Analysis and Commentary by Roosevelt Fellow Mike Konczal
“Yes, but the whole point of a doomsday machine is lost if you keep it a secret! Why didn’t you tell the world, eh?” – Dr. Strangelove
So the DC Circuit Court ruled in Halbig v. Burwell hat health care subsidies can only go to states that set up their own health care exchanges rather than use the federal ones. That means indivdiuals from the 34 states who get subsidized health care from the federal exchange would no longer be able to get subsidies. (Another court ruled against this logic today.) I don’t normally do health care stuff, but I’ve read a lot about this case and something strikes me as very odd.
As I understand it, those on the right who are pushing the Halbig case argue that there’s a doomsday machine built into Obamacare. (Adam Serwer at MSNBC also caught this doomsday machine analogy.) If states don’t set up their health care exchanges then they don’t receive subsidies for health care from the federal government. According to this theory, the liberals who designed health care reform did this knowing that if subsidies were pulled, the system would collapse for states that didn’t set up their exchanges.
It’s important to note that those on the right are not arguing that this is a typo in the bill, because that wouldn’t necessarily be sufficient to overturn the subsidies. They are arguing that Congress intentionally put this language in there to compel, bribe, incentivize, and otherwise threaten states that didn’t set up their own exchanges. In the rightwing argument, liberals were saying “we are making the citizens of your state purchase health care, and if you don’t set up an exchange they won’t get the subsidies necessary to make the system work, so you’d better set up an exchange.”
The right’s argument hinges on the idea that since there’s no evidence that this isn’t the intent, it must be the intent. As the two authors of the legal challenge put it, Obamacare “supporters’ approval of this text reveals that their intent was indeed to enact a bill that restricts tax credits to state-run Exchanges. At no point have defenders of the rule identified anything in the legislative history that contradicts” their reading.
Here’s the thing, though: like Strangelove notes, a doomsday machine only works if you tell others about it. So, why weren’t the people in the vast network associated with Obamacare telling everyone about this threatening doomsday device after the bill passed?
If this was actually the intent, you’d expect that during the period where states were debating whether to set up exchanges, this would have been a major threat raised by somebody. Anyone, from President Obama to congressional leaders to health care experts and lawyers to activist groups on the ground in red states fighting for implementation, would have been saying, “if your state doesn’t set up a health care exchange, your citizens are screwed. At the very least, you’ll be leaving money on the table.” (“Leaving money on the table” is always a good point to bring up, and if this doomsday machine really were the intent of the law, it would be true.)
I know of no evidence of this being the case. Does anybody? Numerous people are arguing that the legislative intent is clearly on providing subsidies to the federal exchange users. No wonder the dissent argued that the Halbig ruling was “a fiction, a post hoc narrative concocted to provide a colorable explanation for the otherwise risible notion that Congress would have wanted insurance markets to collapse in States that elected not to create their own Exchanges.”
That doesn’t change what the DC Circuit did, of course, but it should make a random person stop and wonder how much of a cynical ploy this whole thing is.
How have search models influenced the current economic debates? John Quiggin had an interesting post up at Crooked Timber about how poorly the branch of economics that falls under search theory has done in the age of the internet. (Noah Smith has follow-up.)
Search and matching models are fascinating to me because they are central to both the debate over mass unemployment during the Great Recession as well as how economists understand the minimum wage. And here you can see search model being deployed for worse and for better.
The Great Recession
In his 2010 Annual Report, Federal Reserve Bank of Minnesota President Narayana Kocherlakota gave a presentation using the popular Diamond-Mortensen-Pissarides (DMP) search model to explain what he thought was wrong with the labor markets. Given that Kocherlakota was dissenting against QE2 at the time, a lot of eyes were on his arguments. Many focused on his infamous argument he later reversed that low rates cause disinflation, but I found this equally fascinating at the time.
The economy suffered from low job openings. But why were employers not creating job openings and hiring? Kocherlakota summarized the DMP model in this graphic:
Job openings and hires are a function of unemployment, productivity, and what was going on with the unemployed. He concluded that productivity after taxes was falling because of an increase in government debt, regulations and the proposed repeal of some of the Bush-era tax cuts. Also expansions of social insurance, including unemployment insurance and presumably the Medicaid expansion in Obamacare, was increasing the “utility” of not working. This, he believed, was the major reason why unemployment was so high and job openings so low. Using a back-of-the-envelope estimate with made-up numbers, he proposed that the natural rate of unemployment could be around 8.7 percent – very close to the then current 9.0 percent unemployment.
Think about this model and the recession long enough, and two things should jump out. The first is that this model, going back to Robert Shimer’s (2005) seminal work on the topic, is terrible at explaining movements in unemployment. The volatility in vacancies and productivity aren’t anywhere near the magnitude necessary to cause unemployment movements that we see in recessions. Productivity would need to drop significantly to create the changes in unemployment we see in recessions, and it doesn’t move to anywhere near that extent.
The second is that, as Robert Hall and many others have pointed out, productivity actually increased during the recent recession. It’s moving the wrong direction for it to impact unemployment the way we’d see it during the Great Recession. The unemployment-to-vacancy ratio also increased – 2009 was a fantastic time to create job openings according to this model, yet they collapsed. This is extra problematic given that economists have tried to respond to the initial problem by amplifying productivity movements in their models. But, out here in the actual world, the thing is simply moving in the wrong direction to make any sense.
Note that there’s no place for things like aggregate demand or the zero lower bound to plug into the equation. The only things that can matter are things like taxes, government uncertainty and social insurance, and they all work in the negative direction. That search models have become so influential to the background knowledge of unemployment helps explains the default ideology of why economists were so eager to find “structural” explanations for why unemployment was so high.
There’s some debate on this, but it looks like economists are softening on their opposition to raising the minimum wage, particularly if the question is phrased as whether or not a slightly higher minimum wage would pass a cost-benefit test. Search theory might be a reason why. If you are schooled in thinking of the labor markets in a search model, the idea that the minimum wage might not have an adverse employment effect makes more sense. A higher minimum wage means that low-wage workers will search harder for low-end jobs. They’ll be more likely to accept those jobs, and less likely to turn them over as well. These all would help raise the equlibrium employment level.
Even further, if you think that each job has a bit of a search friction surrounding it, then the idea that the employer has a little bit of monopoly power over the job makes sense. Employers might not raise wages to a market clearing rate because that, in turn, would mean having to raise the wages for all their workers. A minimum wage pushes against that. Understanding the labor markets through this lens ideas helps explain why any disemployment effects are minimial compared to the economics 101 story.
As I read it, much of this theory took hold in labor economics to help explain the data people were seeing. Why were there so many vacancies in fast food? Why didn’t minimum wage hikes obviously cause unemployment in the data? This should tell us something – theory, when built up out of observations and data, can tell us something useful. But the same theory moved over to the business cycle, where it ignores conflicting data and is propelled downward by partisan and ideological forces, can be an utter disaster.
With President Obama’s student loan announcement in the news this week, an argument over whether or not taxpayers make a profit from student loans is no doubt close behind. We do make a profit using the government’s accounting tools, but there’s an argument that we should instead use “fair value accounting,” or the rate at which the private market adjusts for risk (here’s Jared Bernstein with a recent piece). By that standard, we see a much smaller profit.
Most people reference the CBO on this, though its numbers are entirely opaque. For instance, it says that it “relied mainly on data about the interest rates charged to borrowers in the private student loan market,” but there are gigantic adverse selection problems right out of the gate. The private student loan market is where the worst credit risks go, so of course they have higher rates. Is the CBO able to control for this? Nobody knows.
But beyond that, there’s a simple finance logic reason for why I don’t buy the argument for fair value accounting. I don’t believe that taxpayers face prepayment risk, and to whatever extent they do, it’s a matter of politics, not economics, that determines this.
The concept of prepayment risk might not make sense for people without some financial background, so let’s walk through it. If you lend money to a person you know, whether it’s a questionable relative or a partner who asks to hold some money until they get their check next week, you just want to get paid back in full. And, here’s the kicker, you are really happy if you get paid back sooner than you had expected. You want the money back.
Is that how private capital markets work? No. Let’s say you manage a large portfolio of private student loans. And let’s say you get a note at the office that they are being paid back more quickly than you had expected. Are you happy? No. You are not, and you might even get fired.
Why wouldn’t you be happy about getting paid back earlier?
1. You have to physically do something with the money you get paid back to get it earning more money again. No matter what you end up doing — reinvesting it in student loans, putting it into a different set of assets, or just stuffing it in the equivalent of a mattress — it takes time, energy, and resources, all of which cost money.
2. Often you want to set a certain time frame for repayment. Say you really want to have a cash flow at a certain date far off into the future because you are funding a pension or insurance liability. Getting paid back earlier doesn’t meet that goal, and it confuses your expectations for cash flows.
3. Crucially, you are likely to get paid back exactly when you don’t want the money. Say you locked in private student loans at a high interest rate, but then interest rates decline dramatically. At this point students will pay back their loans more quickly, which leaves you with more cash on hand at a time when interest rates are low.
This isn’t some partisan ideological point; it’s just basic finance. You can see it described in a CFA study guide under call and prepayment risk and reinvestment risk. (People more baller than I who actually did the CFA can nitpick specifics, but the general layout is correct.)
So private investors in student loans are genuinely worried that they’ll get paid back too quickly, and as a result charge a higher interest rate which leads to a larger discount rate. Because, and follow this, their goal isn’t to “get paid back.” Their goal is to achieve a consistent rate of return given a risk profile, with predictable cash flows given other institutional constraints. Getting paid back quickly is a risk to all this.
So, here’s my question: do taxpayers face this prepayment risk? If you saw a headline that said “student debtors are paying off their public student loans faster than expected,” would you be happy as a citizen, or furious?
I’d say happy. As a citizen, I’m not interested in earning a certain amount of profit consistently and with certainty over time, especially with the money paid back by student debtors, though I am as a private investor. If citizens were paid back more quickly, we could return the money to taxpayers, or use it for different purposes, or whatever. I certainly wouldn’t say “how are we going to continue to make the profit we were making?” as a citizen, though that’s exactly what I’d say if I were an investor in a private student loan portfolio. We could debate this — perhaps you think the goal of the government here is to extract maximum financial profits no matter what. But it would be a political debate, divorced from the logic of financial market valuation.
This is not a trivial concern. Anyone with experience modeling a mortgage-backed security is very conscious of how greater prepayments impose massive risks and uncertainty. Normally the private sector goes to great lengths to imposes penalties and limitations on paying back loans early, though the government doesn’t do this for student loans. And since citizen do not face prepayment risks the way the private sector does, the discount rate for public funds, by definition, must be less than private funds when it come to student loans. Hence private sector discount rates aren’t a valid benchmark.
Note that the Financial Economist Roundtable (cited approvingly by Jason Delisle here) brings up prepayment risk specifically as something that fair value accounting is meant to capture. But the prepayment risk they specify — which is “costly to lenders because prepayments are most likely to occur when market interest rates have decreased and loan values have appreciated,” reflecting the third issue noted above — exists primarily because private capital has to reinvest money in a worse environment. Do taxpayers have to reinvest money they get from student loans? No, unlike private direct lenders, they don’t. The financial logic has broken down. (And don’t even get me started on using the private sector’s liquidity risk as a measure of the state’s.)
I have yet to see an argument addressing this head-on, much less a convincing one, but perhaps this post will change that.
Several people are comparing Chris Giles’s piece in the Financial Times, which criticizes the data Thomas Piketty used in his book Capital in the 21st Century, to the Reinhart-Rogoff (R-R) incident from last year. That was when Carmen Reinhart and Kenneth Rogoff’s paper ”Growth in a Time of Debt,” which found that growth went negative above a 90 percent debt-to-GDP threshold, was criticized by Thomas Herndon, Michael Ash, and Robert Pollin (HAP). HAP found data and methodology errors in R-R, and now Giles finds data and methodology errors in Piketty. (I wrote about Giles’s article here.)
So the critiques must be similar, right? No. They are quite different, and in fact there are at least four ways in which they are practically the opposite of each other: in their transparency; in the object of their criticism; in the severity of their critiques; and in their democratic implications.
Transparency and Accessibility of the Data
Piketty’s data is public. That is why we are debating it, because that’s how Giles went about critiquing it. R-R kept their data hidden for years as their policies shaped the international debate over austerity.
R-R based their argument on post-war debt and growth, but their site had no spreadsheet saying “here are the countries and growth rates we used for the post-war period.” Instead they offered links to various other sites for growth data, without clarifying which ones they used. If you tried to replicate the data yourself, as many did, you’d find 110 high-debt data points, but R-R only used 96. Again, it wasn’t clear which were being used.
It’s a minor point, but one worth emphasizing. I can think of at least three sets of economists who stated publicly that R-R had not released their data between 2010 and 2012 . This was before Carmen Reinhart sent their raw data to an innocuous graduate student named Thomas Herndon, which formed the basis for HAP.
Attacking the Data Versus Attacking the Argument
Giles is questioning Piketty’s underlying, original data. HAP took the data that R-R provided for granted, even though it likely would have similar questions, and instead criticized what they did with said data.
A lot of people are pointing out that creating brand new data sets, especially using data that spans countries and centuries, will necessarily involve a lot of difficult calls around merging and splicing various sources. To put that a different way, it would be odd if someone went back into the raw, underlying data and didn’t find some difficult calls that could be questioned.
Critics took R-R’s underlying data for granted in the debate. Perhaps they shouldn’t have. As Bivens and Irons of EPI pointed out in their 2010 discussion, R-R use gross debt, which seems inappropriate compared to debt held by the public if the story they’re telling is about debt and economic outcomes. Yeva Nersisyan and Randy Wray argued that R-R also did a poor job of noting whether a debt was denominated in its own currency.
Those are good points, but they’re not what HAP focused on. They looked at the methodology and construction of results and took the R-R data as given instead of nitpicking the underlying data calls — calls which are always fraught with ambiguity. Critics generally didn’t try to undermine the data R-R presented in This Time is Different; they took on a supplemental argument tacked onto that data, and the problems they found were less subjective and much more devastating.
The Actual Problems Identified Were Far Different in Scale
Giles focused his analysis on the most speculative data chapter in the book. According to Piketty, inequality in the ownership of wealth is one of the two channels that can lead to greater income inequality, but it’s the less important and far more speculative one, developed at the end of the book and added with many, many caveats by the author himself. This chapter is also at the farthest edge of the research frontier, as evidenced by the fact that new research on this topic is still breaking. Even if the whole chapter collapses, there are still very open questions about the growth of capital stock, how much of the economic pie capital will take home, the rise in labor inequality, and many other topics that comprise a much bigger part of the book.
In contrast, within 72 hours of HAP, support for the idea that there was a debt “threshold” collapsed. John Taylor said that the G20, a far cry from a group of liberal bloggers, omitted specific deficit or debt-to-GDP targets as a result of HAP’s critique. What happened?
First, the actual methodological problem was more important in R-R. It became clear that the choices made in weighting and averaging radically overstated the effects of one year from New Zealand in which R-R recorded a negative 7.6 percent change in GDP. But more generally, HAP showed that the final results were very sensitive to minor data adjustments.
This gets confused in the subsequent narrative, but R-R largely accepted the numbers of HAP. In fact, they said that the smaller numbers HAP found were in line with their new research, which found a smaller decline and correlation between debt and GDP, implicitly abandoning their 2010 paper that had become the focus of world policy. But they still argued that a negative relationship was present.
Since the data was made available by HAP, it took only 24 hours before other researchers found major problems that R-R’s response did not address. Specifically, the economist Arin Dube showed that “simple exercises suggest that the raw correlation between debt-to-GDP ratio and GDP growth probably reflects a fair amount of reverse causality. We can’t simply use correlations like those used by R-R (or ones presented here) to identify causal estimates.” In other words, low growth led to a higher debt-to-GDP ratio, not the other way around.
There was no convincing answer forthcoming from R-R about this issue. A month later, the economist Miles Kimball and Yichuan Wang found that they “could not find even a shred of evidence in the Reinhart and Rogoff data for a negative effect of government debt on growth.”
That no other researchers have used Giles’s findings to immediately disprove, or at least cast doubt on, Piketty’s central arguments is telling. This could still happen, so it’s important to be critical. But the general work in Capital, leaving aside the question of inequality of the ownership of capital in Chapter 10, has evolved over decades and has had its tires kicked many, many times. The debt threshold of R-R never passed peer review, and it is unlikely it could have given the obvious reverse causality issues.
The Difference in Democratic Accountability
It seems like everyone who brings up Capital in the 21st Century has to immediately remark about how impossible it would be to do anything about Piketty’s findings given our current reality. Did you hear that Piketty’s solutions in Capital are impractical? They’re impractical, you know. A global wealth tax? Impractical!
But some people, when they act, create their own reality. Even though it had never been replicated, R-R’s paper was immediately moved to the center of elite discussion. It was one of the most cited pieces of evidence during the Great Recession. It became a justification for austerity, and it was one of the central economic arguments for the Ryan Plan, the budget that Mitt Romney would have tried to put into place had he won the 2012 election.
Some people want to argue that the R-R Excel error was no big deal. And in an econometric sense, they might have a point. But in a political sense, it mattered. It showed that hundreds of millions of people’s lives were being guided by a piece of research with an error that literally anyone would have found if R-R had let another set of human eyeballs look at it.
This is why democratic accountability is so important with economics. It’s good to see Piketty checked here, even if the concerns are overplayed; as Piketty says, the distribution of wealth “is too important an issue to be left to economists, sociologists, historians, and philosophers. It is of interest to everyone, and that is a good thing.” Indeed it is, just as austerity and government budgets are. First, “Government Debt and Economic Growth.” Bivens and Irons of EPI, July 2010, footnote 5: “The actual data used in the [R-R] study have not been made available to the public by the authors.”
Second, “Not Following Professional Ethics Matters Also.” Dean Baker, July 2010: “Mr. Rogoff and Ms. Reinhart have declined to adhere to standard ethics within the economics profession and have refused to share the data on which they base their conclusion with other researchers.”
Third, “Is High Public Debt Always Harmful to Economic Growth?” Minea and Parent, Feburary 2012, footnote 4: “Our efforts for obtaining the database used by RR were…unfortunately unsuccessful.”
Chris Giles at the FT just wrote a critique of the data in Thomas Piketty’s Capital. Many people will rightfully debate the empirics of what Giles has found, which he believes shows that inequality of the ownership of wealth – how much of wealth is held by the top 1% – isn’t increasing, but it’s important to understand how it fits into the larger argument.
Their Problem With the Theory
Giles writes: “The central theme of Prof Piketty’s work is that wealth inequalities are heading back up to levels last seen before the first world war.”
This is incorrect, or at least badly stated. Piketty’s central theme is not that inequality of the ownership of wealth is going to skyrocket. If you look at the text , he’s somewhat agnostic about this, but it’s not determinative. The central theme is that the 1% already owns a lot of the capital stock, and the capital stock is going to get gigantic relative to the rest of the economy.
Inequality expert Branko Milan also tweeted this point, but let’s go through it and break down the theory Piketty puts forward. I used three dominos in my Boston Review writeup, and I’m adding a fourth here to make Giles’ critique explicit. Let’s describe Piketty’s argument as four dominos falling into each other:
1. The return on capital is greater than the growth rate. The infamous “r > g” inequality. Meanwhile growth begins to slow, perhaps because of demographics.
2. The amount of capital, or private wealth, relative to the size of the economy will begin to grow rapidly as growth slows. This is the “past tends to devour the future” line. The size and role of wealth of the past will take on a greater relevance to the everyday economy.
3. If the rate of return doesn’t fall, or doesn’t fall that quickly, the capital share of income will increase. More of our economic pie will go to people who own capital.
4. The ownership of capital is very concentrated, historically and across a wide variety of countries. It is unlikely to fall quickly, much less spontaneously democratize itself, in response to these trends. So the income and power of capital owners will skyrocket.
So right away, rising inequality in the ownership of capital is not the necessary, major driver of the worries of the book. It isn’t that the 1% will own a larger share of capital going forward. It’s that the size and importance of capital is going to go big. If the 1% own a consistent amount of the capital stock, they have more income and power as the size of the capital stock increases relative to the economy, and as it takes home a larger slice. However, obviously, if inequality in wealth ownership goes up, it will make the situation worse. (It’s noteworthy that these numbers Giles is analyzing aren’t introduced until Chapter 10, after Piketty has gone through the growth of capital stock and the returns to capital at length in previous chapters.)
The way that Giles could put a serious dent into Piketty’s theory through this analysis is by showing that inequality of wealth ownership is falling in the recent past. This is not what Giles finds. He mostly finds what Piketty finds, except in England, where it’s flat instead of slightly growing in the recent past.
From the four dominos, we can also see what flaws in the data would make people believe that Piketty’s argument is fundamentally unsound. Remember that Piketty has constructed data for each of these trends, not just the fourth one. Piketty and Zucman’s data on private wealth and national income, for instance, is here. But to really dent the theory you need to take down one of the dominos. Most have been fighting about the third one – that either the rate of return on wealth will fall quickly, or that it is determined by institutional factors that are politically created.
But the idea that the ownership of capital will become more concentrated isn’t an essential part of the theory. Though obviously if it does grow, then it’s an even greater problem.
Notes on the Empirical Arguments
I’m not blown away by the criticism so far, but I hope Piketty responds to the individual issues. Especially what’s going on in Britain, because this could be a good learning experience. A few quick points from me, will hopefully have more later. The two major criticisms outside Britain are:
Giles argues that when comparing Britain, France and Sweden, Piketty should weigh by population, instead of equally. Why? Because weighing the countries equally “is questionable, as it gives every Swedish person roughly seven times the weight of every French or British person.”
But weighing here, as always, depends on what you are trying to examine. I’d say the variable is the system of laws and economies that produce a consistent output among a group defined by space over time – i.e. the nation-state. And, especially if you want the variable not to be size but different economic systems, you have a collector’s set of what Gøsta Esping-Andersen calls The Three Worlds of Welfare Capitalism between England (liberal), France (corporatist) and Sweden (social democratic). If none of them are producing a fall in wealth inequality, that’s a remarkable fact. Weighing them by economic system makes sense. I’d be happy to be convinced otherwise, but Giles makes no such deep argument.
USA Data Missings?
Giles states that “it is not possible to say anything much about the top 10 per cent share between 1870 and 1960, as the data for the US simply does not exist.” However, as Matt Bruenig points out, since Piketty’s book came out there’s been significant new work by Emmanuel Saez and Gabriel Zucman telling us exactly that. Check out the slides, they are awesome. Well respected work that fills in the makeshift gaps Piketty had to use to make the wealth inequality data for the United States in this period. This is a sign of a good work – subsequent work is bearing out its results.
And this new work points to wealth inequality increasing in the United States. Dramatically. Go figure. Piketty’s conclusion from Chapter 10, which is when he introduces inequality in the ownership of wealth: “To sump up: the fact that wealth is noticeably less concentrated in Europe today than it was in the Belle Epoque is largely a consequence of accidentlal events…and specific institutions. If those institutions were ultimately destroyed, there would be a high risk of seeing inequalities of wealth close to those observed in the past….Nothing is certain: inequality can move in either direction….it is an illusion to think that somthing about the nature of modern growth or the laws of the market economy ensures that inequaity of wealth will decrease and harmonious stability will be achieved.”
It’s fair to say that this isn’t the only worrisome sign he points out in the book.
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There’s a certain liberal fascination with the idea of conservative “reformers” showing up and recalibrating the Republican Party toward policies that would benefit working Americans and lead to potential bipartisan solutions. This fascination is on display in the reaction to the new Room to Grow report, available for free online, by the YG Network. Already being covered by liberals, this volume features various reform conservative writers addressing a range of innovative economic policy ideas, with the hope that Republicans lawmakers will pay attention.
But if this is the best the new wave of conservatives can do on financial reform, it’s probably not the biggest worry that elected Republicans aren’t listening. The chapter that focuses on Dodd-Frank and the regulation of the financial markets after the crisis is by American Enterprise Institute’s James Pethokoukis. It’s billed as “financial reforms to combat cronyism,” but it offers little in terms of reform. The reformers should, at the very least, explain what they would repeal or replace in Dodd-Frank (a tension that exists with Obamacare as well), and this is left unclear.
The problems start with Pethokoukis’s take on the story of what went wrong in the first place. But he also glosses over the key issues facing policymakers today. The general idea of attacking “cronyism” and promoting competition tells us nothing about what needs to be done, making it so this report is a poor guide to the actual ongoing debates happening in financial reform. And this silence on contentious matters is so deafening that it bodes poorly for any kind of genuine positive agenda for the right or bipartisan alignment with liberal reformers. Understanding where Pethokoukis goes wrong, however, can tell us why conservatives are going to have a hard time dealing with actual reform in the age of Dodd-Frank.
The Story of What Went Wrong
For Pethokoukis, a lack of competition in the financial markets led to the crisis of 2008. To whatever extent there were problems, those problems existed because of the government’s safety net and backstopping of deposits and commercial banks.
A quick glance at most accounts of the financial crisis argues otherwise. The whole point of deregulation in the financial markets was to increase competition. The book that made the case for repealing Glass-Steagall argued for “an enhanced role for competition.” Economists associated with the Clinton administration also believed deregulation would lead to more competition and fix the financial sector. There was an explicit assumption that private entities like the ratings agencies would act as better regulators because they faced competition, and they explain how those agencies became so pivotal to the entire system.
So what went wrong? All these new types of “shadow” banks turned out to have the same problems as any other banking sector. They had massive conflicts of interest, were capable of generating panics and runs with no lender-of-last-resort to fall back on, and there were no regulatory tools to wind them down. The goal of Dodd-Frank, in this version of the story, is to extend the core, tried-and-tested methods of financial reform to this shadow banking sector. Under these new regulations, the FDIC can take down shadow banks, derivatives have to be traded in an exchange, the CFPB provides transparency and accountability for consumers, and so on. Perhaps this narrative is wrong, or perhaps these are terrible policy goals that follow from it, but it goes entirely undiscussed in Pethokoukis’s account.
No Conservative Answer to Too Big To Fail
The problems become more obvious when you consider two of the most debated parts of Dodd-Frank: the FDIC’s ability to create a death panel for failing banks, known as resolution authority; and the Federal Reserve’s power to act as a “lender of last resort” in periods of crisis. Pethokoukis only obliquely addresses these issues, though they go to the core of Too Big To Fail.
He argues that Dodd-Frank “explicitly permits bailouts through its resolution authority provision.” What he is referencing is sadly not cited, because Dodd-Frank in fact requires “that unsecured creditors bear losses in accordance with the priority of claim.” (If Pethokoukis would argue that the power to differentiate payments is a de facto bailout, then all of bankruptcy is a permanent bailout, as those powers look just like critical vendor orders or other parts of the bankruptcy process in the proposed FDIC rules.)
Pethokoukis also argues against any type of lender-of-last-resort functionality for the non-commercial banking sector. Awkwardly, this in turn functions as a defense of the 2007 status quo. Take an investment bank, allow it to be subject to market panics, and have no resolution process in place other than tossing it into bankruptcy. This is the exact experiment we did with Lehman Brothers.
In supporting materials, Pethokoukis argues that conservative reformers “have ideas to end Too Big To Fail once and for all,” but it’s not clear what they actually are, or even what they could look like. He doesn’t engage in the debate over resolution authority, and he doesn’t mention various conservative replacements to Dodd-Frank that involve a special bankruptcy code. Maybe that’s because the leading proposals make it purposely difficult to lend in a crisis by penalizing lenders, an approach that violates the wisdom of economists going back to Bagehot.
Not a Roadmap for Our Current Debates
Now granted, the report is about messaging and priorities rather than the intricacies of specific reforms. But even here Pethokoukis’s general guiding star of pro-competition and anti-cronyism doesn’t tell us anything about what we need to know to assess the problems on the ground.
Derivative reforms are notably missing from this paper. I’d argue that forcing price transparency in the derivatives market is pro-competition because it leads to better information and an even playing field, and that pushing for aggressive international enforcement of those rules is anti-cronyism, because Wall Street shouldn’t get to flout the rules by cleverly housing its operations somewhere. Would conservative reformers agree? Based on this report, I have no idea.
Is the fact that Wall Street has such an extensive presence in commodities like aluminum a cause for concern? Do we want to push back on the market mediated complex credit chains that comprise shadow banking? Did Dodd-Frank not go far enough in restructuring the financial system, or did it already go too far with the Volcker Rule and concentration limits? The fact that the conservative reformers’ framework is incapable of guiding us in any plausible direction on these major unfolding issues is very problematic. It points to an absolute void in reform conservative policy on the practical regulatory challenges of the day.
The most promising thing in Pethokoukis’s piece is the call for higher capital requirements, perhaps on the order of 15 percent. Though a very good idea, this won’t end Too Big To Fail. And again this doesn’t engage with the current debates over capital, which involve how to balance multiple needs of capital. If you have a straight leverage requirement by itself, won’t that be gamed by firms taking on big risks? If you have a lot of capital but no liquidity, won’t you be subject to runs? Should banks hold long-term, unsecured debt, perhaps engineered to turn into equity during a failure? People often seek a silver bullet here, but one of the points of Basel is to try and balance all these needs against each other. Pethokoukis is correct that requirements should be higher, but unclear on this balancing act.
Mediating Institutions Require Regulations
Capital requirements aside, it’s surprising how unsurprised I am by the supposedly bold new thinking on financial reform contained in this report. The report is ideologically focused on using the government to build the spaces between the individual and state, the space of mediating institutions that include the market. But one of the best ways we can do that is by enforcing transparency and accountability among people participating in a market. Indeed, arguably the biggest blow to cronyism in 2014 has been the disclosure by the SEC of serious, widespread breaches in the private equity market – breaches that are reportable because of Dodd-Frank.
Here’s an example of a policy I’d love to see the right embrace: fiduciary requirements updated for a landscape of 401(k)s, IRAs, and all the other personal, private, tax-exempt savings accounts that people have to deal with. The Department of Labor is trying to do this right now, in fact, and the House Tea Party is trying to stop them.
One might expect that conservatives thinking in terms of civil society would support fiduciary requirements. They’ve existed since antiquity, going back to the Code of Hammurabi, Judeo-Christian traditions, Chinese law, and, a bonus for the right, centuries of common law. Using the state to set a guidepost for ethical norms that have existed across time and place, and thereby boosting people’s ability to take responsibility for their investments, is remarkably consistent with a richer civil society. But it’s not there in this report.
I hope these reformers succeed in checking the furthest right-wing elements of their party, although the rehabilitation of Bush-era “compassionate conservatism” (a term whose absence is conspicuous) is a far heavier lift given the libertarian focus of today’s conservatism. But if this vision is going to be centered on mediating institutions rather than direct state action, it will be essential for reformers to understand how the state creates the market, and how it sets the terms for enforcing consumers interests, for private agents to get access to information, and for trading, prices, and risk to move throughout the economy. The core balance of transparency, accountability, stability, and innovation is not something that can simply be waved away by appeals to a “free” market as is done here.
When I wrote a long piece about the Voluntarism Fantasy at Democracy Journal, several people accused me of attacking a strawman. My argument was that there’s an influential, yet never clearly articulated, position on the conservative right that we jettison much of the federal government’s role in providing for economic security. In response, private charities, churches and “civil society” will rush in and do a better job. Who, complained conservatives, actually argues this?
Well, here’s McKay Coppins with a quite flattering 7,000 word piece on how Paul Ryan has a “newfound passion for the poor.” What is the animating core and idea of his new passion?
Ryan’s broad vision for curing American poverty is one that conservatives have been championing for the last half-century, more or less. He imagines a diverse network of local churches, charities, and service organizations doing much of the work the federal government took on in the 20th century. Rather than supplying jobless Americans with a never-ending stream of unemployment checks, for example, Ryan thinks the federal government should funnell resources toward community-based work programs like Pastor Webster’s.
I’m happy to have been part of the editing team on this piece by JW Mason for The New Inquiry’s money and finance issue, Disgorge the Cash. It summarizes some of the issues he’s been developing at his blog slackwire on the relationship between the financial sector and the real economy. As both an economic matter, with the relationship between corporate borrowing, investments and dividends before and after the early 1980s, as well as a socio-cultural matter of managers and their relationships to the firms they manage, it’s fascinating stuff. It also points to a question, one Piketty doesn’t touch in his new Capital book, of whether supermanagers who are creating the runaway 1% labor incomes gain should really be thought of more as part of capital income.
Much of the rest of the finance and money issue is now online, though you should still subscribe.
From the piece:
In 1960, there was a strong link between borrowing and investment. A firm that was borrowing $1 million more than a typical firm of that size would usually be investing $750,000 more. […] Before 1980, there was no statistical relationship between borrowing and payouts in the form of dividends and share repurchases at the firm level. But since then, a clear positive relationship emerged, especially at business-cycle peaks. Firms that borrow more have significantly higher payouts to shareholders. […] It was a common trope in accounts of the housing bubble that greedy or shortsighted homeowners were extracting equity from their houses with second mortgages or cash-out refinancing to pay for extra consumption. What nobody mentioned was that the rentier class had been playing a similar game longer and on a much larger scale.[…]At the moment, finance seems to be doing its job well. The idea that corporations will spontaneously socialize themselves looks utopian and naïve. The evolution described by Keynes, Berle and Means, Galbraith, and other theorists of managerialism early in the 20th century had been halted or reversed by its end.But that doesn’t mean it wasn’t real. Just look at the scale of the financial apparatus required to keep productive enterprises focused on profit maximization, and the fear capitalists have of allowing managers discretion over corporate resources, even when their incentives have been arduously “aligned.” Isn’t it testimony to how tenuous and unnatural production for profit is? In these far from revolutionary times, radicals often fret about the difficulty of transforming the existing organization of production into socialism. But this project is nothing compared with the Sisyphean task faced by the other side, of constantly transforming the existing organization of production into capitalism.
He also finds that this effect is stronger for those who are unlikely to receive unemployment insurance.
One comment I had. There’s an argument that the long-term unemployed are the weakest employees, those who were fired during the first wave of layoffs that started in 2008. These workers were going to have a hard time finding jobs not based on the labor market but because, to be blunt, they weren’t good workers. (One manifestation: Tyler Cowen did a lot with this idea of zero marginal product workers, ignoring that the marginal product of labor is impacted by demand, back in 2011.) Since long-term unemployed workers look a lot like the general unemployment pool, this is thought to be driven by softer, not-quantifiable, worker characteristics.
Leave aside for a moment the difficulty that the long-term unemployed, those who were unlucky and have been looking for a job for more than 52 weeks, have in finding a job. Even those who have been unemployed zero weeks are having trouble finding jobs in this economy. And this is important evidence against the idea that the labor market is doing better than people realize if you just ignore the long-term unemployed.
Here’s a data point that I’m particularly interested in: how often are employed people going straight to another job, rather than leaving their job and enduring a period of unemployment before finding new work?
Though most people think of the employed spending some time in unemployment before starting a new job (an idea that was central to the recent theory that quit rates predicted a healthy job market), a substantial number of people move directly from one job to another without ever counting as unemployed. Since our statistics (and most of the economic models) are set up to observe people who are looking for work but are unable or unwilling to accept a job, these steadily employed workers can go missing in the discussion. That’s a shame, because historically they comprise almost half of all those who accept a new job.
The Rortybomb blog has long been a fan of the job flows data, or the statistics that show who is moving between employment and unemployment and in and out of the labor force. However, the easiest way to access this data didn’t distinguish between those who stayed employed with a single employer and those who stayed employed but moved between different employers.
Luckily, someone pointed me in the direction of the Employer-to-Employer Flows in the U.S. Labor Market , compiled by the Federal Reserve, which breaks out those who move from one employer to another without being unemployed (described as “EE transitions” for the rest of this post). This data is current through the end of 2013.
If the economy is heating up significantly and the long-term unemployed aren’t capable of taking jobs, then the EE transition rate should be increasing. So how is it doing?
This is the percentage of the employed who are in EE transition (the results are the same for EE transition as a percentage of the labor force). As we can see, it declined during the crisis and hasn’t recovered even as of 2013.
Let’s also look at this from a different point of view: what percentage of those taking jobs are currently employed? If the economy was heating up and the unemployed or those out of the labor force couldn’t take jobs, we would expect this to increase. Taking EE transitions as a percentage of all those who are transitioning into new jobs, we see the following:
New hires are increasingly coming from the ranks of the unemployed and those not in the labor force rather than the currently employed. Where the employed were 40 percent in the 1990s, and 35 percent in the pre-crisis 2000s, it’s down to 30 percent now.
Why does this matter? First off, these quits also create a new job opening, which the unemployed can take. There’s a significant labor economics literature that argues that job-to-job transitions are a major driver of wage growth for workers (starting here and continuing to this day, h/t Arin Dube). If the number of people moving directly from one job to another is in decline, that’s a bad sign for wage growth, as well as inflation and monetary policy. This appears to be undertheorized and not discussed enough in academic or policy discussions.
But why is this happening? The American Time Use Survey hasn’t been able to tell me whether the employed are spending more or less time searching for other jobs since the recession started; the sample size is too small to make conclusive predictions about changes. If potential wage gains are a primary motivation of job-to-job transitions, then lack of wage growth or even inflation could be contributing to less churn in the economy.
When it comes down to it, the problems of those who aren’t working and want a job are similar to the problems of those who are working but want a new job. As Alan Krueger found in this chart in his recent paper (also see Ben Casselman’s chart here), the rate of successful job searches is down not just for the long-term unemployed, but also for the short-term unemployed, when compared to 2007. It appears the same holds true for those with an unemployment duration of zero. The page indicates that it was last updated in 2004, or perhaps 2011. But the excel document has data through the end of 2013. Sneaky.
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