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The noble David Balan emailed me the following observations on our immigration bet.  With his kind permission:

I do agree that Bryan has won our bet.  But I will commit the following violation of the Bettor's Oath.

In the blog post that led to the bet, Bryan wrote:

The upshot: When I hear that Obama plans to shield many millions of illegal immigrants from the nation's draconian immigration laws, I'm skeptical.  Such an action requires the very iconoclasm the democratic process ruthlessly screens out.  Bold announcements notwithstanding, I expect him to (a) slash the numbers, (b) cave in to public pressure, and/or (c) fail to effectively deliver what illegal immigrants most crave - permission to legally work.

In the comments, where I accepted the bet, I wrote:

If you're offering, I'll take Nathaniel's side of the bet too. I have no deep insight here, just my sense that Obama would have nothing to gain from saying he's going to do this and then not doing it. If he wasn't committed to seeing it through, he would have just skipped the whole thing.

Bryan's reason for taking his side of the bet was that Obama would not go through with a meaningful shielding of immigrants.  My response was that I didn't see why he would say it if he didn't plan to do it.  What ended up happening was that Obama lost in court, and we will never know what he would have done if he had won.  I didn't offer this as a caveat at the time of the bet simply because I didn't think of it.

Bryan won fair and square; clearly these bets are decided based on whether the specified events happened or not, not on the reasons.  And this is certainly not a claim that I was "really right."  But the issue did end up getting resolved on grounds that were (to a first approximation) unrelated to, and offered no opportunity for the resolution of, the stated basis of our disagreement.

 If I lose my other open bet about the price of gasoline in 2018, which I appear to be on track to do, there will be no such caviling.

My reaction: I actually agree with Balan that Obama "wouldn't say it if he didn't plan to do it."  But this neglects the crucial question: How much did he want to do it?  In the grand scheme of Obama's political ambitions, what was its priority?  If Obama cared about immigration half as much as I do, he would have made amnesty and liberalization his top issue in his first term when his party controlled both Houses of Congress.  Instead, of course, he assigned pride of place to Obamacare.

In the most recent Econ Journal Watch, Cass Sunstein states that he has changed his mind about one of the most libertarian proposals he and co-author Richard Thaler make in their book Nudge: Improving Decisions About Health, Wealth, and Happiness. I reviewed their book in the Summer 2008 issue of Regulation. My review is titled "A Less Oppressive Paternalism."

Here's what I wrote on their chapter on marriage:

In a chapter titled "Privatizing Marriage," Thaler and Sunstein advocate, quite sensibly, moving in a libertarian direction by separating marriage and state. They point out that, despite the evidence, almost 100 percent of people who get married think that they are highly unlikely to get divorced. This is one of those systematic, but wrong, biases that people have. People also think that arranging pre-nuptial agreements will "spoil the mood." The result? Most people are vulnerable to "a legal system that has an astonishing degree of uncertainty." They advocate a nudge: a default contract that favors the weakest parties, typically women. Then, people would be free to avoid the default by tailoring a contract to their desires. They also suggest that taking marriage away from the state would, with one fell swoop, solve the thorny problem of gay marriage. Let churches and other organizations choose whatever marriages they want to approve and let people choose their churches. Interestingly, their nudge is a small part of this proposal, just as with their proposal on malpractice.

In short, I thought it made a lot of sense.

But now, in his article "The Statements I Most Regret," Sunstein writes:

What a terrible idea. For countless people (including the present author, married in 2008, after chapter 15 was done), official marriage is important, even precious. It recognizes a status, and it does so in the distinctive way that comes from the state itself. Abolishing that status would impose a serious loss--and it might well have unintended bad consequences for spouses and children alike.

To be sure, Thaler and I were trying to solve a particular problem: the intense and seemingly intractable debate over same-sex marriage. We thought that privatization would be a way to make that debate disappear. We failed to foresee the immense power of the movement for same-sex marriage, which was able to achieve its goals in an extraordinarily short time. But even if that movement had turned out to fail, our proposal would throw away an indispensable institution.

So his rejection is not mainly due to the success of same-sex marriage. It's about his unwillingness to give up the government's imprimatur on marriage. This is more evidence that Sunstein, as I have said elsewhere, is the less libertarian of the Sunstein/Thaler pair.

What about his argument that the abolishing the legal status of marriage "might well have unintended bad consequences for spouses and children alike?" He and Thaler actually deal with that argument in their Chapter 15. They wrote:

Its [official marriage's] benefits are surprisingly low; in many ways it is an anachronism. The most that can be said is that official marriage might contribute to a kind of commitment that benefits both couples and children." (emphasis their's)

Later in Chapter 15 they come up with good solutions that deal with children but don't require the government's recognition of marriage.

CATEGORIES: Regulation

Two and a half years ago, I made the following bet with Nathaniel Bechhofer:
If, by June 1, 2017, the New York Times, Wall St. Journal, or Washington Post assert that one million of more additional illegal immigrants have actually received permission to legally work in the United States as a result of Obama's executive action since November, 2014, I owe Nathaniel Bechhofer $20.  Otherwise he owes me $20.
David Balan joined with Bechhofer, to the tune of $100.

By Bechhofer and Balan's mutual consent, I have now won.  As is often the case, I wish I lost.  And I think I would have lost if Obama had made immigration his top priority from the day he gained office.  But I doubt it was even in his top 5.  If Obama really cared about immigrants, he would have ended his presidency by pardoning the 20,000+ people in federal prison for immigration offenses, not closing the border to the victims of Cuban Communism.

David Beckworth has a new post discussing the implications of declining interstate mobility for whether or not America is an optimal currency area. Adam Ozimek has a post suggesting that lower labor mobility might imply a need for additional monetary stimulus:

So overall, we less mobility out of struggling places, and even if we could incentivize more mobility out of struggling places it is likely that this adjustment measure's efficacy has fallen as declining populations create a different negative economic shock that would counteract the positive effects of a tighter labor market. What is the implication for monetary policy? If the Fed was setting interest rates for the worst performing 20% of the U.S., it would keep interest rates lower for longer. This would result in overheating in some parts of the country that are farther along in their recoveries. However, the costs of above trend inflation in the cyclically recovered parts of the country are lower than the costs of remaining cyclical slack in the struggling parts. Letting inflation run ahead of target will help the places that are behind catch up, while those places that are ahead will merely experience some low cost excess inflation.
I don't think this is correct, although I have an open mind on the issue. Here are some thoughts:

1. The Fed targets inflation at 2%. Monetary theory suggests that policy is roughly superneutral with respect to changes in trend inflation, at least in the long run. That means there is no long run trade off between inflation and unemployment. The average unemployment rate will be about the same at 2% trend inflation and 6% trend inflation. I say "roughly" because this is not exactly true, but the science of economics is not far enough advanced to know whether average unemployment would be slightly lower at 6% trend inflation, or slightly higher.

2. Because of point one, it's meaningless to talk about monetary policy "hawks" and "doves". A hawk or a dove is someone who does not have a clear understanding of monetary theory. The decline in mobility has no obvious implications for the optimal trend rate of inflation.

3. Ozimek's post doesn't mention a higher trend rate of inflation, but rather the possibility that monetary policy should be more expansionary at this point in time. This raises the question of whether declining mobility impacts the optimal degree of flexibility in the Fed's "flexible inflation target." This is certainly possible.

4. The best way to think about flexibility is to start by imagining a simple inflation target---single mandate---and then consider what happens if Congress adds a second mandate for employment. Most economists don't think the second mandate affects the optimal trend rate of inflation (except ruling out ultra-low trend inflation), but do think that it impacts the optimal cyclicality of inflation. With a dual mandate, policy should be a bit more expansionary during periods of high unemployment and a bit more contractionary during periods of low unemployment. That is, policy would be slightly more countercyclical---"leaning against the wind." NGDP targeting is one example.

5. I'm not sure how declining labor mobility impacts the optimal degree of flexibility, but I'd guess that it implies that the Fed should pay a bit more attention to unemployment than would be the case if labor mobility were high. Adam seems to have the same view.

6. The unemployment rate is currently 4.3%, which is the lowest rate since 1970, excluding a two-year period around the millennium. Obviously this is a period of relatively low unemployment. Thus if we are going to ask monetary policy to pay a bit more attention to the unemployment rate, then we'd actually want a tighter monetary policy at this point in time.

In general, the best way to think about monetary policy is not to imagine what sort of policy would make us better off at this moment in time (that would almost always be a more expansionary policy), but rather what sort of monetary regime performs best over a long span of time, given the structure of the economy. For this timeless perspective, the issue is not about hawks vs. doves, it's about how much weight to put on the employment part of the dual mandate. But remember, if you put more weight on employment it means a tighter monetary policy when the unemployment rate is lower than average---like right now.

I wish monetary policy could always be more expansionary than average, but unfortunately that only works in one place:

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PS. I think you could actually make a stronger argument for declining mobility creating a need for a higher inflation target---based on how the zero bound problem affects the Fed's ability to hit its dual mandate. But that's very different from calling for easier money right now.

The "free market" strain of conservatism is considered obsolete pretty much everywhere, a relic of the past, particularly among conservative politicians. These latter aim to provide voters with more energetic plans to action, a robust vision of the role of state, a stronger propensity for government investment and, of course, a softer, kinder approach to social and welfare policies. Free market conservatism of the sort that dominated in the 1980s is considered incompatible with the aspirations of a kinder and fairer society, incapable of dealing with the complexities of a globalised world, and ultimately responsible for growing inequality and financial turmoil.

Even would-be successors to Ronald Reagan and Margaret Thatcher are buying into their caricatures: as neither Reagan or Thatcher were such "radical" libertarians as they were portrayed, nor have any of them slashed the welfare state in the supposedly heartless way they opponent said they would. The NHS survived Mrs Thatcher basically untouched, neither, in spite of his denunciation of welfare queens, did Reagan fundamentally change the US welfare policies. Still, both of them helped in breathing new life into the rhetoric of self-reliance and individual independence, and they opened up to the mere possibility that, indeed, some areas of human life can be preserved, and even flourish, without direct government intervention.

This rhetoric has long been abandoned by "conservative" leaders in the United States and in the United Kingdom, not to mention in continental Europe, and still such a rhetorical evolution is constantly deemed a novelty. Perhaps because the alternative to Reaganism and Thatcherism on the conservative side is typically a deliberate rejection of principled stances, many "compassionate" and "pragmatic" conservatives do not stick in our memory, whereas the two icons of free-market conservatism loom large.

This has happened, most recently, in the UK, where Theresa May has clearly steered the Tories away from any limited government rhetoric, embracing industrial policy (whose demise was the true triumph of Mrs Thatcher) and building arguments that perceptive observers even considered implicitly rejecting Hayek. Theodore Dalrymple, on our sister website the Library of Law and Liberty, has a splendid essay on Mrs May's political agenda:

In the matter of taxing and spending, she is to the left of Mr. Blair, of the supposedly left-wing Labor Party. He was only for spending without taxation, while she is for spending without a promise that she will not raise taxation. I suppose that this is an advance of a kind; but even Mr. Blair, who was to economic thought what Walt Disney was to the zoological study of mice, did not believe in price controls of vital commodities as a means of assisting the poor, as she appears to do with regard to the prices of gas and electricity. Here the late Hugo Chavez is more her guru than is Mrs. Thatcher.
Read the whole thing.

Now, Mrs May's strategy seemed, until a few days ago, electorally very wise. She was confronted with a political ghost of the Christmas past, Jeremy Corbyn, a disinterested, pure and idealistic advocate of good ol' command and control socialism. Corbyn was so exceedingly unattractive, chances were good that many of his voters could switch to a credible Tory leader, if only she talked the right (left) talk. This was Mrs May's strategy: growing the base of her own party by watering its wine. Mark Littlewood, the Director General of the Institute for Economic Affairs in London, put it brilliantly: "we're being offered any political colour, as long as it's red". To be sure, there are plenty of reasons for a corporatist political strategy to work better with voters than some, even timid, promise to do away with special interest privileges. What is surprising, however, is the complete rejection of the ambition of freeing markets even as political propaganda.

The proof of the pudding is in the eating, in politics even more so. Is that strategy working? The latest polls are showing May's lead over Corbyn getting embarrassingly small, for she called elections in full confidence of the result.

Now, certainly mistakes were made in May's campaign (but Corbyn's one wasn't perfect either). Politics has a lot to do with candidates looking attractive and credible, beyond any ideological matter. The terrorist attacks in Manchester and London may eventually convince public opinion to stick with an otherwise unpopular leader. It well may be that May's platform, though unconvincing, is nonetheless more electorally convincing than anything more free market types would have worked out. And yet it would be good, for once, to have some solid conservative politician attempting to give free market conservatism another try. It may well prove as electorally disastrous as most conservative politicians think. Or maybe not.

Yesterday I asked:

Suppose you - and you alone - discover that the stock market is mean-reverting.  

True, False, and Explain:  If you are rational, you will NOT obey the permanent income hypothesis.
To review:

If the stock market is mean-reverting, low returns now predict high returns in the future, and high returns now predict low returns in the future. 

If you obey the permanent income hypothesis, your current consumption depends solely on your total wealth (including future labor income, of course), not current income.

My answer: TRUE. As long as there are no binding credit constraints, mean reversion implies that after periods of exceptionally low or high returns, the market valuation of your wealth is temporarily misleading.  When returns have been low, you can expect your wealth to grow unusually quickly in the future; when returns have been high, you can expect your wealth to grow unusually slowly in the future.  The researcher who correlates the market valuation of your total wealth with your current consumption will therefore find that you are less responsive to stock market changes than the PIH implies. 

Intuitively, imagine that the stock market fell 50% today, but you (and you alone) knew for sure it would return to its initial price tomorrow morning.  You'd have near-zero reason to revise your consumption this evening, because you're only poorer "on paper" - and you can readily borrow to resolve today's cash flow problems.

What if there are binding credit constraints?  Then there's another effect in the opposite direction.  Key idea: Mean reversion implies unusually good investment opportunities after stock market falls.  If you can't borrow unlimited amounts at the market rate, you will have to partially "self-finance" to take advantage of these temporarily good opportunities.  As a result, your current consumption tends to be more responsive to stock market crashes than the PIH implies.  During bad times, you'll want to really "tighten your belt" to take advantage of the situation.
In the real world, the relative size of these two effects is unclear - at least to me.  But it would be a miracle if they exactly cancelled, leaving the PIH unscathed.

David R. Henderson  

The Nightmare in Your Future

David Henderson

The title of this post is the subtitle of a talk I gave in about 2004 at Santa Clara University. The whole title was "Social Security: The Nightmare in Your Future." I had two goals: (1) to get students paying attention to how much they were likely to pay in Social Security taxes for not very good benefits--I also threw in Medicare, which was worse; and (2) to get them to think seriously about ending Social Security and Medicare, both of which I called "intergenerational abuse."

My daughter was a student at SCU at the time, but, not being in economics, she was not required to attend. She came up with a guy friend beforehand and explained that they would probably stay for half an hour at most because Tuesday night was party night. I told her I understood. An hour and a half later, after the talk had ended, they both came up and my daughter said, with a lot of energy, "I didn't know these things." It opened her eyes. Count me a proud papa.

Now, Mauricio Soto, a senior economist with the IMF, has produced a short readable analysis that backs up my point, not just for the United States, but for many rich countries. (HT2 to Timothy Taylor.) The piece is appropriately titled "Pension Shock."

Soto writes:

Population aging puts pressure on pension systems by increasing the ratio of elderly beneficiaries to younger workers, who typically contribute [sic] to funding these benefits. The pressure on retirement systems is exacerbated by increasing longevity--life expectancy at age 65 is projected to increase by about one year a decade.

To deal with the costs of aging, many countries have initiated significant pension reforms, aiming largely at containing the growth in the number of pensioners--typically by increasing retirement ages or tightening eligibility rules--and reducing the size of pensions, usually by adjusting benefit formulas. Since the 1980s, public pension expenditure per elderly person as a percent of income per capita--the so-called economic replacement rate--has been about 35 percent. But that replacement rate is projected to decline to less than 20 percent by 2060 (see Chart 1, right panel).

Solutions? One is a change in government policy:
For those born between 1990 and 2009, who will start to retire in 2055, increasing retirement ages by five years--from today's average of 63 to 68 in 2060--would close half of the gap relative to today's retirees.

The other is private:
Simulations suggest that if those born between 1990 and 2009 put aside about 6 percent of their earnings each year, they would close half of the gap in economic replacement rate relative to today's retirees.

My advice to young people: start now.

Soto makes one claim that needs to be challenged. He writes:

Pensions and other types of public transfers have long been an important source of income for the elderly, accounting for more than 60 percent of their income in countries that are members of the Organisation for Economic Co-operation and Development (OECD). Pensions also reduce poverty. Without them, poverty rates among those over 65 also would be much higher in advanced economies.

See the problem in the last sentence? What is he assuming about people's actions absent Social Security and other such intergenerational tax-and-spend schemes? If he had said "higher," I might not object. But "much higher?" Soto doesn't know that and there is good reason to doubt his claim. Ask yourself this: how many people do you run into who tell you they will be fine in retirement because they have Social Security? How many people would say the same if there were no Social Security? What percent of people would act differently if there were no Social Security? For Soto's claim to be correct, it would have to be a low percent.

CATEGORIES: Social Security

Here's a question from my last Ph.D. Microeconomics exam.  Post your answers in the comments, and I'll share my suggested answer tomorrow.

Suppose you - and you alone - discover that the stock market is mean-reverting.  

True, False, and Explain:  If you are rational, you will NOT obey the permanent income hypothesis.

"Now there's [sic] many, many options that people are replacing chains with," Victor Fernandez, the executive director of insights at the restaurant-industry tracker TDn2K, recently told Business Insider.

Many of these options involve cooking at home. Grocery chains are increasingly competing with restaurants, thanks to lower prices and perks such as pick-up and delivery, new technology, and trendy features like wine bars and to-go meals. And meal-delivery kits like Blue Apron are focused on getting millennials on subscription plans to persuade them to stay in and cook a certain number of days a week.

Convenience is also a factor, both when it comes to delivery and speed of service. And casual-dining chains are still playing catch-up regarding delivery.

"The only part of casual dining that's growing right now is the off-premise side," Bonnie Riggs, a food-service industry analyst for NPD, recently told Nation's Restaurant News.

This is from Kate Taylor, "Millennials are killing chains like Buffalo Wild Wings and Applebee's," June 3, 2017. HT2 Janet Bufton.

The late great economist Joseph Schumpeter had something to say about this in his 1942 classic Capitalism, Socialism, and Democracy.

Here's from his bio, where I quote his thoughts on his famous term "creative destruction:"

Innovation by the entrepreneur, argued Schumpeter, leads to gales of "creative destruction" as innovations cause old inventories, ideas, technologies, skills, and equipment to become obsolete. The question is not "how capitalism administers existing structures, ... [but] how it creates and destroys them." This creative destruction, he believed, causes continuous progress and improves the standards of living for everyone.

Schumpeter argued with the prevailing view that "perfect" competition was the way to maximize economic well-being. Under perfect competition all firms in an industry produce the same good, sell it for the same price, and have access to the same technology. Schumpeter saw this kind of competition as relatively unimportant. He wrote: "[What counts is] competition from the new commodity, the new technology, the new source of supply, the new type of organization ... competition which ... strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives."

Scott Sumner  

Real and nominal shocks

Scott Sumner

Last July, Arnold Kling made the following observations:

Tyler Cowen on Brexit, Steven Pinker, and Joseph McCarthy

Posted on July 22, 2016 by Arnold Kling

And also other topics. The link goes to a Twitter post with a video.

Judge for yourself, but to me it sounds like he is telling a PSST story. He says that, for better or worse, the UK spent the last twenty years working with a set of rules on trade in services with other European countries, and now that those rules have been cast into doubt by the Brexit vote, the British economy is in trouble. It is a very different take from that of those who think in GDP-factory terms.

Here are my thoughts on these issues:

1. Real and nominal shocks have very different effects on an economy. Real shocks tend to cause re-allocation from one sector to another, without significantly impacting the unemployment rate.

2. Real shocks may impact the long run level of real GDP, without a big impact on the business cycle. Nominal shocks strongly impact the business cycle, without significantly affecting the long run level of real GDP.

3. Brexit is a real shock that will not create a UK recession, but may well impact the long run level of real GDP.

4. The "GDP factory" model is not useful when thinking about real shocks (such as 2006-07), but is useful when thinking about nominal shocks (such as 2008-09)---which tend to influence the overall economy, not just a few sectors.

During 2006-07 there was a lot of re-allocation out of housing, without a US recession. During 2008-09 there was a significant drop in America's nominal GDP, which had the effect of reducing real output in the "GDP factory".

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CATEGORIES: Macroeconomics

David R. Henderson  

Trade Deficit or Stuff Surplus?

David Henderson


Notice that if imports exceed exports, as they have done for decades in the United States, then, on net, more dollars leave the United States by Americans' purchases of imports than come in by Americans' sales of exports. Such a situation is termed a current-account deficit, or "trade deficit." But the terminology could just as well be formulated the other way around, in a framework of husbanding stuff. Then, under the same condition of imports exceeding exports, the focus is on the stuff that, on net, is flowing into the United States. Now we view the exact same world but see a surplus. Instead of looking at matters as the conventional language does, we might call this new view the in-kind account. What in the conventional view is a "trade deficit" is in the in-kind view an "in-kind surplus."

This is a key paragraph from this month's Econlib Feature Article "The 'Trade Deficit': Defective Language, Deficient Thinking" by Daniel B. Klein and Donald J. Boudreaux.

And one of their concluding paragraphs:

In our view, rather than elevating money over stuff or elevating stuff over money, economists ought to speak in a way that ascribes a presumptive mutual gainfulness and rightness to whatever voluntary decisions people make regarding all that is their own--that is, their money-and-stuff. That means eschewing any form of the "deficit"/"surplus" talk.

I recommend the whole article--it's not long.

CATEGORIES: International Trade

David R. Henderson  

Cents and Sensibility

David Henderson

Princeton University Press has recently published Cents and Sensibility: What Economics Can Learn from the Humanities. Chapter One is on line here.

The book is by literary critic Gary Saul Morson and economist Morton Schapiro. Their basic message, as the title implies, is that economists can learn from the humanities. I'm open to that message because I already agree with it. The issue will be how they pull it off. Unfortunately, the publisher has made it very clear that I may not quote from it without permission. It's Saturday night as I write this, and so I think permission will be hard to get.

In one section in Chapter One, I think they do pull it off to some extent. It's where they lay out how narrow economists can be in seeing The Merchant of Venice as being about government regulation and the legal and social framework for markets. But in the same paragraph, they write that one should "wince" at seeing The Road Not Taken as being about choice and opportunity cost. It's not? That's what I got out of it in high school long before I had heard the term "opportunity cost." It's clearly about choice. And when you have just two choices, the value of the road not taken is the opportunity cost of the road taken.

In the rest of the book, will the authors explain why The Road Not Taken is not about choice and opportunity cost? I don't know.

There is one section that I found particularly disturbing. It's where Schapiro, the economist, criticizes the famous memo written by Lant Pritchett and co-signed by the World Bank's chief economist Larry Summers in which he argued that it made sense to move toxic waste from rich countries to poor ones. The memo was brief and didn't lay out the reasoning clearly, but that make sense given that it was being distributed internally among, I presume, mainly economists. The missing reasoning is that there were gains from exchange: the rich countries' value of getting rid of the waste exceeded the poor countries' disvalue of living with the waste. Both sides could gain from the transfer of waste. If I were being demagogic, I would respond to Summers' critics: why do you hate poor people? Preventing that transfer prevents them from making themselves better off.

Now it could be that Schapiro's criticism is that the poor people in the poor country don't get to choose and their government chooses for them and imposes it on them. That's a legitimate criticism. But Schapiro doesn't make that criticism: at least, he doesn't make it in Chapter One. Indeed, the criticism that Schapiro does make doesn't sound like that of an economist. He argues that most policy decisions involve situations where some people lose and some gain. True. But here was a case where, if it were done right, there would have been just winners.

This story by Schapiro makes me concerned that either (a) he doesn't understand basic economics, or (b) he does understand basic economics but is playing to people who are hostile to, or ignorant of, economics.

There is a third alternative: that he has a good criticism of this memo, one that will show up in later chapters. But it isn't in this one.

Scott Sumner  

Two new picks for the Fed?

Scott Sumner

The NYT reports that President Trump is about to nominate two people for the Board of Governors:

The Trump administration has selected candidates for at least two of the three open positions on the Federal Reserve's Board of Governors, according to people with direct knowledge of the decision.

The expected nominees include Randal K. Quarles, a Treasury Department official in the George W. Bush administration, and Marvin Goodfriend, a former Fed official who is now a professor of economics at Carnegie Mellon University.

Here is a WSJ piece written by Randal K. Quarles and Lawrence Goodman:

Focusing on bank size is politically appealing but diverts attention from the major source of systemic risk in the financial sector: a shortage of stable deposits. Banks are but one part of an interconnected financial sector providing over $40 trillion of credit to the economy, but that credit is supported by only about $11 trillion of bank deposits.

The gap must be closed largely with professionally managed, "wholesale" funding, such as short-term repurchase agreements. Wholesale funders are quick to pull their support by not rolling over short-term credit if they perceive those funds are at risk. This leads to periodic runs on financial institutions and the resulting demand for government intervention to prevent the failure of those institutions. . . .

Mr. Kashkari's alternative proposal, promoted by academics including most vocally Stanford economist Anat Admati, is to ramp up bank capital to such a degree that the possibility of failure would be remote to nonexistent. But the consequence of a dramatic increase in bank capital is an increase in the cost of bank credit, meaning higher interest rates across the board. Those who favor much higher bank capital argue this would not happen, because investors would accept lower returns if the banks they put their money in were safer.

In the real world of capital markets, however, there are not enough natural investors in bank equity seeking utility-like returns. Institutions capitalized largely with debt would encounter similar constraints.

Given these structural facts, the job of the regulatory system is clear. First, facilitate the reallocation of capital during the inevitable periodic crises through orderly liquidation of failing or failed banks. Second, adopt a monetary policy rule, such as the Taylor rule, that would normalize interest rates and reduce the incentive for big banks and even smaller institutions to take dangerous risks.

This completely misses the point. The problem with our banking system is not that wholesale funding that is susceptible to bank runs---the Fed can provide almost unlimited liquidity in an emergency---the problem is excessive risk taking with FDIC-insured deposits. Quarles doesn't seem to recognize the role of moral hazard in making the banking system less stable.

Even worse, he suggests that monetary policymakers should worry about excessive risk-taking when deciding where to set interest rates. If interest rates had been set according to the Taylor Rule during the recovery from the Great Recession, we'd still be in recession. Indeed the ECB made a similar mistake in 2011, raising rates during a weak recovery, and thus precipitating a double dip recession.

This part of the NYT story also raises some concerns:

At the Fed, Mr. Quarles would take the place of Daniel Tarullo, who led the Fed's push to tighten financial regulation after the 2008 crisis, though he was never formally nominated to serve as the vice chairman for supervision.

Mr. Quarles is regarded as significantly more sympathetic than Mr. Tarullo to the industry's concerns that regulation is overly restrictive, limiting economic growth.

Deregulation of banking would be a great idea, once we've solve the moral hazard problem. Unfortunately the American banking system doesn't want to solve the moral hazard problem, because that would be "costly". Yes, but wasn't the 2008 financial crisis also sort of costly?

The good news is the pick of Marvin Goodfriend, who is a superb monetary economist and well qualified to serve on the board. Don't pay attention to discussion of "doves" and "hawks", which are pretty meaningless terms in a world of 2% inflation targets. Rather there are economists who take seriously the Fed's responsibility to provide nominal stability, and those who do not. Goodfriend is most certainly in the former group.

PS. I'd expect Miles Kimball to be pleased about Goodfriend, who is (AFAIK) the first economist to propose negative IOR.

PPS. The NYT also has this interesting tidbit:

Mr. Quarles, 59, is a managing director at the Cynosure Group, a private equity firm based in Salt Lake City. His wife's great-uncle is Marriner Eccles, the Fed's chairman from 1934 to 1948 and the namesake of the Fed's marble headquarters on the National Mall in Washington, where Mr. Quarles would have an office.
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HT: Tyler Cowen

David R. Henderson  

Cook vs. Cass on Global Warming

David Henderson

I wouldn't have even noticed the National Review debate between Oren Cass and John Cook, if a creepily worded article title at Vox hadn't caught my attention. The title: "Scientists are testing a 'vaccine' against climate change denial." The author is Michelle Nijhuis. It would be bad enough for someone to have an actual vaccine against denial of anything. One thing makes the article less creepy than the title: Ms. Nijhuis is not referring to an actual vaccine but to a way of arguing that reduces people's defenses. One thing, though, makes the article more creepy. She doesn't seem to distinguish between climate change denial and disagreement with specific claims about climate change. So it seems that, if she had her way, she would have people on her side of the issue use the "vaccine" on anyone who doesn't agree with some of the most extreme proponents: those who think humans are causing 100 percent of global warming.

Why do I make that last claim? Because she approvingly cites John Cook, whom I have posted about earlier, as someone who uses the vaccine. And the item she cites by Cook is his claim that 100% of global warming is caused by humans. Cook writes:

There is a consensus of evidence that human activity is causing all of recent global warming. Not some of it. Not even most of it. All of it.

I would give you the blow by blow, but it's more edifying if you read the debate in order: first Cass, then Cook, then Cass.

Imagine a banking system where the public would lend money to the Treasury at X% interest, and the Treasury would then lend the same funds to commercial banks at the same X% interest rate. All bank deposits were held by the Treasury. That sounds kind of socialistic, doesn't it? And yet this might also be viewed as a description of the actual American banking system, during the 1990s and 2000s. The Treasury backstops all FDIC-insured deposits.

Of course in recent years, progressives have complained that the 1990-2007 system was a product of radical deregulation, and the 2008 banking crisis was blowback from public policies that reflected a laissez-faire ideology. So which is it?

I'd say neither. Ideological framing gets in the way of understanding what's actually going on in banking. After a recent post criticizing FDIC, commenters suggested that removing deposit insurance would hurt small savers. But if protecting small savers were the goal, surely there are much less costly ways of doing so.

While waiting out endless delays at the airport, I recently came across a magazine that specialized in commenting on major New Your City real estate developers. (No, this story has no Trump angle.) This article caught my eye:

Sometimes it seems like Bank of the Ozarks is the only show left in town, lending hundreds of millions to developers across the city amid a condo financing drought. Its aggressive approach has led some industry insiders to question whether the Arkansas-based lender is becoming overexposed to a downturn in the New York City condo market. . . .

Ozarks, which was for most of its history a small community bank with a handful of branches in Arkansas, has been one of the most prolific lenders in the city in recent years. It recently provided a $108 million construction loan for Xinyuan Real Estate's new condominium project at 615 10th Avenue in Hell's Kitchen. It's also a lender on JDS Development and the Chetrit Group's Brooklyn megatower rental project at 9 Dekalb Avenue and on Tishman Speyer's Macy's development in Downtown Brooklyn. . . .

Last year, Carson Block, founder of Muddy Waters Research, said he was shorting Ozarks' stock because he believed the bank was moving too aggressively in the real estate space.

I don't believe in "bubbles", so don't take this as a prediction that Bank of the Ozarks will run into trouble. Rather, my point is that this sort of aggressive strategy makes far more sense in a world of FDIC, than without deposit insurance. How many people would want to put their life savings into this sort of bank, if FDIC did not guarantee the deposits?

Back in the 1920s, banks were managed far more conservatively than today. Patrick Sullivan recently reminded me of a study by Eugene White, which pointed out that the huge 1920s real estate boom and bust did not cause a banking panic:

Although long obscured by the Great Depression, the nationwide "bubble" that appeared in the early 1920s and burst in 1926 was similar in magnitude to the recent real estate boom and bust. Fundamentals, including a post-war construction catch-up, low interest rates and a "Greenspan put," helped to ignite the boom in the twenties, but alternative monetary policies would have only dampened not eliminated it. Both booms were accompanied by securitization, a reduction in lending standards, and weaker supervision. 'Yet, the bust in the twenties, which drove up foreclosures, did not induce a collapse of the banking system. The elements absent in the 1920s were federal deposit insurance, the "Too Big To Fail" doctrine, and federal policies to increase mortgages to higher risk homeowners. This comparison suggests that these factors combined to induce increased risk-taking that was crucial to the eruption of the recent and worst financial crisis since the Great Depression.
Many people are surprised to find out that banks were managed much more conservatively during the 1920s than today. After all, weren't there frequent bank failures prior to the enactment of FDIC in 1934? Yes, but this reflected two special factors:

1. Because of unit banking laws, the US had thousands of small, poorly diversified banks in rural areas. Many of these banks failed during the 1920s and 1930s.

2. Monetary policy was far more unstable during this period, resulting in a roughly 50% fall in NGDP between 1929 and early 1933, as well as other big declines in 1920-21 and 1937-38. In contrast, NGDP fell by only 3% during the Great Recession.

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The importance of the unit banking laws is obvious when you consider than Canada had no bank failures during the Great Depression, despite a similar fall in NGDP. Today, that sort of decline in NGDP would wipe out virtually the entire US banking system. Canada owed its success to having large well-diversified banks with branches all across the country.

So why doesn't Congress fix the moral hazard problem? Because for Congress, moral hazard is not a bug, it's a feature. Cloud Yip recently interviewed Charles Calomiris, who had this to say about moral hazard in banking:

The pattern is that the governments, on the one hand, protects banks in the forms of deposit insurance or government bailouts when a crisis happens, or give banks certain opportunities. In exchange, the government asks things from the banks. In the last 40 years, especially across democracies, the thing that the government was asking the bank to do is to get heavily involved in residential real estates funding or to subsidize mortgages.

One of the thing that has been happening all over the world is that people in democracies are hoping that their governments can come up with programs that would make housing more affordable. The easiest way for governments to do that is to get banks to subsidize mortgage risk. The way the governments get the banks to subsidize mortgage risk is by protecting the banks. They give the banks something in exchange and then tell the banks "OK. Now we have given you the protections. We have given you these new rights. They are very valuable to you. The cost is that you have to do something that we, the government, found politically expedite." What Sophia Chen and I are finding now is that the story about the US in our book "Fragile by Design" may actually be a broadly-based story.

There are many possible solutions to moral hazard. For instance, my checking account is a Fidelity MMMF, invested in safe government bonds. We don't need FDIC to offer safe investments to small savers. Another option is requiring all FDIC-backed deposits to be invested in save assets such as Treasuries, and let banks use uninsured deposits for riskier loans. In that case we could basically repeal all of Dodd-Frank. Indeed, we wouldn't need any bank regulation at all. But that sort of reform would hurt bank profits, especially at smaller banks. And they have far more political power than America's taxpayers, who will again be on the hook when another round of go-go bankers runs into trouble.

PS. You don't see either party trying to fix the moral hazard problem. There's a reason for that.

Our findings provide evidence that helps us better understand the impacts of immigration in United States history. The first is that, in the long-run immigration has had extremely large economic benefits. The second is that there is no evidence that these long-run benefits come at short-run costs. In fact, immigration immediately led to economic benefits for those already living in the area in the form of higher incomes, higher productivity, more innovation, and more industrialization.
This is an excerpt from Jeffrey Miron, Nathan Nunn, Nancy Qian, & Sandra Sequoia, "Migrants and the Making of America: The Short- and Long-Run Effects of Immigration During the Age of Mass Migration," May 31, 2017. It's based on Nathan Nunn, Nancy Qian, and Sandra Sequeira, "Migrants and the Making of America: The Short- and Long-Run Effects of Immigration during the Age of Mass Migration," January 2017.

Their methodology for reaching this conclusion is very clever: it involves railroads. Take a look for yourself.

Nathan Nunn is at Harvard University and is affiliated with the National Bureau of Economic Research and Bureau for Research and Economic Analysis of Development; Nancy Qian is at Yale University and is affiliated with the National Bureau of Economic Research and Bureau for Research and Economic Analysis of Development; Sandra Sequoia is at the London School of Economics and Center for Economic and Policy Research.

HT2 Jeffrey Miron of Harvard University and the Cato Institute.

The Great Depression had two primary causes: an excessively tight monetary policy caused NGDP to drop in half between 1929 and early 1933, and then a set of New Deal policies such as the National Industrial Recovery Act (NIRA) slowed what would have been an extremely fast recovery after the dollar was devalued in 1933.

I've already talked about how reasoning from a price change contributed to the tight money policy of 1929-33. Most pundits and policymakers looked at the rapidly falling level of nominal interest rates and assumed that money was easy. In fact, rates were falling because of a decline in demand for credit, caused by the Depression itself. Money was actually very tight.

While cleaning up my office, I noticed an old NYT story that points to another type of reasoning from a price change:

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You might think this is simply another example of foolish Italian public policy, which doesn't apply to the US. In fact, this sort of policy provided one inspiration for FDR's New Deal, and specifically the NIRA. Roosevelt believed that falling prices were the cause of the Great Depression, and set up the NIRA (and AAA) to restrict production and raise output.

I'm sure most of my readers see the problem here. Only deflation caused by falling demand could be said to have caused the Depression. A policy of boosting demand would raise both prices and output, thus contributing to recovery. However, a decrease in supply would raise prices by reducing output, making the Depression even worse.

This is not just a right wing critique of the New Deal; Keynes discussed the same problem in an open letter to FDR, published in the NYT back in December 1933:

That is my first reflection--that N.I.R.A., which is essentially Reform and probably impedes Recovery, has been put across too hastily, in the false guise of being part of the technique of Recovery. . . .

I do not mean to impugn the social justice and social expediency of the redistribution of incomes aimed at by N.I.R.A. and by the various schemes for agricultural restriction. The latter, in particular, I should strongly support in principle. But too much emphasis on the remedial value of a higher price-level as an object in itself may lead to serious misapprehension as to the part which prices can play in the technique of recovery. The stimulation of output by increasing aggregate purchasing power is the right way to get prices up; and not the other way round.

Keynes sees FDR putting the cart before the horse, trying to artificially raise prices, not have them rise as a consequence of recovery promoted by boosting demand.

[Notice that Keynes refers to "aggregate purchasing power" which is essentially NGDP. Elsewhere I've argued that much of the General Theory is quite "market monetarist", with his focus on the relationship between nominal hourly wages and NGDP being quite similar to my "musical chairs model."]

The tight money policy of 1929 was adopted to slow the stock market boom. I suppose that's also a sort of reasoning from a price change, failing to distinguish between asset price rises caused by an overheated economy, and those reflecting good fundamentals. But I'd argue that this policy error is better described as reflecting a rejection of the efficient market hypothesis. Either way, when policymakers ignore the basic principles of economics, bad things tend to happen.

BTW, reasoning from a price change also caused the Great Recession. In addition to the well-known interest rate fallacy, the Fed and ECB were fooled by rising inflation in 2008, wrongly viewing that as evidence that monetary policy was too easy. The Fed passively tightened while the ECB actually raised rates in July 2008. In fact, the higher inflation was caused by a reduction in AS, not a rise in AD.

PS. It's interesting how often the US adopts fads that started in Italy. When Italy elected Silvio Berlusconi in the late 1990s, I shook my head in disbelief. At the time, I couldn't imagine American voters doing anything remotely similar.

PPS. Some people argue that the New Deal had "fascist" roots, pointing to inspiration provided by Mussolini. There's a bit of truth in that claim, but it's also a bit unfair---given that in the modern world the term 'fascism' is associated with highly repressive and racist policies adopted in places like Germany. The meaning of words evolves over time, and that accusation had more merit in 1933 than today.

PPPS, Keynes' entire 1933 letter is quite interesting and worth reading. For instance, it makes clear that Keynes' belief in liquidity traps was not a "myth".

David R. Henderson  

AARP on Drug Prices

David Henderson

A few years ago I finally succumbed and became a member of the AARP. My reason is that it gave me a substantial discount on my eye glasses, a discount that more than paid for the annual fee. As a result I get the AARP Bulletin and occasionally read it.

In the May issue, the cover story was on drug prices and costs. Regular readers of this blog won't be surprised to know that there was little in it with which I agreed. The "investigate report" doesn't even mention the role of the Food and Drug Administration in withholding drugs from the marketplace.

I won't bother going into all the areas in which I disagreed with the story. But, because I'm a glass half full person, I'll mention two points on which I agree. They are these:

1. The report makes this statement: "Medicare and Medicaid, by contrast, are required to cover almost all drugs approved by the FDA, regardless of whether a cheaper, equally effective drug is available." This is true--and unfortunate. My view is that Medicare and Medicaid should be allowed to say no to particular drugs. It is this current requirement that gives the drug companies tremendous power to charge high prices to Medicare.

2. The report recommends that it be legal to import drugs from other countries. I agree. I have written about this, with co-author Charley Hooper, briefly here and more extensively here.
My guess is, though, the author, and, presumably, the AARP, want drug companies to be forced to sell unlimited quantities abroad in order to satisfy the huge demand for imports by Americans. That I don't favor.

Scott Sumner  

More Ginis please

Scott Sumner

The Gini coefficient is a popular tool used by economists to measure economic inequality. Unfortunately, economists tend to rely on income data, which is not a very good measure of economic well being. Conceptually we'd like to use consumption data, but that is more difficult to measure.

This article caught my attention:

In Real Wage Inequality (PDF), author Enrico Moretti looks at cost-of-living data in U.S. cities from 1980 to 2000 in order to determine whether growing nominal wage inequality is really indicative of a growing disparity in living standards. Because college-educated workers are more likely to live in cities with higher costs of living, especially higher housing costs, some of their newfound income gains must go toward paying for life in these expensive areas. The growing disparity in wages that we observe is partially an illusion.

Whether the wage inequality we see in the data translates into actual inequality in standards of living turns on a key question: are college-educated workers grudgingly relocating to expensive cities because that's where they can be the most productive and earn the most? Or is it because they really like those cities and are willing to pay more to live there?

If the former is true, high-skill jobs in sectors like finance and technology just happen to be concentrated in coastal cities that are not especially attractive places to live, but do have high housing costs. In this scenario, high-skilled workers are unlucky in where their jobs are located, and inequality is not as severe as it appears from income data alone.

If the latter is true, then living in these expensive cities is a sort of luxury good that is increasingly only affordable for the well-educated. High-skilled people choose to relocate there because they can command high incomes to afford the higher rents. Meanwhile, low-skilled people living in these cities face rising rents and may have to move away.

These possibilities are not mutually exclusive, and there is probably some truth to both stories.

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I find a third hypothesis to be more plausible. I believe that residents of 2000 sq. foot condos on the Upper East Side are better off than they would be living in a 2000 sq. foot home in Kansas. And I also believe that residents of 2000 sq. foot homes in Kansas are better off than they would be living in a 2000 sq. foot condo on the Upper East Side.

Tastes differ, and people sort into areas where they prefer to live. Of course I'm staking out an extreme position, and there are obviously lots of exceptions. But that's also true of the other two hypotheses.

It would be very interesting for someone to take a data set like Zillow and compute the Gini coefficient for the value of housing units, and another one for the size of housing units. The value of house Gini would probably show much less inequality than income Ginis, and the size of house Gini would show even less inequality. Unfortunately, this only deals with owner occupied units, so another technique would be needed for apartments.

I also believe that the value of house Gini would be a decent proxy for nominal consumption inequality, as consumption is often roughly proportional to housing costs. In one sense it would underestimate housing inequality----richer people often own multiple homes. But in another sense it would overestimate housing inequality, as "life cycle changes" result in measured inequality even in a society where everyone has the same lifetime consumption. I.e., I consume much more housing than when I was 20 years old. My hunch is that these two biases roughly offset, leaving value of housing unit inequality a pretty good proxy for nominal consumption inequality.

And I'd say the same about the Gini for housing size. I'd guess this is much lower (i.e. more equal) than the Gini for housing values, and I'd also guess that this reflects the fact that real consumption inequality is not as bad as nominal consumption inequality. Residents of San Francisco may consume more than residents of Kansas, but their extra consumption is much less in real terms than in nominal terms.

These are all guesses on my part, and maybe someone has already studied this type of inequality data. It's not my area of expertise. But if I did focus on inequality, housing data would interest me far more than income data.

HT: Tyler Cowen.

I'm now cruising to Bermuda.  Which has me thinking: In an open borders world, cruising would probably drastically decline.  Why?  Because cruise ships show the logic of open borders in stunted form. 

Think about it: On a cruise ship, people of all nations - and all skill levels - work together.  Top-notch pilots and mechanics from Scandinavia ply their craft alongside cabin stewards and janitors from the Third World.  Via comparative advantage, their cooperation allows them to provide an affordable, high-quality vacation to eager consumers.

So where's the stunting?  Simple: This cosmopolitan cooperation is illegal on dry land.  Resources therefore pour into the unregulated sector, creating a beautiful tourist experience.  But that's nothing compared to what laissez-faire could accomplish.

By analogy: Remember the famous private plots of Soviet agriculture?  The socialist government owned all the land... except for a tiny fraction in private hands.  Yet this tiny fraction of private land produced a quarter to a third of Soviet foodstuffs!  All the pent-up potential of Soviet farmers poured into the one legal outlet.  Cruise ships work the same way: Immigration restrictions funnel labor into the one place where humans of all nations can legally work side-by-side.  Loopholes in destructive policies are a good thing, but there's no substitute for repeal.

P.S. Here are my earlier thoughts on the economics and philosophy of cruising.

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