomplished.

Meanwhile, the economy is falling even further below its long-term trend.

Thursday, August 11, 2011

Austerity Doom Loop

The preoccupation with deficits and (nonexistent) inflation by policymakers on both sides of the Atlantic is short-circuiting the recovery, such as it was.

Even more troubling is the possibility that Very Serious People will interpret their policy failures as a sign that spending cuts have simply not gone far enough -- an austerity doom loop. It goes something like this:

1. Look at those deficits! We have to cut spending or the bond vigilantes will go Galt on us! (never mind that they are more than happy to lend to us at historically low rates).
2. Spending cuts lower growth expectations.
3. Investors pile into government debt in a flight to safety.
4. Austerians claim lower yields vindicate their agenda. Confidence has been restored!
5. Unemployment does not come down. Deficits worsen.
6. Repeat.

The market for ideas, like others, is not necessarily self-correcting. Which is why it would be helpful if President Obama -- who should know better -- would stop parroting GOP talking points about deficits and the confidence fairy.

Wednesday, August 3, 2011

Democrats In Denial

When it comes to President Obama, liberals can't seem to get past the first stage of grief. It's one part cognitive dissonance, another part rationalization.

Liberals look at Obama and see an incontrovertibly intelligent man. And yet, he seems unable to discern the most basic political realities -- obviously a problem for a politician. Indeed, this latest exercise in Republican hostage-taking was so predictable -- to everyone but the White House, that is -- that reporter Marc Ambinder predicted it last December. At the time, Ambinder asked Obama why he had not included a debt ceiling increase in the agreement to extend the Bush tax cuts, given that the GOP would undoubtedly use the debt ceiling as leverage to extract future cuts. Obama was oblivious.

What is going on here? After all, it's no secret that the Republicans have just two overarching goals: 1) knee-capping Obama's presidency, and 2) keeping taxes on the rich low. The GOP has been quite explicit about both these aims. How could Republican intransigence still be such a shock to Obama after two and a half years of unprecedented obstructionism and extortion? Liberals alternate between hoping that Obama's weak negotiating is either some kind of still obscure rope-a-dope scheme -- "jujitsu" or "11-dimensional chess" -- or that he will finally draw the proverbial line in the sand and stand up to the Republicans.

The truth is more depressing. The only principle Obama is unwilling to compromise on is compromise itself. He values process over policy. This pose as the most reasonable man in the room might not be a problem if the other side was negotiating in good faith. They are not. Rather, their midterm rout has emboldened the GOP to take hostages. They threaten economic ruin unless their policy demands are met. And they keep doing so for a simple reason: it has worked thus far.

This is where rationalization comes in. Taken individually, none of the deals the Republicans have dictated to Obama have been that bad. The Bush tax cuts extension included a dose of stimulus in a payroll tax holiday and extended unemployment insurance. The threat of a government shutdown in April did not lead to draconian spending cuts. Neither did the brouhaha over the debt ceiling: $21 billion in FY2012 cuts will not affect Obama's electoral fate. It could have been much worse (how's that for a re-election slogan?). But that completely misses the point.

The GOP strategy is cuts by a thousand cuts. Each time they take a hostage, the Republicans wrest modest enough concessions that the Democrats give in rather than risk economic calamity over such relatively small stakes. Insofar as chipping away at the deficit has burnished Obama's centrist credentials, there's a defensible argument that he is winning the -- wait for it! -- future by mollifying independents on spending. Messaging trumps policy, too. Again, a rationalization. The reality is that the economy is far, far more important than political framing. James Carville had it right. Even an overgenerous interpretation of these deals as tactical victories for Obama adds up to a strategic defeat. The Republicans have taken stimulus off the table -- and Obama can't even blame them for it, given his cooperation and pro-austerity rhetoric. A belated "pivot" towards jobs, which Obama laughably thinks could pass the House, would hardly make a dent in our jobs crisis even if it somehow did get enough Republican support.

Still, liberals hope. They have already turned their attention to what figures to be the next political brawl: the expiration of the Bush tax cuts in late 2012. The New Republic's Jonathan Chait has been pounding the table for Obama to call the GOP's bluff, and veto any bill that keeps the Bush tax cuts for incomes above $250,000. This is politics worthy of the jujitsu moniker. It simultaneously places the blame for a middle class tax hike on the Republicans, while raising the revenue necessary to keep Social Security and Medicare close to their current forms. So, does Chait expect Obama to adopt this strategy?
The problem, though, is that we can't be sure Obama really intends to draw that line. There's a limit to how much faith one can place in a man who has so badly misjudged his political opponents time and time again. The debt ceiling ransom may be a shrewd strategic retreat, or it may be the largest in a series of historic capitulations. We won't know until the fight over the Bush tax cuts has been settled.
Unfortunately, we likely already know. Indeed, Obama's abortive attempts at a "grand bargain" during the debt ceiling negotiations included offers of tax reform, i.e. lowering rates and closing loopholes. It's certainly true that this offer was made in the context of larger negotiations, but Treasury Secretary Tim Geithner's recent op-ed still endorsing the idea should erase all doubt about the administration's intentions.

Democrats need to realize Obama cares more about appeasing the Washington Post editorial board than he does his own base. Instead of hoping that he will become the politician they want him to be, they should try to pressure him to do so. It's time to recognize he's not the one we were waiting for.