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How QE2 could cause low investment

This is pure speculation (also called theory). I have no respect for economic theory definitely including my own efforts, so the post will all be after the jump.

I will write about, sketch and definitely not write out a model in which Fed purchases of 7 year Treasury notes causes low investment. It happens to be a fact that following the Fed’s purchases of 7 year Treasury notes investment has been lower than forecast when the purchases began. I don’t consider this anything along the lines of evidence, not even weak evidence, and am theorizing for the fun of it.

7 year notes are not completely safe assets. Real returns over the full 7 years depend on inflation. Returns over briefer periods depend on inflation and future shorter term rates. This means that QE2 might have an effect on the economy by removing risky assets changing the risk born by private agents. This is a plausible explanation for the apparent effectiveness of QE1 (the Fed bought mortgage backed securities, commerical paper and made loans to banks). It is one rational for quantitative easing in general.

The problem is that removal of a stochastic asset does not necessarily reduce risk. Insurance makes stochastic payments. It generally reduces risk (except for CDSs it turns out). It seems plausible to me that medium and long term Treasury securities provide a useful hedge for firms considering whether to invest in fixed capital.

If I wrote a model (which I won’t) uncertainty would be uncertainty about future real GDP growth. It is possible that GDP will grow robustly so that returns on fixed capital are high or that it will grow slowly (or there will be a second dip) so returns are low. Firms are assumed to be risk averse. Partly this is due to the administrative costs of bankruptcy. Partly it reflects a principal agent model as the CEO of a firm can’t hedge his or her exposure to the risk of bankruptcy by being CEO of a diversified portfolio of firms.

This means that uncertainty about the returns on fixed capital causes lower investment. Fortunately, managers can hedge this risk by buying medium and long term Treasury securities. It is clear (here assumptions about monetary policy and Taylor rules and such) that poor GDP growth will cause low short term interest rates in the future. Also the non model would have an expectations augmented Phillips curve if I bothered to write it down. Poor GDP growth causes low inflation.

For both reasons a firm with a huge pile of cash might prefer to invest some in fixed capital and the rest in medium and long term Treasuries in order to avoid risk and possible bankruptcy.

If the Fed removes long term Treasuries, this becomes less attractive. It becomes more attractive to keep the financial wealth of the firm in cash or t-bills. This reduces the hedge on the risk in the returns on fixed capital and reduces the optimum investment in fixed capital.

For this argument to work, it is necessary that firms be sitting on huge amounts of financial assets. As they are.

I am quite sure that a model along the lines sketched here could be written and would give the desired result that QE2 is contractionary. Importantly, the model relies on the assumption that quantitative easing consists of purchases of medium or long term Treasury securities and not, say, high yielding corporate bonds.

My personal sincere view is that QE2 was a total flop and that it was a total flop because of problems with quality not quantity. I really think that, for quantitative easing to work, the Fed must purchase a large quantity of low quality assets. I think that the FOMC had a heated debate and compromised agreeing to buy assets which they don’t normally buy, but agreeing on assets which were as similar to their usual T-bills as possible. This makes sense if it was required by law or if their aim was to minimize the bang for the buck. Otherwise it is incomprehensible.

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QE2 and the Laffer Curve.

I am not able to get anyone to debate me on monetary policy in a liquidity trap. Therefore I resort to crude provocation.

I recall two claims about monetary policy which were not controversial until this year. First that the effects of a shift in monetary policy peak after roughly 6 months. Second that it acts through investment and especially housing investment (the second follows from the view that it acts via interest rates but not the short term rates which the Fed can control but medium and long term rates which matter a lot for housing and some for investment in productive capital).

After fiddling with the dates to avoid the inconvenient fact that medium term nominal interest rates went up when the actual QE2 purchases began the money supply side economists decided that the date the policy began was late August. That means that the data you present here would, in a sane world, be the last nail in the coffin of the hypothesis that the Fed can stimulate the US economy when it is in a liquidity trap by buying 7 year Treasury notes.

I get rude after the jump.

I note already that 7 year real interest rates are higher than they were when the actual purchases started and equal to what they were when Bernanke first mentioned QE2 (late August).

So I ask you what evidence could possibly convince you that QE2 was ineffective. You have a powerful imagination and should be able to think of something (I can’t).

I also note that the quality (intelligence and integrity) of data analysis of the money supply side economists reminds me of the data analysis by supply side economists. I think they have resorted to each and every cheap rhetorical trick used by the supply siders. For every bit of bogus supply side data abuse, I claim I can find the same bogus trick played by advocates of quantitative easing.

If I am presented with no such examples, I will conclude that the money supply siders admit that they as bad as supply siders. I will present my examples of similarly bogus data analysis tomorrow.

update: as promised, they are posted. But since they are not up to angrybear levels of seriosness and civility (would you believe raging Shrew ?) they are posted at Robert’s Stochastic Thoughts

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Town Hall Meetings on the Ryan Budget Raise Concerns

Various congressional representatives held town hall meetings recently, and the news channels and print media were abuzz with the lively give-and-take, including shouting matches. See, e.g., House G.O.P. Members Face Voter Anger Over Budget, New York Times, Apr. 26, 2011; Republicans facing tough questions over Medicare overhaul in Budget Plan, Washington Post, Apr. 22, 2011.

The issue–the House’s adoption of the Ryan budget proposal and its clear agenda of overturning New Deal safety nets embodied in the current understanding of Medicaid, Social Security and Medicare.

Those at or near retirement are worried that the Ryan proposal will hurt everybody. The Ryan proposal comes with frequent disclaimers about protecting the already older population and needing to act now to protect our grandchildren, a clear effort to massage the message to appeal to current grandparents. See, e.g., House G.O.P. Members Face Voter Anger Over Budget, New York Times, Apr. 26, 2011 (noting Webster’s statement that “not one senior citizen is harmed by this budget” while implying that it is necessary to prevent grandchildren from “looking at a bankrupt country”); Congressional Republicans go home to mixed reveiws,, Apr. 26, 2011 (noting North Carolina GOP Rep. Renee Ellmers’claim that “If you’re 55 and older, your Medicare and Social Security will not change”).

But the Ryan proposal clearly envisions mechanisms that would likely lead to decimation of these programs–either through turning them into limited vouchers (Medicare proposal); turning the funds over to the states to use as they see fit (Medicaid proposal) or limiting benefits (Social Security proposal) in ways that will –probably sooner rather than later– hurt everybody.

  • These proposals take place in a context of expansive, concerted attacks on these “entitlement” programs, often failing to acknowledge the historic support for these programs or their foundation in the recognition that federal support is required to protect against the abject poverty and humiliating degradation that accompanied the Great Depression;
  • Benefits for elderly and sick Americans are cut to provide savings to offset some of the loss of revenues from tax cuts for Big Business and the wealthy, both of whom already pay relatively low taxes, in what hardly seems a bargain to the working poor, the elderly or in fact the overwhelming majority of Americans who are not in the top 15% income or wealth distribution. (This in spite of Ryan’s claim that there is no huge tax cut for big corporations and the wealthy–he asserts that the proposed 25% rate is “in exchange for losing their tax shelters”. See, e.g., Evening News coverage of Paul Ryan holding Wis. town meetings, at;photovideo )
  • In spite of the high cost for the vulnerable poor and elderly of these budget proposals, they don’t appear likely to achieve their proffered rationale of reducing debt and deficits–in fact, the CBO has said that the Ryan budget proposal will result in higher deficits and bigger debt burdens over the next decade.
  • It appears shortsighted to wring one’s hands about a “bankrupt country” while considering only one potential solution, especially when that solution is highly detrimental to the most vulnerable populations, and without considering the full facts regarding the amount of debt, the ability of the U.S. to weaken the dollar further to aid unemployment and debt payment, the ability of the U.S. to raise taxes judiciously rather then merely cutting spending, or the ability of the U.S. to let the tax law play out as it is currently slated to do (with the Bush tax cuts that were extended 2 more years over their originally intended short life due to sunset in 2012). As Jim Johnson, a former Ryan supporter who has “grown increasingly disgusted” with Ryan noted, “[Ryan] says Medicare is unsustainable. I’m thinking, ‘Yeah, it’s because medical costs are out of control.’ …Why isn’t he attacking it at that level?” Congressional Republicans go home to mixed reviews, CBS
  • Any voucher system for health care will inevitably fail to cover increasing health care costs, resulting in rationing even the most basic health care by socio-economic class–the very problem that Medicare, Medicaid, and the limited health care reforms undertaken by the last Congress were intended to address. The Center for Budget and Policy Priorities concluded that out-of-pocket medical costs would skyrocket for low-income seniors; the Washington Post’s Fact Checker Glenn Kessler (in GOP Lawmakers tout Medicare reform by stretching a comparison to the health benefits they receive, Apr. 29, 2011) notes that the CBO analysis concluded that the Ryan Medicare system would pay only 32% of health care costs by 2030, compared to 70-75% if traditional Medicare remained in place.
  • Addressing the problems in the U.S. health care system solely by market means that put the onus on health care recipients to seek cost-savings has failed miserably over the last forty years and cannot help but fail more spectacularly when the Medicaid backup is weakened and the nature of health care needs is such that one of the best antidotes to market problems (the only one permitted in radical market thinking that objects to regulatory safeguards)–informed consumers who can review options and select among competing providers–is simply not applicable. Car accident victims don’t shop for surgeons; cancer victims don’t know enough to select based on price; etc.
  • The Ryan proposal appears one-sided in its decision to cut spending on potentially vulnerable populations rather than to address the means through which health care is provided or to consider ways to control profit-taking in the health care system. The market ideology of the proposers leaves many options that might work better off the table (single payer; tax on excessive compensation; revamping the non-profit hospital system; attaching strings to the R&D and other tax expenditures in the tax code; using the clout of a national system to negotiate better doctor and drug pricing for Medicare and Medicaid, etc.);
  • Many of those states that would acquire more control over the use of Medicaid funds are controlled now, as is the House, by people who have announced their intent to cut taxes on the wealthy and business while cutting or taxing pensions and health benefits for public employees and cutting funds available for Medicaid and other poverty-directed programs; it is not a difficult leap to see the interrelationship of these trends;
  • Plans to cut benefits for those who may enjoy them in the future pave the way in at least two ways for decisions shortly thereafter to cut benefits for those who currently enjoy them: first, by creating lowered expectations; second, by creating an unfair disparity that supports an “us against them” attitude between the current elderly and those who will get lesser benefits in the future. (Note that this resembles the way the right has encouraged an “us against them” attitude of private workers, who have been deprived of union benefits through the harsh anti-union tactics used by Big Business, against public employees, who have generally benefited in the past from more reasonable attitudes towards unions fostered in legislative bodies that have, in the past, understood the nature of the bargain that public employees make (which might be summarized as ‘work hard, get paid less than you could in the private sector, and accept later benefits in pensions and health care for lesser salary/percs now).

Is is surprising that left-leaning activist groups like Move-On point to the Ryan budget proposal as a “naked, unapologetic attack on working Americans for the sake of Big Insurance and the riches of the rich” (quote from Move-On email on this matter)?

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Hoocoodanode, Great White North edition

Hoocoodanode that replacing someone described as “too Professorial” with someone whose concept of True Patriot Love was to spend the time of the Life of Legendary Jesus out of the country (being a Torture Apologist from the comfort of Cambridge, Mass while Maher Arar traveled different roads) and then act upon his return as if he were the Second Coming could have negative consequences with the electorate?

The glory for the Conservative Party for the past twenty years has been that the ABC vote would split between the Liberals and the NDP and the PQ would distract enough people in the non-oil-producing East to keep them in power. So in some small way, we should credit Ignatieff for doing the impossible—uniting the Canadian center-left.

Update: CT has a post from Tom Slee that discusses everyone except the elephant in the room, with more joie de vivre than I did (but less surety).

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The Fine Print (Supreme Court and lawsuits, class action)

by Beverly Mann

The Fine Print

It’s hardly a secret that Chamber of Commerce types have co-opted a bare majority of the Supreme Court as their proxy in their war against business litigation, and that the most potent categorical weapons are arbitration as a forced substitute for lawsuits and the effective elimination of class actions.

In a manipulative, far-reaching opinion that the Court issued Monday, the five corporate proxies killed both birds with one stone.

The stone was thrown in a lawsuit by a California AT&T cell-phone service customer who signed a service contract with the company and received what the company said was a free phone but for which the customer later was billed $30 in sales tax—the sales tax on the regular retail price of the phone.

The contract, like virtually all consumer contracts and many other types of non-negotiable standard contracts between a business and a customer or client, or between an employer and employee, includes an arbitration provision. The provision waives the right to sue, and provides that any disputes be resolved instead in arbitration, a setup in which the business pays the arbitrator and, as a wink-and-nod practical matter, will use that arbitrator again in other arbitrations, or not, depending on, well … you know. The blindfolded lady holding the evenly-balanced scales of justice isn’t around.

Update: (Dan here…. From Scotusblog AT&T Mobility v. Concepcion (No. 09-893), and the Court’s opinion is here

The arbitration provision in AT&T’s form contract, like the form contracts of many other large corporations or firms, doesn’t just require a waiver of the right to sue. It also bars class arbitrations. It requires, in other words, that each customer who claims to have been defrauded out of a small amount of money proceed through arbitration independently of every other victim of the alleged scam—and, as a practical matter, because the amount is so small, without an attorney.

The Federal Arbitration Act of 1925 requires courts to honor arbitration clauses—that is, to dismiss lawsuits when the business defendant asks the court to do that on the basis of the arbitration clause. But the FAA includes a provision that allows courts to invalidate the arbitration clause under “generally applicable contract defenses.” Such as that the contract was signed under duress, or that one of its provisions is unconscionable as a matter of public policy (usually because one party had no bargaining power and could play no role in deciding the terms of the contract, and the provision is unfair to that party). Normally, contract law, including these defenses to enforcement of contracts, is a matter of state law, not federal law. So usually it is state law that determines the circumstances under which a court can invalidate an arbitration clause and allow the customer, the securities-firm client, the employee, to sue in a real court.

Or was.

At the center of the Supreme Court case was a 2005 California Supreme Court opinion that interpreted two state statutes. The California court construed those statutes as providing that if three conditions are met, the unconscionability defense can be used to void the part of an arbitration provision that waives the right to arbitrate as a class in California.

The three conditions are that the agreement be a standard-form contract without negotiation (known as a contract of adhesion), that the disputes probably will involve small amounts of money, and that the party who wants the contract provision voided is alleging a scheme to defraud. In its opinion Monday, Scalia, writing for the majority, said this conflicts with the purpose of the FAA, which—he said—was to encourage arbitration agreements and to ensure a quick, easy process. Breyer, though, writing for the four dissenters, pointed out that Congress’s actual stated purpose was to require courts to treat arbitration agreements as contracts, for the purposes of enforcing them and, when required under contract law, voiding them—and that that is what the text of the FAA says.

Scalia also said that class arbitration defeats the purpose of arbitration. Which I suppose is true if the purpose of arbitration, or at least arbitration as the only option under law, is to undermine any real threat of meaningful penalty for corporate wrongdoing.

But Scalia claims a different for purpose for arbitration: to provide a simplified, quick process. He complains that class arbitration complicates the process. Which, as Breyer notes, it does, but says, “So what?” The purpose of arbitration is to provide a quicker, simpler process than full litigation. Which class arbitration does, since it replaces not individual litigation but class litigation.

Breyer doesn’t take the next step, though. But someone should, soon. The Court’s majority interprets the FAA as allowing contracts of adhesion to remove the right to litigate as a class although class litigation otherwise would be appropriate. And the majority interprets the FAA as allowing those contracts to remove the right to arbitrate as a class when class litigation would be appropriate. This seems, I think, to raise questions about the constitutionality of this statute, now that the Court has said the purpose of it was not simply to require courts to treat arbitration provisions as contracts under normal contract law but rather to allow a party to a contract of adhesion to strip courts of their authority to void those provisions, contract law notwithstanding.

If Congress’s purpose was not to allow parties of relatively equal bargaining power to negotiate a contract that provided for arbitration, but was instead to remove access to the court system, independent of contractual rights—and if that is now the statute’s effect—it would seem that the statute itself violates basic constitutional precepts of due process of law. The Court’s majority’s new conflation of arbitration law and class action law, and their imposition of their own surprisingly-undisguised policy preferences as law, appears designed to do exactly that.

crossposted at The Annarborist

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The Future of the Fed

Spent the morning at this event: presentations and discussion by Joe Stiglitz, Yves Smith, Mike Konczal, Joe Gagnon, Matt Yglesias, Tom Palley, and many others.

Mike K. tole me he expects that video will be available this evening, at least of the speakers’s presentations. I plan to post at more length later; meanwhile, you can review the real-time commentary on Twitter by @NewDeal2.0 and others with the #FutureofFed hashtag. (Some of my early Tweets went out as #FedFuture before I “got with the program” and surrendered that 1.4% of TweetSpace to the Greater Good.)

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Where Has the Spending Gone, Joe Dimaggio?

by Mike Kimel

Where Has the Spending Gone, Joe Dimaggio?

Lately there’s been a gnashing of the teeth about the deficit and the debt and what to do about it. Democrats point out that when GW took office, there was no deficit, and that a big part of the problem is that federal tax revenues have fallen from 20.6% of GDP in Fiscal Year 2000 to 14.9% in Fiscal Year 2010 (warning – Excel file), and are slated to fall to 14.4% this fiscal year. I found a nice graph here. Despite the nonsense that gets referred to as Hauser’s Law, the big fall in tax revenues is is in large part due to the tax cuts, although the poor economy also plays its share.

(Note – so I don’t have to keep typing it, all years in this post are fiscal years.)

But for there to be a deficit, tax revenues (whether high or low) have to be less than spending. And spending has also gone up (again see OMB Table 1.2 referenced above) from 18.2% of GDP in 2000 to 23.8% of GDP in 2010, and is slated to go above 25% of GDP this fiscal year. (It is worth noting – federal spending as a percentage of GDP fell in every single year during the Clinton administration… which means Newt Gingrich doesn’t get credit for it unless you believe he had one heck of a time machine.)

I thought it would be interesting to see where that spending is going, so I pulled the data from OMB Table 3.1 and graphed it below. (Dotted lines indicate future projected spending.)

Figure 1

The figure indicates that for the most part, spending in most categories has been pretty flat. Defense spending, though, rose from 3% of GDP in 2000 to 4.3% in 2008, 4.8% in 2010, and is slated to go above 5% this year. Afghanistan, Iraq, and now Libya all cost money, especially if conducted with sweetheart no-bid deals. The bigger ticket category that saw increases was “human resources” – that was 11.4% of GDP in 2000, reached 13.2% of GDP in 2008, and is expected to top 16% this year.

So what are these human resources? I don’t have the definition in front of me, but I think that includes things like unemployment compensation, food stamps, and the like. Put another way, some of the spending (it’s 3:36 AM right now – I think the “how much” part of “some” has to wait for another post) is happening because the tax cuts didn’t work as advertised. But then, its not like that should have been a surprise.

Cross-posted at the Presimetrics blog.

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Liquidity, Markets, and Pricing: A Contemporary Example

A lot of trading in the Fixed Income (and especially FX) market is done for “liquidity” purposes. There is often an underlying goal involved (e.g., push prices higher with small lots, sell large ones at the elevated prices) and frequently such strategies are discussed as “algorithmic trading.” (Example: the algorithm estimates that you will need to buy 5 $100MM lots of JPY at incrementally higher rates to be able to sell $1B USD at the higher JPY level.)

The liquidity of the “markets” is facilitated by algorithmic trading: the seller for the first five trades in the above example doesn’t care about the purpose of the counterparty’s trade, just that the price bid is agreeable.

Then there are the times when algorithmic pricing goes terribly wrong:

Eisen began to keep track of the prices until he caught on to what was happening: The two sellers of that particular book — bordeebook and profnath — were adjusting their product prices algorithmically based on competitors:

Once a day profnath set their price to be 0.9983 times bordeebook’s price. The prices would remain close for several hours, until bordeebook “noticed” profnath’s change and elevated their price to 1.270589 times profnath’s higher price. The pattern continued perfectly for the next week.

The biologist continued to watch the prices grow higher and higher until they hit a peak price of $23,698,655.93 on April 19. On that day “profnath’s price dropped to $106.23, and bordeebook soon followed suit to the predictable $106.23 * 1.27059 = $134.97.” This means that someone must’ve noticed what was happening and manually adjusted the prices. [italics mine]

As a mathematical exercise, the shift from $106.23 to $23,000,000 and change is clear: one dealer must price their copy higher than the other dealer. (If both do so, you get to the same point or higher even quicker.) Similarly, if both dealers price at a fraction below 1.000 of the other, the price will converge toward $0.00 as the algorithm progresses.

Consider the implication for a potential third seller, though. Depending on when they check, they may believe they have a book that will make them (if and when sold) rich. But the “market” they see is two computers offering against each other—there is no bid-side shown, and pricing “to sell” (say, $850K when both of the others are offered at around $1.7MM) implies that the third potential seller is carrying that asset at an inflated value.

Market transactions do not require two entities to like each other, or even to understand what the other is trying to do. Indeed, if your alogirthm is buying at 85.3 JPY/USD and mine is selling at that level, neither of us necessarily cares why the other is transacting. And the rest of the market sees an actual trade against which they can adjust their pricing.

It’s only when the algorithms are trying to do the same thing that $23MM+ books are offered.

The implication for mark-to-market valuation seems obvious, and is left as an exercise to the reader.

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Oh Yeah: Crowding Out Has Been a Huge Problem

Guest post by Steve Roth

Oh Yeah: Crowding Out Has Been a Huge Problem

Cross-posted at Asymptosissize=”2″>

Right-wing economists love to claim that government spending “crowds out” private spending, especially investment spending on fixed assets. It’s probably true at some level and in some situations.

But if it was true for postwar America, you’d expect to see some evidence in the historical data, right?

Not so much:

Note: Government includes all levels — federal, state, and local.

The investment share of government, ex-defense, fell by 29% from the 60s to the 80s, while the share devoted to business increased 18% (28% from the 50s to the 80s) — the very period when the blossoming New Deal programs and Johnson’s Great Society were supposedly creating Leviathan, embodied.

Those changes in share percentages don’t really put across the magnitude of the change, though. Business investment started at a much higher level, so the absolute increase in business investment utterly dwarfs all the other changes.

Curiously (given the right-wing narrative) the business share flattened out once we started feeling the manifestly salutary effects of the Reaganomics world view. It actually declined slightly under Dubya and six years of unfettered Republican control. Go figure.

Defense investment has plummeted since the 50s (and — naturally — the 40s) — a 31% decline in its share from the 60s to the 80s, 58% from the 50s to the 80s, and 78% from the 50s to the 00s.

(Note: “domestic” assets are those located in the U.S. — except that government assets include U.S. military installations, embassies, and consulates worldwide. So this rapid decline may represent a worldwide construction binge in the 50s and 60s which was largely completed by the 70s. Defense investment generally includes much higher proportions of spending on structures — this was especially true in the 50s and 60s — compared to business investment, which devotes much, and increasingly, more to equipment and software.)

Wondering what caused Tyler Cowen’s Great Stagnation (the slowdown in economic growth since the mid-70s)? Here’s what looks like a smoking gun: Government investment spending as a percent of GDP fell off a cliff from the 50s/60s to the 80s — a 42% drop in sixteen years from ’68 to ’84, down 48% from ’58 to ’84. It’s been floating around that low level for the last 26 years.
Oh and for those who are curious, government consumption spending as a percent of GDP has been flat since the mid-70s.

The crowding-out theory of postwar America is in fact anachronistic by about six decades. When Simon Kuznets (who in the early thirties created the system of national accounts now used by every country in the world) published Capital in the American Economy in 1961, reviewing trends from 1869 to 1955, he cited the proportional growth of government investment as the dominant trend in capital formation over the decades he was examining.

The postwar trend has been in exactly the opposite direction.

I’m just sayin’: stopped clocks are wrong most of the time.

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