Category: Equitablog

Where Oh Where Is the Excess Demand Going?

Posted on by Brad DeLong
Graph Consumer Price Index for All Urban Consumers All Items Less Food Energy FRED St Louis Fed

How is it that people can think that an excess supply of money can show up as an excess demand for financial assets–and thus produce large losses on leveraged portfolios and thus a financial crisis when it unwinds–without also showing up as an excess demand for currently-produced goods and services–and thus as inflation? That is the question that perplexes Paul Krugman as he tries to decode the thought of John Taylor and the BIS financial-stabilistas. It perplexes me too:

Paul Krugman: The Stability Two-Step: “Ben Bernanke[‘s]… takedown of… John Taylor and maybe the BIS….

…I wonder whether it’s making the issue more complex than it needs to be…. The financial stability group… are all permahawks. Taylor and the BIS have often argued that money is too loose; have they ever, at least in the past two decades, argued that it is too tight?… But if monetary policy is too expansionary on a sustained basis, surely we expect to see accelerating inflation. And there have in fact been repeated warnings from this group that inflation is about to take off. But what we see instead is this:

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You might expect some rethinking, given this absence of inflationary trouble to materialize. But the only rethinking that seems to happen is a search for new reasons to make the same complaints about loose money….

[And] if it’s really that easy for monetary errors to endanger financial stability — if a deviation from perfection so small that it leaves no mark on the inflation rate is nonetheless enough to produce the second-worst financial crisis in history — this is an overwhelming argument for draconian bank regulation…. Strange to say, however, I don’t seem to be hearing that from Taylor or anyone else in that camp. It’s all very odd stuff…

Originally, at least, the inflationistas and the financial-stabilistas were the same people, and had a coherent–but wrong–argument. The argument went roughly like this:

  1. The upshot of Federal Reserve policy–its current low interest rate policy, its extended guidance promises of very low interest rates far into the future, and quantitative easing–as been to over-liquify the economy: too much money in the hands of people.
  2. As a result we are about to have an outburst of inflation: the excess supply of money in the hands of the risk-loving will produce an excess demand for goods and services and then an excess demand for labor.
  3. Thus inflation will set in, and compound itself as inflation expectations lose their anchor.
  4. Too many of the people who now have the too-much money benefit from strongly-convex compensation structures: if asset prices go up, they gain fortunes; if asset prices go down, they declare bankruptcy and start over.
  5. Thus at the same time as inflation gathers force, those with too-much money will leverage up and pay too much for speculative financial assets. Positive-feedback trading will then set, so an asset price boom produced by supply-and-demand will turn into a bubble driven by extrapolative expectations.
  6. Central banks will then have to control inflation by raising interest rates to cool off aggregate demand. That negative shock will pop the bubble.
  7. And whenever the bubble pops and the crash comes, the resulting chain of bankruptcies and workouts will produce another, deeper depression.

The problem for this line of argument, of course, is that (2) never happened, so (3) never happened, so there will be no need for (6), and (7) will never come to pass.

And if there is no (2)–no excess supply of money spilling over into an excess demand for goods and causing inflation–why should there be a (4)? Why should there be an excess supply of money spilling over into an excess demand for financial assets pushing their prices up above sustainable levels?

This is a question that is, I think, still unanswered by John Taylor, or the BIS, or anyone greatly worrying about financial stability–let alone those greatly worrying about financial stability who also want to repeal Dodd-Frank.

Index funds, inequality, and competition among firms

Posted on by Bridget Ansel

Mutual funds with assets that mirror the composition of large market indices or industries, known as index funds, are widely hailed as a positive financial development. They offer a single financial asset that allows common investors to buy into markets without worrying about diversification since the fund is already diversified. Yet that diversification might have a downside, according to some new research, because the web of common ownership might be undermining competition.

In a column for Slate, University of Chicago Law School professor Eric Posner and E. Glen Weyl, a senior researcher in economics at Microsoft Research New England, point to evidence that cross-ownership of firms results in rising prices for the products and services provided by those firms, which directly harms consumers. Why would this happen? Imagine an index fund with shares in two companies that are in direct competition. Let’s say the companies are Delta Air Lines, Inc. and United Continental Holdings, Inc., the owner of United Airlines. For an index fund, it is actually in its best interest for the two companies not to compete because that might reduce the share prices of both firms.

Posner and Weyl cite a paper by José Azar and Isabel Tecu of Charles Rivers Associates, and Matin C. Schmalz, an economist at the University of Michigan, that looks specifically at the airline industry and cross ownership. They find that increased cross ownership actually results in an increase in airline ticket prices of between 3 to 11 percent. As Posner and Weyl point out, it’s as if index funds have replicated the old trusts that used to dominate the U.S. economy in the 19th century.

Their solution: Congress should outlaw index funds.

Unsurprisingly, that argument has not been received well in some corners. The headline of Matthew Klein’s article at FT Alphaville says it quite bluntly: “Law professors come up with zany plan to ruin your retirement.” Klein is skeptical of the research given the example of the airline industry, which has had trouble making profits and boasts a long history of bankruptcy since its deregulation in 1973. He also points out that it’s not clear whether more activist investors who target ownership in just one of the airlines would necessarily drive the prices for airline tickets down rather than just get the company to pay out more money to shareholders.

This gets at a broader point that Matt Levine at Bloomberg View points out. Posner and Weyl assume that increased competition at the expense of returns is more progressive as the average shareholder is richer than the average consumer. But remember Klein’s point about payouts to shareholders. Levine adds that consumers are also workers. Increased competition and pressure from investors might drive down wages in addition to prices. So the progressivity of the trade-off between index funds and lower consumer prices isn’t as evident as Posner and Weyl would have us believe.

The unconvincing nature of Posner and Weyl’s specific proposal, however, isn’t enough to push aside the underlying issue. Joshua Gans, a professor at the University of Toronto, argues that the role of ownership of firms and its effect on competition cannot be ignored. Indeed, the topic has long been studied in economics. Gans highlights one aspect of this field of research—the role of wealth inequality and firm ownership. He notes that high levels of wealth inequality can interact with firm ownership to seize market power and “rents” (economics speak for monopoly-like profits) in an economy. In fact, wealth inequality is highlighted as an important factor in José Azar’s dissertation, which served as the foundation for the paper highlighted by Posner and Weyl.

So the increased cross-ownership of firms appears to have an effect on competition and the distribution of resources. But the idea that outlawing index funds—a potentially important source of low-cost retirement savings for a broad swath of workers—seems to be unwarranted. Perhaps we should be more concerned about the distribution of ownership by wealth level.

Update (April 21, 2015, 5:45pm): After talking with Weyl on Twitter and reading a blog post by Posner in response to Klein and Levine’s pieces, I’d like to add a few notes to this piece.

First, as Weyl notes, increased competition in a market where firms have a lot of market power may actually increase wages. Market power decreases labor demand and that pushes wages down. Increased competition could reduce market power, increase labor demand, and boost wages. This would actually increase the progressive effect of their proposal as lower consumer prices and higher wages would mostly help households at the bottom and middle of the income distribution.

Secondly, Posner argues their proposed reform of mutual funds wouldn’t significantly harm the returns of middle-class investors. He states that “the gains from further diversification within industries after the benefits from diversification across industries are obtained, are tiny.” In other words, mutual funds that can only diversify across industries and not within wouldn’t be much worse off than index funds. Weyl says the two are working on quantifying this.

Finally, Posner says that the mutual fund change is not “an exclusive remedy.” The core problem is cartelization and market power, so increased enforcement of antitrust law would be a straight forward response. Given the evidence of market power and monopoly rents elsewhere in the economy, this proposal is quite reasonable.

Must-Read: Robert Skidelsky: The Conservative Election Manifesto

Posted on by Brad DeLong

Must-Read: Robert Skidelsky: The Conservative Election Manifesto: “The Conservatives have continued to spin their familiar yarn of having rescued Britain from ‘Labour’s Great Recession’…

… the mother of all lies. The Great Recession was caused by the banks. Governments, the Labour government included, by bailing out the banks and continuing to spend, stopped the Great Recession from turning into a Great Depression. Yet practically everyone seems to believe that the Great Recession was manufactured by Gordon Brown. The Conservatives claim that ‘by halving the deficit we have restored confidence to the economy’. This cheerfully ignores the near academic consensus that their deficit-reduction policies over the last 5 years have made the British economy between 5 and 10% smaller than it would have been with more sensible policies…. The Conservative narrative has become the Overton Window of our day, outside of which policies are unthinkable. But sooner or later reality will break in, and what is now unthinkable will become sensible again. But not in this election.

Must-Read: Adam Hale Shapiro: Did Massachusetts Health-Care Reform Affect Prices?

Posted on by Brad DeLong

Must-Read: Adam Hale Shapiro: Did Massachusetts Health-Care Reform Affect Prices?: “The 2006 health-care reform in Massachusetts relied heavily on the private insurance market…

…Recent evidence shows that the reform boosted payments to physicians from private insurers by 13% relative to other areas. This increase began immediately before the reform became law, suggesting that insurers raised payments in anticipation of the change. The reform may have also caused the state’s insurance premiums to fall. Overall, evidence suggests that the Massachusetts health-care reform shifted dollars away from insurers and towards providers and consumers.

Today’s Must-Must-Read: David G. Blanchflower and Andrew T. Levin: Labor Market Slack and Monetary Policy

Posted on by Brad DeLong

Must-Must-Read: David G. Blanchflower and Andrew T. Levin: Labor Market Slack and Monetary Policy: “In the wake of a severe recession and a sluggish recovery…

…labor market slack cannot be gauged solely in terms of the conventional measure of the unemployment rate (that is, the number of individuals who are not working at all and actively searching for a job). Rather, assessments of the employment gap should reflect the incidence of underemployment (that is, people working part time who want a full-time job) and the extent of hidden unemployment (that is, people who are not actively searching but who would rejoin the workforce if the job market were stronger). In this paper, we examine the evolution of U.S. labor market slack and show that underemployment and hidden unemployment currently account for the bulk of the U.S. employment gap. Next, using state-level data, we find strong statistical evidence that each of these forms of labor market slack exerts significant downward pressure on nominal wages. Finally, we consider the monetary policy implications of the employment gap in light of prescriptions from Taylor-style benchmark rules.

Must-Read: Guntram B. Wolff and André Sapir: Euro-Area Governance: What to Reform and How

Posted on by Brad DeLong

Must-Read: Guntram B. Wolff and André Sapir: Euro-Area Governance: What to Reform and How: “Pre-crisis, the euro area suffered from the built-up of financial imbalances…

…price and wage divergence and an insufficient focus on debt sustainability. During the crisis, the main problems were slow resolution of banking problems, an inadequate fiscal policy stance in 2011-13 for the area as a whole, insufficient domestic demand in surplus countries and slow progress with structural reforms to overcome past divergences…. Euro-area governance… should establish institutions to prevent divergences of wages from productivity… a European Competitiveness Council… and the creation of a Eurosystem of Fiscal Policy (EFP) with two goals: fiscal debt sustainability and an adequate area-wide fiscal position. The EFP should have the right in exceptional circumstances to declare national deficits unlawful and to be able to force parliaments to borrow more so that the euro-area fiscal stance is appropriate…. In the short term, domestic demand needs to be increased in surplus countries, while in deficit countries, structural reform needs to reduce past divergences.

Must-Read: Chris Blattman: The Mistakes Made by Most Development Reformers

Posted on by Brad DeLong

Must-Read: Chris Blattman: The Mistakes Made by Most Development Reformers: “Understand the world you live in. Think about the politics of reform. These are good points….

…It’s kind of amazing they need to be said out loud as news, but people do need reminders. One trouble I have is that I think even very smart and experienced people are profoundly bad at knowing what the problems are in the economy, where the political winds are blowing, and what will work. This needs to be said out loud as well…. I spend a lot of time studying local labor markets in Africa…. I try to figure out what holds back legal work and test programs that deliver those things: skills, capital, socialization, and so on. And I get it wrong almost every time…. Experiments never end like I expect them to…. I was blindsided by how frequently the poorest young men in slums of Nairobi have a home robbery or theft, meaning it’s almost impossible to accumulate capital. I was amazed that, yes, with a little skills and capital that a young woman can become the 183rd tailor in her community and turn a good profit.

This isn’t a defeatist point of view. I’d make a different point: the way I’ve learned how things operate is to work with a government or organization to try out a policy and succeed or fail. This kind of trial and error seems crucial to me. Karl Popper called this the piecemeal social engineer. Deng Xiaoping called it crossing the river by feeling each stone…. A lot of people would say this is China’s secret to success: informal experimentation on a grand scale. The problem, as I see it, is that most governments and aid organizations I’ve worked with are really, really bad at this. They don’t use the lessons from past failures to try again a different, better way. They don’t throw out bad programs…. The important question is not ‘what is the right policy?’, but ‘what is the process for generating good policies over time?’, and more importantly ‘how to get governments and aid organizations to adapt to the good and throw out the bad?’…

Must-Read: David Beckworth: It Takes A Regime Shift to Raise an Economy

Posted on by Brad DeLong

Must-Read: David Beckworth: It Takes A Regime Shift to Raise an Economy: “This week we learned that Ben Bernanke does not view NGDP level targeting, price level targeting, or a higher inflation target…

…as the best way to deal with the zero lower bound (ZLB) problem….

The second possible direction of change for the monetary policy framework would be to keep the targets-based approach that I favor, but to change the target… [to] raising the inflation target, targeting the price level, or targeting some function of nominal GDP… to deal more effectively with the zero lower bound on interest rates. But economically, it would be preferable to have more proactive fiscal policies and a more balanced monetary-fiscal mix when interest rates are close to zero. Greater reliance on fiscal policy would probably give better results, and would certainly be easier to explain, than changing the target for monetary policy.

So Bernanke wants the Fed to keep its inflation target of 2% and complement it with more aggressive use of fiscal policy…. What could possibly go wrong? A lot, actually…. Fiscal policy would [only] have had 60 basis points [of inflation] on average with which to work over the past six years in closing the output gap. Do we really think that would be enough for the level of aggregate demand shortfall experienced over this time? What was needed was a monetary policy regime shift… a permanent increases in the non-sterilized portion of the monetary base to spur rapid growth in total dollar spending. It was never going to happen with a 2% inflation target…. To get the kind of robust aggregate demand growth needed to close the output gap back in 2010, there needed to be a sustained (but ultimately temporary) period of higher-than-normal inflation…

What is the right size and purpose of the U.S. financial system?

Posted on by Nick Bunker

The U.S. financial services industry weathered plenty of criticism in the wake of the 2007 financial crisis, a natural reaction considering the roles played by different financial institutions in inflating a housing bubble and triggering the worst recession since the Great Depression. Of course, more prudential financial regulations are now in place, courtesy of the Dodd-Frank Act of 2010, yet it’s still worthwhile to take a step back and consider the large role of the financial system in the U.S. economy today.

A first and important observation is that the finance sector as a whole has actually become less efficient since the 1980s, according to research by New York University economist Thomas Phillippon. But Noah Smith, a professor at Stony Brook University, points out in a column for Bloomberg View that what we think of as “finance” encompasses a variety of different services. Hedge funds are different from venture capital funds, which are different from community banks. But Smith notes that they all have one thing in common: They take savings and turn them into investments, which is an incredibly important function in a complex capitalist economy.

But how big and dominant does finance writ large need to be within the U.S. economy to perform this important function? Smith argues that the best way to figure this out is to evaluate the value of each specific part of the finance sector. The questions then become, for example, what’s the value of high-frequency trading or debt-driven private equity investing.  His answer is that these are subsectors that probably are “too big on the margin.”

Then there’s the question of purpose. The U.S. financial system turns savings into investment, but are the kinds of investments chosen the most effective? Take, for example, the transformation of the commercial banking sector over the course of the 20th century. Most people think commercial banks are focused on funding business investments, yet the reality is that they increasingly focus on channeling savings into home mortgages while sub-financial sectors such as the bond markets and the leveraged loan markets serve the needs of businesses. Perhaps given these facts, we might want to consider restructuring the commercial banking sector to match its most prominent purpose.

Or consider the role of activist investors who deploy savings to drive the movement of investments toward increased dividends and share buybacks. These kinds of financial firms are setting the standards by which investments are judged. But are these payouts an accurate sign of the long-run stability of firms? If not, then that could have consequences for the broader economy. That’s certainly a question of purpose, not size.

So size might not be the only relevant question when it comes to the financial sector. The structure and the purpose of the financial system and its constituent parts are important to consider as well. If finance acts like an irrigation system for the broader economy, we need to question not only how big specific pipes are but also where those pipes eventually lead.

Over at Grasping Reality: Weekend Reading: Tony Yates: On John Taylor

Posted on by Brad DeLong

Over at Grasping Reality: Weekend Reading: Tony Yates: On John Taylor:

I think Tony Yates gets it 100% correct. It is not just that I do not think that John Taylor’s current positions are incorrect, it is that I cannot imagine a possible world in which they would be consistent:

Tony Yates: John Taylor and His Thesis that Deviations from the 1983 Taylor Rule Caused the Global Financial Crisis: “John Taylor [here/here] recently reiterated his views on what caused the global financial crisis…

…He contends the following: That the Great Moderation was due to adherence to the Taylor Rule [and to ‘rules-based’ fiscal policy].  That during the early 2000s, monetary policy was set looser than that prescribed by the Taylor Rule.  This caused the build up of debt and risk-taking, which ultimately led to the bust, and the end of the Great Moderation.  Weak activity following the crisis has been due to departures from rules based monetary policy, in the form of unconventional monetary policy. And departure from rules based fiscal policy, in the form of the fiscal stimulus enacted by Obama in 2009.  These departures have created uncertainty that has weighed against activity. Tighter policy on both counts would have led to more buoyant activity during the recovery on account of being more certain.

I think he’s wrong on every point…