## Saturday, October 21, 2017

### Greg's algebra

How much do workers gain from a capital tax cut? This question has reverberated in oped pages and blogosphere, with the usual vitriol at anyone who might even speculate that a dollar in tax cuts could raise wages by more than a dollar. (I vaguely recall more blogosphere discussion which I now can't find, I welcome links from commenters. Greg was too polite to link to it.)

Greg Mankiw posted a really lovely little example of how this is, in fact, a rather natural result.

However, Greg posted it as a little puzzle, and the average reader may not have taken pen and paper out to solve the puzzle. (I will admit I had to take out pen and paper too.) So, here is the answer to Greg's puzzle, with a little of the background fleshed out.

The production technology is $Y=F(K,L)=f(k)L;k\equiv K/L$ where the second equality defines $$f(k)$$. For example $$K^{\alpha}L^{1-\alpha}=(K/L)^{\alpha}L$$ is of this form. Firms maximize $\max\ (1-\tau)\left[ F(K,L)-wL \right] -rK$ $\max\ (1-\tau)\left[ f\left( \frac{K}{L}\right) L-wL \right] -rK$

## Friday, October 20, 2017

### Taylor for Fed

I might as well share with blog readers my favorite for the Fed: John Taylor.

A preface is in order though.

Monetary policy is not, right now, the flaming hot mess that characterizes so much of the Federal Government. And all the candidates are good.

The Fed's official mandate is low interest rates, low inflation, and maximum employment -- as large as monetary policy can make it. Interest, inflation, and unemployment are each lower than they have been in living memory. The stock market is high yet surprisingly quiet (low volatility).

One may question whether this is because or despite the Fed. (My view, largely despite.) One may quibble about low growth and labor force participation. One may worry about over-regulation, though Congress mandated most of it. But by the standards of the Fed's mandate, we must admit that the outcomes we see are fine. In any other branch of the Federal government, performance like this relative to mandates, together with a tradition of reappointment, would argue for Ms. Yellen's swift reappointment.

Ms. Yellen's critics, such as the Wall Street Journal editorial page, are forced to argue that she might fall short faced with future challenges. She might keep interest rates too low for too long, and let inflation pick up. (Inflation is still nowhere in sight.) She might raise interest rates too fast if the economy does start to grow more, in fear of inflation, and choke off supply side growth. (Yes, the two criticisms are inconsistent.) She might not handle the next crisis well.

Indeed. And taking the measure of people and trying to figure out how they will deal with future challenges is just what this process is supposed to be about. One can also complain that the process of monetary policy has too much discretion, too many speeches, and needs a more stable rules based approach. I have complained that the Fed is massively over-regulating finance, and this will cause a less competitive and efficient financial system in the future.

But recognize that all this is hypothetical, and there is little to complain right now about in the outcomes we tasked the Fed to achieve.

Still, let us suppose Mr. Trump decides he wants a new person at the Fed. Why John?

John is, quite simply, the top monetary economist of his generation. He understands the theory, he understands the empirical work, he deeply knows the history. He took the baton from Milton Friedman.

### How does inflation work anyway?

Monetary policy, central banking and inflation are hard. It's well to remember that. Today's blog post adds up a few things that seem like they're obvious but are not.

Inflation is hard.

Central bankers are puzzled at persistently low inflation.  From WSJ,
Ms. Yellen said, as the “biggest surprise in the U.S. economy this year has been inflation.”
“My best guess is that these soft readings will not persist, and with the ongoing strengthening of labor markets, I expect inflation to move higher next year,” Ms. Yellen said, adding that “most of my colleagues on the [interest-rate-setting Federal Open Market Committee] agree.”
Of course, they've been expecting that for several years now.  And she seems fully aware that they may be wrong once again:
She cautioned, however, that U.S. central bankers recognize recent low inflation could reflect something more persistent. “The fact that a number of other advanced economies are also experiencing persistently low inflation understandably adds to the sense among many analysts that something more structural may be going on,”
"Something more structural" is a pretty vague statement, for the head of an agency in charge of inflation, that has hundreds of economists looking at this question for years now! That's not criticism. Inflation is hard.

Why is it so hard? The standard story goes, as there is less "slack" in product or labor markets, there is pressure for prices and wages to go up. So it stands to perfect reason that with unemployment low and after years of tepid but steady growth, with quantitative measures of "slack" low, that inflation should rise, as Ms. Yellen's first quote opines.

That paragraph contains a classic economic fallacy, that of composition; the confusion of relative prices and the level of prices and wages overall. If labor markets get "tight," companies finding it hard to find workers, then yes, one expects wages to rise. But one expects wages to rise relative to prices. You only tempt workers to move to your company by offering them wages that allow them to buy more. Similarly, if there is strong demand for a company's products, its prices will rise. But those prices rise relative to other prices and to wages. Offering a company higher prices when its wages, costs, and competitor's prices are all rising does nothing to get it to produce more.

So, in fact, standard economics makes no prediction at all about the relationship between inflation -- the level of prices and wages overall; or (better) the value of money -- and the tightness or slackness of product and labor markets! The fabled Phillips curve started as a purely empirical observation, with no theory.

## Thursday, October 19, 2017

### Tyler: Equity financed banking is possible!

Tyler Cowen wrote an extended blog post on bank leverage, regulation and economic growth on Marginal Revolution. Tyler thinks the "liquidity transformation" of banks is essential, and that we will not be able to avoid a highly levered banking system, despite the regulatory bloat this requires, and the occasional financial crisis. As blog readers may know, I disagree.

A few choice quotes from Tyler, though I encourage you to read his entire argument:
I think of the liquidity transformation of banks in terms of...Transforming otherwise somewhat illiquid activities into liquid deposits. That boosts risk-taking capacities, boosts aggregate investment, and makes depositors more liquid in real terms.
Requiring significantly less bank leverage, at any status quo margin, probably will bring a recession.
...many economies are stuck with the levels of leverage they have, for better or worse.
I fear ... that we will have to rely on the LOLR function more and more often.
I don’t find the idea of 40% capital requirements, combined with an absolute minimum of regulation, absurd on the face of it. But I don’t see how we can get there, even for the future generations.
Depressing words for a libertarian, usually optimistic about markets.

This is a good context to briefly summarize why "narrow", or (my preferred) equity-financed banking is in fact reasonable, and could happen relatively quickly.

Tyler's main concern is that people need a lot of "liquidity" -- think money-like bank accounts -- and that unless banks can issue a lot of deposits, backed by mortgages and similar assets, bad things will happen -- people won't have the "liquidity" they need, and businesses can't get the investment they need.

Here are a few capsule counter arguments.  In particular, they are reasons why the economy of, say 1935 or even 1965 might have required highly levered banks, but we do not.

1) We're awash in government debt.

## Thursday, October 5, 2017

### Cowen on Fed Chair

Tyler Cowen has a good thought on the Fed chair question. The next chair has to be a good politician, in all the positive senses of that word, more than a good technocrat:
The Fed has functioned as a technocracy for a long time, but might the future bring a Fed that is irrevocably split between competing factions? ...the future could bring a Fed divided over how much it should assert its political independence, how much it should assume responsibility for possible asset bubbles, how it should respond to an international financial crisis, or how much it should align with an “America First” mindset. ....
The backdrop is this: Ben Bernanke’s Fed, with its bailouts during the financial crisis, ate up a lot of the Fed’s political capital, though arguably for the worthwhile cause of saving the financial system. As a result, the Fed no longer has its pre-crisis credibility. As long as the American economy is on the path of a slow and steady recovery, with relatively high asset prices, that’s bearable.
But the next time major economic volatility comes around, Fed decisions will be scrutinized and politicized like never before. This will happen in the mainstream media, on social media, and perhaps by our very own president in his tweets or offhand remarks. The key factor for any Fed leader will be the ability to maintain and project a coherent, unified voice at the Fed, so that the Fed remains an island of relative sanity in the polarized nation. This will be a problem of crisis management, but unlike Bernanke’s crisis management it will be fought first and foremost in the trenches of public opinion.
(The open vice chair positions are good ones for technocrats, who need to be able to translate the abstruse language of the staff.)

My related thought: We focus a lot on interest rate policy, but most of what the Fed does these days is financial regulation and supervision, and those decisions are likely much more important going forward.  The challenging question there is "macro-prudential." Is it the Fed's job to worry about "asset bubbles," and to micromanage "credit booms" and their eventual busts? Or is it better for the Fed to limit its authority, to preserve independence, credibility, and insulation from political demands for action and political criticism of its actions, by pronouncing there are economic events beyond its scope?

Moreover, if the Fed is to limit the scope of its financial dirigisme, it had better do so beforehand not afterwards. If everyone expects the Fed to set prices and bail out hither and yon, and then the Fed gets religion (perhaps under relentless political pressure), the crisis will be so much worse. Bernanke also benefitted from acting far beyond expectations of what he would or could do. The next chair will be in the opposite situation, have to set limits of crisis reaction, and disappoint expectations. It's much better to do that ahead of time -- and much harder for an institution like the Fed to scale back people's expectations, and to renounce and pre-commit against attractive-sounding powers.

Update:

Narayana Kocherlakota predicts Jerome Powell. In line with some of the above thoughts, Narayana's view basically is that monetary policy is doing fine. Low unemployment, low inflation, low interest rates, low macro and financial volatility. Mission accomplished. Moreover, if there is a hawk vs. dove question, President Trump looks likely to be on the dove side of it. (Sadly, I doubt that rules and precommitment vs. discretion is ringing in the appointment decision.) However, supervision and regulation is the key issue going forward, and Narayana views Powell as Yellen monetary policy plus a regulatory/supervisory reform.

(I learned to use both words from Ms. Yellen's Jackson hole speech. Regulation is rules, supervision is sending Fed people to look over banks' shoulders. It's a good distinction.)

## Wednesday, October 4, 2017

### Atlas on Health

My colleague Scott Atlas has a superb oped in today's (October 4) Wall Street Journal. Instead of just arguing about health insurance and how we, via the government, will subsidize and pay for health care demand, let's fix the equally catastrophically broken health supply system.
"Republicans have now failed twice to repeal and replace ObamaCare. But their whole focus has been wrong. The debate centered, like ObamaCare, on the number of people with health insurance. A more direct path to broadening access would be to reduce the cost of care. This means creating market conditions long proven to bring down prices while improving quality—empowering consumers to seek value, increasing the supply of care, and stimulating competition."
This is the kind of out of the box, out of the usual left-right mudslinging idea that might someday spark a bipartisan reform, if our legislators could someday get past scoring symbolic points and sit down to actually fix something. (I have written similar ideas, but nowhere near as clearly, or as based in lots of fact-based scholarship and detail as Scott has.)

### VAT -- full text

Now that 30 days have passed, the full text of the WSJ oped advocating a VAT instead of all other federal taxes. Previous post with extra comments.

By John H. Cochrane
Sept. 4, 2017 2:38 p.m. ET

Soon the Trump administration and congressional leaders will unveil their tax-reform proposal. Reports indicate the proposal will include some reductions in corporate and personal rates and the end of some tax deductions. But true reform is likely to be stymied by the usual interests, by those who see the tax code primarily as a way to transfer income to or from favored or disfavored groups, and by politicians who dole out deductions, exemptions and subsidies to supporters.

So if the process stays its normal course, don’t expect the complex and dysfunctional U.S. tax code to change much. But if our leaders were to attempt a really fundamental reform, they could break the political logjam. Changes must be simple, understandable and attractive to voters. And only fundamental reform paired with deregulation can hope to raise economic growth to 3% or more.

The best way to do this is to eliminate entirely the personal and corporate income tax, estate tax and all other federal taxes, and to implement instead a national value-added tax—essentially a national sales tax.

## Thursday, September 28, 2017

### Tax Reform

I read with interest the Unified Framework for Fixing our Broken Tax code. The bottom line is a cut in the corporate tax rate to about 20%, roughly the world average. It also proposes an end to the estate and gift tax.These are small steps in the right direction. It's not a once-in-a-generation clean-out-all-the-junk tax reform.

As an economist I am most saddened by what is missing. Tax reform, designed to support long term growth, should have two main characteristics:

1) Lower marginal rates, by broadening the base. This reduces the disincentives to work, save, invest, start businesses, while raising the same revenue.

2) Simplicity, stability, transparency, and consequent evident fairness. (By fairness I mean each of us knows the others are paying taxes too, and do not suspect that lobbying, political connections, and clever tax lawyers are getting others off the hook.)

These two are essentially missing from the document. The left has seen the tax code pretty much entirely as a vehicle for subsidy and redistribution for a long time. This Republican document, sadly seems to have bought that view.  The goal is to
"put more money into the pockets of everyday hardworking people."
Well, without changing government spending, that means less money in someone else's pocket.

## Monday, September 25, 2017

### Health Care Policy Isn't so Hard

Last July, as the last Republican Obamacare bill was imploding, Greg Mankiw wrote "Why Health Care Policy is So Hard" in the New York Times. For once, I think Greg got it wrong. Health care policy isn't hard at all, at least as a matter of economics. (Politics, and ideological politics, is another question, but not Greg's question nor mine.)

There are some important underlying themes uniting how Greg's piece goes wrong (in my opinion)
• A little bit of economic education can be a dangerous thing
While most opinionated people and most "policymakers" are blissfully unaware of any economics, a little bit of economics education can sometimes mislead. Economics is full of pretty fairy tales, passed on through the decades or even centuries. The day after one sees the beautiful tale of the natural monopoly, or the externality, or the public good, then like a two-year-old with a hammer to whom everything looks like a nail, one starts to see natural monopolies, externalities and public goods all over the place. Wait a moment. Just because it's in the textbook -- even Greg's textbook -- doesn't mean every single industry and case fits.

The other rhetorical error is of the type, "well, we can't have homeless people who get heart attacks dying in the streets." No, of course not, but, is every single line of the ACA and tens of thousands of subsidiary regulations absolutely necessary to provide for homeless people who suffer heart attacks? Why must your and my health insurance be so totally screwed up -- and so totally micromanaged by the Federal government -- just to solve the problem of homeless people heart attacks? I'm struggling to find just the right category for this sort of argument
• Gross disregard of the size of effects.
• Straw man -- a theoretical problem with a completely free market justifies any regulation.
• Disregard of the choice at hand -- it's not benevolent perfection vs. free market.
• Using problems as talking points. If the same "problems" exist elsewhere and you don't want to or need to fix them, then you're not serious about that "problem" for health.
Maybe we can come up with a better one sentence characterization later. (There must be a Greek word for these rhetorical tricks!)

Let's review Greg's "why health care policy is so hard" problems.
"...free market sometimes fails us when it comes to health care. There are several reasons.

## Friday, September 22, 2017

### A paper, and publishing

Even at my point in life, the moment of publishing an academic paper is a one to celebrate, and a moment to reflect.

The New-Keynesian Liquidity Trap is published in the Journal of Monetary Economics -- online, print will be in December. Elsevier (the publisher) allows free access and free pdf downloads at the above link until November 9, and encourages authors to send links to their social media contacts. You're my social media contacts, so enjoy the link and download freely while you can!

The paper is part of the 2012-2013 conversation on monetary and fiscal policies when interest rates are stuck at zero -- the "zero bound" or "liquidity trap." (Which reprised an earlier 2000-ish conversation about Japan.)

At the time, new-Keynesian models and modelers were turning up all sorts of fascinating results, and taking them seriously enough to recommend policy actions. The Fed can strongly stimulate the economy with promises to hold interest rates low in the future. Curiously, the further in the future the promise, the more stimulative.  Fiscal policy, even totally wasted spending, can have huge multipliers. Broken windows and hurricanes are good for the economy. And though price stickiness is the central problem in the economy, lowering price stickiness makes matters worse. (See the paper for citations.)

The paper shows how tenuous all these predictions are. The models have multiple solutions, and the answer they give comes down to an almost arbitrary choice of which solution to pick. The standard choice implies a downward jump in the price level when the recession starts, which requires the government to raise taxes to pay off a windfall to government bondholders. Picking equilibria that don't have this price level jump, and don't require a jump to large fiscal surpluses (which we don't see) I overturn all the predictions. Sorry, no magic. If you want a better economy, you have to work on supply, not demand.

I wrote the paper in the spring and summer of 2013, posted it to the internet, and started giving talks. Here's the story of its publication:

## Thursday, September 21, 2017

### Duet Redux

Another duet of headlines with an interesting lesson, both from the Wall Street Journal:

Solar power death wish
Suniva Inc., a bankrupt solar-panel maker, and German-owned SolarWorld Americas have petitioned the U.S. International Trade Commission (ITC) to impose tariffs on foreign-made crystalline silicon photovoltaic cells.
Solar cells in the U.S. sell for around 27 cents a watt. The petitioners want to add a new duty of 40 cents a watt. They also want a floor price for imported panels of 78 cents a watt versus the market price of 37 cents.
they’re resorting to Section 201 of the Trade Act of 1974 because they don’t need to show they are victims of dumping or foreign government subsidies. They only need to show that imports have harmed them
California Democrats Target Tesla
The United Automobile Workers are struggling for a presence in Tesla’s Fremont plant, and organized labor has called in a political favor.
Since 2010 California has offered a $2,500 rebate to encourage consumers to buy electric vehicles. But last week, at unions’ behest, Democrats introduced an amendment to cap-and-trade spending legislation that would require participating manufacturers to get a sign-off from the state labor secretary verifying that they are “fair and responsible in their treatment of workers.” The legislation, which passed Friday, is a direct shot at Tesla. The Clean Vehicle Rebate Project has amounted to a$82.5 million subsidy for the company
Both moves ought to pose a liberal conundrum. If you want carbon reduction, you want cheap solar cells, so that more people will buy them. The planet does not care where the solar cells are produced. If you want electric cars, you want cheap electric cars so that more people will buy them.

But those who falsely sold green energy as a job producer, a boon to the economy; not a costly alternative to fossil fuels, a cost that must be borne to save the planet, now face this conundrum.

The deeper lesson here is the corrosive nature of subsidies and protection. Once the government starts subsidizing solar cells and electric cars, there is a quite natural force demanding access to the subsidies. Why should the owners of the Tesla company get largesse from the taxpayers, and not their workers too?

Solar cells are just the latest embodiment of the infant industry fallacy -- that protection from competition will allow an industry to grow and become competitive.  Instead, they become infantile industries, expert and getting protections and subsidies not producing cheap solar cells.

The infrastructure paradox is similar. We need infrastructure. Yet federal contracting requirements, requirements for union workers and union wages, and everything else attracted to federal money being handed out, drive costs up to astronomical levels.

For energy, this is an abject lesson in the wisdom of a simple carbon (and methane) tax in place of all the subsidies and winner-and-loser-picking our government does. (Let's not fight about whether to do it. The point is if we want to restrict fossil fuels and subsidize a move to non-carbon energy, this is how to do it.) Subsidies and protection invite demands for subsidies and protection, not clean energy.

## Tuesday, September 19, 2017

### Stranded profits

The tax reform discussion includes the idea that by moving to a territorial system, US companies will bring lots of money stranded offshore back to the US, unleashing a wave of investment here. While I think a territorial system makes sense, as does reducing or eliminating the corporate tax, as a pure matter of economics, I don't think this repatriation argument makes sense.

Here's why. (The following is a story, not a fact about Apple accounting.) Apple sells an Iphone in Spain. Apple Spain pays a huge licensing fee on software, owned by Apple Ireland, so it's not a profit in Spain. Apple Ireland thus collects huge amounts of cash from all over the world, taxed at the low Irish corporate tax rate. Apple Ireland deposits this cash in an Irish bank. (I presume they do fancier things with the money, but I'm telling a story here). The cash is "stranded" overseas, right?

No. The Irish bank can lend the money anywhere. It can buy US mortgage backed securities, it can lend the money wholesale to US banks who lend it out to US businesses. It can even lend the money to Apple US. If Apple or any other US company wants to invest, they can borrow from the Irish bank. Conversely, if profits are repatriated to US banks, those banks can lend the money overseas.

If Apple's Irish bank invests exclusively in, say Spanish condos, then the Spanish bank that would have made the condo loan instead loans to the US. Conversely, even if the profits are "repatriated" to a US bank, if investment opportunities are better abroad, that's where the investment will happen.

You can't avoid two fundamental truths: 1) Money is fungible. 2) Savings - Investment = Net Exports.

Yes, there are some second order effects. If money comes back to US banks, US banks get to earn the fees. Internal capital can be cheaper then external; it's inefficient to send your own money to yourself through a bank. But these are second order, and that's not the argument being made.

It's still a good idea, but for other reasons. Reduction or elimination of corporate taxes will make US investment more profitable, and that will attract money from abroad. But don't count on a wave of repatriated profits to mean much more than a big financial change.  Even if it happens. There are many other reasons to keep pots of money overseas these days. Bad arguments for good policies are not, in the end, a good idea.

## Wednesday, September 13, 2017

### Duet

Sometimes the blog posts write themselves from contrasting newspaper headlines.

New York Times

New Gene-Therapy Treatments Will Carry Whopping Price Tags
By GINA KOLATA September 11, 2017

Emily Whitehead, the first pediatric patient to receive the gene-therapy treatment Kymriah, which put her leukemia into remission. The treatment has a $475,000 price tag, raising questions about how patients and insurers will pay. ... One drug, to prevent blindness in those with a rare genetic disease, for example, is expected to cost between$700,000 and \$900,000 per patient on average,..

Washington Post

The dam is breaking on Democrats’ embrace of single-payer
By Aaron Blake September 12 at 9:39 AM

Sen. Cory Booker (D-N.J.) became the fourth co-sponsor of Sen. Bernie Sanders's (I-Vt.) “Medicare for all” health-care bill Monday. In doing so, he joined Sens. Elizabeth Warren (D-Mass.) and Kamala D. Harris (D-Calif.).
What do those four senators have in common? Well, they just happen to constitute four of the eight most likely 2020 Democratic presidential nominees, according to the handy list I put out Friday.
Update: Gillibrand just signed on to Sanders's "Medicare for all" bill. So now 5 of my top 8 potential 2020 Democratic nominees have now come out for the bill -- before it is even introduced. "Health care should be a right, not a privilege, so I will be joining Senator Bernie Sanders as a cosponsor on his Medicare-for-All legislation," Gillibrand said.
Hint. Budget constraints? Hint 2: get ready to start making lots of noise if you want treatment.

By the way, let us watch for the crucial buzzword question. Does "single payer" mean there is a single payer that anyone can use -- but you're free to buy and sell your own insurance on top of that, hopefully deregulated since there is no need to regulate anymore, everyone has access to medicare for all? Or does "single payer" mean there is a single payer that everyone must use -- private insurance, private practice, just paying cash illegal, to cross-subsidize the system? I fear the latter. We'll see.

The previous champion was stories on the same page in WSJ, roughly self driving trucks coming soon'' and shortage of truck drivers.'' I lost the link.

## Friday, September 8, 2017

### Online Asset Pricing is back!

The online Asset Pricing Ph.D. class is back! It died in a Coursera "upgrade," but it is now migrated over to Canvas.

Click here to go to the online class. My Asset Pricing webpage has links to the class, book, and many other useful materials.

It should be open and free to anyone, including all the quizzes, problem sets and exams.

Since it's on the Canvas system, if you are teaching at a University that uses Canvas, you should be able to integrate it with your class, assign all or part of it, and receive grades from quizzes and problem sets. Thus, you can use it as a flipped classroom, assign selected videos and quizzes in advance of a lecture.

It is also ideal for a Ph. D.  program summer school for year 0 or year 1. Again, through Canvas you should be able to assign the class, in whole or in part, and get grades.

It's also well suited to self-study. If you just want to watch the videos and read the notes, they are all here via youtube links on the Asset Pricing webpage.

Huge thanks to Emily Bembeneck and Allison Kallo at the University of Chicago, Mikhail Proshletsov, and above all to Nina Karnaukh now at Ohio State. Nina masterminded all the hard work of moving the class pages and quizzes from the Coursera system to the Canvas system, and fixing innumerable glitches along the way. Thanks also to the Booth School for paying for the transition.

## Thursday, September 7, 2017

### In the name of Science

 Source: climatefeedback.org
"Climate Feedback" has produced a "scientific review" of my WSJ oped with David Henderson on (Oped ungated full text here, see also associated blog post.)

In the blog post, I wrote,
"If it is not clear enough, nothing in this piece takes a stand on climate science, either affirming or denying current climate forecasts. I will be interested to see how quickly we are painted as unscientific climate-deniers."

To recap, the oped said nothing about climate science, nothing about climate computer model forecasts, and did not even question the integrated model forecasts of economic damage. We did not deny either climate change nor did we argue against CO2 mitigation policies in principle. For argument's sake we granted a rather extreme forecast (level of GDP reduced by 10% forever) of economic costs. We did not even question the highly questionable cost-benefit analyses of policies subject to cost benefit analysis. We mostly complained about the lack of any cost benefit analysis, and the quantitative nonsense of many claims.

So, it's curious that there could be any "scientific" review of a purely economic article in the first place. How do they do it?

## Monday, September 4, 2017

### Tax Reform Again

A Wall Street Journal oped on tax reform. This complements an earlier oped and see the tax link at right for many others.

The bottom line: I argue for a national VAT instead of (and that is crucial) individual and corporate income taxes, estate taxes, and anything else.

Why? I want to break out of our stale argument. "Lower taxes to boost the economy"  vs. "you just want tax cuts for the rich." It's not going to go anywhere.

I also want to break out of the process. Proposing cuts within the current structure of the tax code, even if proposing them with offsetting cuts in deductions, leads naturally right back to the mess we're in.

Once you tax income much of the rest of the mess follows inexorably.  If we go back to the beginning, and tax spending not income, so much mess vanishes.

## Thursday, August 31, 2017

### On climate change 2

Now that 30 days have passed I can post the full Wall Street Journal climate change oped with David Henderson. The previous post has more commentary. A pdf is here.

By David R. Henderson and  John H. Cochrane
July 30, 2017 4:24 p.m. ET

Climate change is often misunderstood as a package deal: If global warming is “real,” both sides of the debate seem to assume, the climate lobby’s policy agenda follows inexorably.

It does not. Climate policy advocates need to do a much better job of quantitatively analyzing economic costs and the actual, rather than symbolic, benefits of their policies. Skeptics would also do well to focus more attention on economic and policy analysis.

To arrive at a wise policy response, we first need to consider how much economic damage climate change will do. Current models struggle to come up with economic costs commensurate with apocalyptic political rhetoric. Typical costs are well below 10% of gross domestic product in the year 2100 and beyond.

That’s a lot of money—but it’s a lot of years, too. Even 10% less GDP in 100 years corresponds to 0.1 percentage point less annual GDP growth. Climate change therefore does not justify policies that cost more than 0.1 percentage point of growth. If the goal is 10% more GDP in 100 years, pro-growth tax, regulatory and entitlement reforms would be far more effective.

## Wednesday, August 30, 2017

### Yellen at Jackson Hole

Fed Chair Janet Yellen gave a thoughtful speech at the Jackson Hole conference.

The choice of topic, financial stability and the Fed's role in financial regulation and supervision, says a lot. Financial regulation, supervision, and other tinkering, is much more centrally a part of what the Fed is and does these days than standard monetary policy. Whether overnight interest rates go up or down a quarter of a percentage point may be the subject with the greatest ratio of talk to action, and of commentary to actual effect, in all of economics. Interest rates are likely to stay around 1% for the foreseeable future. Get used to it. But the Fed is deeply involved in running the financial system, and all the talk points to more.

Rather unsurprisingly, she did not give the speech I might have given, or that some of the others campaigning for her job have given, bemoaning the current state of affairs. She's been in charge, after all. If she viewed the Dodd-Frank act as a grossly complex Rube Goldberg contraption, and the Fed only following silly rule-making dictates to comply with the law, she would have said so loudly long before this. Whether with an eye to reappointment, to write the first draft of history, or -- my sense of Ms. Yellen -- out of forthright Jon Snow-like irrepressible honesty, one should not have expected a stunning critique.  Moreover, her speech is dead-center of the world in which she lives, that of international policy and regulatory organizations. It would be a lot to expect a Fed chair to lead intellectually and to strike out far from the consensus of the bubble.

Still, I am disappointed. Even accepting her view of the crisis, and the current slow growth era, there are far more "Remaining Challenges" than her three paragraphs. There are far more questions to be asked, paths to choose, and fundamental choices to be made.

Which deregulation?

## Monday, July 31, 2017

### On Climate Change

David Henderson and I wade in to perilous waters in the July 31 Wall Street Journal. We try to stake out a different and more productive conversation than the usual shouting match between alarmists and deniers.
Climate change is often misunderstood as a package deal: If global warming is “real,” both sides of the debate seem to assume, the climate lobby’s policy agenda follows inexorably.
It does not. Climate policy advocates need to do a much better job of quantitatively analyzing economic costs and the actual, rather than symbolic, benefits of their policies. Skeptics would also do well to focus more attention on economic and policy analysis.
As usual, I have to wait 30 days to post the whole thing.

As economists, we both have a healthy skepticism of large computer based forecasting models. The famous 1972 club of Rome forecast that we would run out of resources, and the grand failure of large scale Keynesian models in the late 1970s are two humbling examples. The "climate" models also feature a lot of questionable economics. A crucial question -- how much carbon will the world's economies add on their own, without Paris-accord policies? That's economics, very questionable economics, and not meteorology.

That said, however, the point of the oped is to try to shift the debate away from climate science and mixed climate-economic computer models. Stop arguing about climate, and let us instead investigate costs and benefits of policies. That strikes us as a much more fruitful place for discussion. If you are wary of the climate policy agenda, the costs and benefits of those policies are more fertile ground for discussion than the science of carbon emissions and atmospheric warming. If you only argue about the climate, then you implicitly admit that if the models are right about climate, the whole policy agenda follows. Do not admit that point. They may be right about climate and wrong about policy.

## Wednesday, July 19, 2017

### Thornton on interest rate humility

Dan Thornton has an interesting essay, The Limits of Monetary Policy: Why Interest Rates Don’t Matter.’’

Just why do we think that the Fed raising and lowering interest rates has a strong effect on output (or inflation)? Just why does the Fed control short-term interest rates rather than the money supply, or something else?

Dan's essay is a nice quick tour through the history of this question. No, there is not as much logic and evidence behind this hallowed belief as you might think, and yes, people did not always take the power of interest rates for granted as they seem to do now. Dan's historical tour is worth keeping in mind.

This question is especially relevant right now. We are unlikely to see big changes in interest rates going forward. And central banks are busy thinking of different things to control -- the size of the balance sheet; treasury, MBS, corporate bond, and even stock purchases; use of regulatory tools to control lending. So we may be on the cusp of a fairly major change in thinking about what central banks do -- what their primary tool is -- and how that tool affects the economy. (And, I hope, whether it is wise for central banks to use new tools that come along. Their mandate is not to be the great macroeconomic-financial planner after all.)

As Dan points out,
it is a well-known and well-established fact that interest rates are not very important for investment, or for spending decisions generally.
Quoting Bernanke and Gertler
… empirical studies of supposedly “interest-sensitive” components of aggregate spending [fixed investment, housing, inventories, and consumer durables] have in fact had great difficulty in identifying a quantitatively important effect of the neoclassical cost- of-capital variable [interest rates].
That is by and large true. But I see an alternative breaking out. Investment is strongly influenced by stock prices, by the risk premium in the cost of capital. The total cost of capital is risk premium plus risk free rate, and the risk premium varies much more than the risk free rate.

Here is the latest version of a graph I've made several times to emphasize this point. ME/BE is the market to book ratio of the stock market, or "Q.'' P/(20xD) is the ratio of price to 20 x Dividends. IK is the ratio of investment to capital.

Investment responds to the stock market, and the stock market moves because risk premiums move, not because interest rates move.

The "alternative" then is the increasing amount of attention paid to the Fed's effect on stock and corporate bond prices, together with evidence like this that investment responds to risk premiums in stock and corporate bond prices.

I am a long-time skeptic of the stories that say low levels of interest rates encourage asset price "bubbles." After all, borrowing at 1% and investing at 5% is the same as borrowing at 5% and investing at 9%. Why should the level matter to the risk premium? But those stories are repeated more and more often (like the story about interest rates!) So overall, what may break out is a story that the central bank can influence risk premiums-- this needs segmented markets, leveraged intermediaries, and other financial frictions, modern heirs to the "credit channel"-- and risk premiums influence investment. Macro-finance is full of this sort of analysis right now.

I recoil at the idea that central banks should start operating this way -- targeting risky asset prices, using a range of tools to do it, and thereby trying to control investment spending.  Central planners can set prices too, but that doesn't mean they should. But this may be where the world is going.

Now, back to Dan. After reminding us that consumption and investment spending does not respond (much) to interest rates, Dan's intellectual history. (Excerpts here, the original is worth reading)
“So why do policymakers believe that monetary policy works through the interest rate channel and that monetary policy is powerful?” Well, there was one important event that brought economists and policymakers to this conclusion. Specifically, the Fed under Chairman Paul Volcker brought an end to the Great Inflation of the 1970s and early 1980s.
Prior to this event, Keynesian economists … believed that monetary policy was totally ineffective. “Why?” Keynesians believed that the only thing monetary policy could affect was interest rates. Since interest rates were not important for spending, the effect of monetary policy actions on interest would have essentially no effect on spending and, consequently, no important effect on output. Keynesians believed that monetary policy was essentially useless.
There was a smaller group of economists called monetarists who believed that monetary policy could have a large effect on output. But they believed this effect was due to the effect of monetary actions on the supply of money, not interest rates. Both Keynesians and monetarists believed that the effect through the interest rate channel would be tiny.
It's worth remembering that the power of pure interest rate changes is a recent idea. Separately,
Bernanke and Blinder find that monetary policy works through the bank credit channel of monetary policy—not through interest rates. However, … because banks have financed most of their lending by borrowing funds from the public since the mid-1960s, it is unlikely that the bank credit channel is important. …It is now well-recognized that the bank credit channel of monetary policy is very weak.
I'm not sure Bernanke and Blinder (as well as other fans) agree with the last sentence, but the bank lending channel has always suffered the problem that 1) Fed actions have little effect on lending -- as Dan mentions, reserve requirements really don't bite 2) Only very small businesses really rely on bank lending. There are lots of them, but not much GDP.

So how did belief in the power of interest rates come about?
When he became chairman of the Fed, Paul Volcker made ending inflation the goal of policy. … He announced that he wanted to pursue a new approach to implementing monetary policy that “involves leaning more heavily on the [monetary] aggregates in the period immediately ahead.” …it seems to have worked. Inflation declined from its April 1980 peak of 14.5% to about 2.4% in July 1983….The policy change was also followed by back-to-back recessions…. the fact that the change in policy was followed by a marked reduction in both inflation and output led economists and policymakers to dramatically change their view about the power of monetary policy to effect output and inflation.
…economists debated whether the success of the Volcker’s monetary policy was due to a marked reduction in the supply of money or to higher interest rates. But the growth rate of M1 monetary aggregate changed little over the period. Moreover, the growth rate of M2 actually increased. In contrast, the federal funds rate, which was 11.6% the day the FOMC changed policy, increased to a peak of 17.6% on October 22, 1979. The funds rate then cycled, hitting cyclical peaks above 20% in late 1980 and mid-1981. Given the behavior of the M1 and M2 monetary aggregates and the behavior of the federal funds rate during the period, a consensus formed around the idea that the success of Volcker’s policy was attributable to high interest rates not to slow money growth.
Like the Phoenix, the idea that monetary policy worked through the interest rate channel rose from the ashes. … the FOMC adopted the federal funds rate as its policy instrument in the late 1980s, circa 1988. … Policymakers pay essentially no attention to monetary aggregates…
And academic analysis of monetary policy is focused entirely on interest rates. Dan doesn't mention new-Keynesian models, but they epitomize the current thinking. The Fed sets interest rates, with no money at all, and higher interest rates induce people to spend less today and more tomrrow.
The problem is that nothing else changed. There have been no new studies showing that spending is much more sensitive to changes in interest rates than previously thought. … Bernanke and Gertler’s statement that monetary policy does not work through the interest channel is as true today as it was 20 year ago. What has changed is economists’ belief that monetary policy works through the interest rate channel. … economists’ and policymakers’ belief that monetary policy has strong effects on output through the interest rate channel is more akin to religion than to science. It is built on a belief that it seems to have worked once.
This belief is reinforced by fact that few economists believe that policy could work through any of the other possible channels of policy: the exchange rate channel, the wealth effect channel, the money supply channel, or the credit channel. Monetary policy seems to work, but it cannot work through any of these other channels. Conclusion: it must work through the interest rate channel.
Quoting Alan Greenspan
We ran into the situation, as you may remember, when the money supply, nonborrowed reserves, and various other non-interest-rate measures on which the Committee had focused had in turn fallen by the wayside. We were left with interest rates because we had no alternative. … – Alan Greenspan, FOMC Transcript, July 1-2, 1997, pp. 80-81.
Where does this leave us? In the short run, the fact remains. We have no alternative. If I were to wake up as Fed chair tomorrow, I'd move the interest rate levers just about the same way as anyone else does. In the short run, I think these reflections should add to our humility -- we really don't understand the mechanism as well as most analysis suggests, and a new idea will come sooner or later.

In the longer run, those new ideas seem to be breaking out. Central banks, increasingly gargantuan financial regulators, are using a wide range of tools to influence the economy via asset prices. In my own view this is a bad idea. But like most bad ideas it is slipping in sideways largely un noticed.