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About That, er, Monetary Expansion…

Brad DeLong has a spat with Scott Sumner:

The IS-LM model led economic historians to argue money was easy in 1929-30, because rates fell sharply. It led modern Keynesians to assume that money was easy in 2008, because rates fell sharply…

Well, I would say that not just “modern Keynesians” but a lot of people believed that monetary policy was expansionary in 2008.

They believed so not just because (safe) nominal (and real) interest rates were falling, but because the money supply was expanding. Indeed, since 2007 the Federal Reserve has tripled the monetary base

But there remains a reason I suggest that cutting off Tim Geithner’s (and/or Ben Bernanke’s) private parts, stuffing them into his mouth, and perp-walking him publicly down Dewy Square* would be a good re-election move for the Obama Administration, and it comes back to basic economics. Specifically, Brad DeLong’s favorite monetary equation


Now, most of the time, we derive V—Velocity. We kinda sorta hafta. The velocity of money is not something that you really observe directly; to solve the equation for V(i), we have to know Y, P, and M.

But then we’re making assumptions about them. Two of them are probably reasonable:

Y = GDP (or GNP if you add in XM, but let’s not). We shorthand this as “aggregate output.” Even if we weren’t pretending it’s constant in the short-term, we can fairly well define this and hold to the definition. GDP=GDP, as it were.

P = Price Level. This is slightly more difficult conceptually, because we aren’t going to include everything. But if we assume (short-term) that the “market basket” is constant (or at least fungible**), we can come up with a representative index level and just treat this as “inflation.”

The third, however, is more problematic:

M is the Base Money Supply, which is circulating.

Recall that V = Velocity, or, the number of times in a year that a dollar is spent, a definition that led to Keynes’s observation that V isn’t so much a constant (pace Fisher) as dependent on interest rates—V(i). This doesn’t (or, more accurately, shouldn’t) change much in the short-term, even at the zero-bound.

But “velocity” assumes money is circulating, which why it is multiplied by the Monetary Base from the start. If the monetary base has all the mobility of an overBotoxed actor’s face, we’re going to have a problem. I would call the following graphic “Where’s the Real Increase in the Monetary Base?”

The above graphic is Ben Bernanke’s fault. And even Brad DeLong knows this. The proof below the fold.

Or, at least, he strongly suggests he does, citing WSJ columnist David Wessel:

The Fed is not out of ammo, the economists at the Bank Credit Analyst insist…

The three:

Target a higher inflation rate or pre-specified level for the consumer price index or nominal gross domestic product. Problem: “could undermine the Fed’s long-standing commitment to price stability.”

Stimulate bank lending by putting a tax on excess reserves, hoping that banks will the lend out the money if the have to pay borrowers to take the loans. Problem: “could lead to the collapse of money market funds and the disintermediation of the financial system.”

Buy corporate debt, equities, real estate or foreign currency. Problem: Could require an act of Congress. “Given that the U.S. economy remains stuck in a liquidity trap,” Berezin concludes, “fiscal policy would be the most straightforward way to stimulate….However, the likelihood that the U.S. will receive major fiscal stimulus anytime soon is close to zero.”

I’m not sanguine about the latter. Even absent economic issues (which are minimal in the current environment), the political ones are problematic.*** That it makes more sense than telling people to put their money into a 401(k) that consists 90% of company stock is a low bar to jump. On the other hand, buying Yuan until it has to appreciate is worth exploring.

The first has been getting traction for years. And I admit I can’t decide who was stupider: the people who set a 2% target on no evidence (sorry, David, I held to this even after reading your cites) or the people who decided a “2% target” meant “<=." It now has enough traction that it will get out of the avalanche about the time the snow melts. So that leaves the second one. Which brings us back to the Monetary Equation problem. Recall that the definition of Velocity is "the number of times in a year that a dollar is spent." I buy something at the Dollar Store, they use that dollar to buy more products and pay employees, the suppliers and employees buy more supplies and other products, respectively, etc.**** So Brad DeLong ("I see no risks in attempting any of these three--and great risks in continuing to dither") agrees with Peter Berezin of Bank Credit Analyst (and me) that we don't want banks holding Excess Reserves as a matter of monetary policy at the zero bound. Fundamental principle of economics: you want to tax things you wish to discourage. You want to subsidize things you wish to encourage. As the Rabbi once said, "All else is commentary." So what did the Federal Reserve do in the face of a desperate attempt from the Fed to stimulate the Base Money Supply?

The Financial Services Regulatory Relief Act of 2006 originally authorized the Federal Reserve to begin paying interest on balances held by or on behalf of depository institutions beginning October 1, 2011. The recently enacted Emergency Economic Stabilization Act of 2008 accelerated the effective date to October 1, 2008.

Employing the accelerated authority, the Board has approved a rule to amend its Regulation D (Reserve Requirements of Depository Institutions) to direct the Federal Reserve Banks to pay interest on required reserve balances (that is, balances held to satisfy depository institutions’ reserve requirements) and on excess balances (balances held in excess of required reserve balances and clearing balances).

this lead to something that will surprise no economist of any caliber, let alone a Professor at Princeton:

By the time of the stimulus, roughly that amount had been taken out of circulation as the change in Excess Reserves. Even if every cent had been well-allocated, it was already out of circulation.

Ben Bernanke giveth, but Ben Bernanke taketh away even more, in spades.

What Monetary Stimulus?

*Again, I don’t encourage this action. But if you think I can’t create or find a suggestion for each of the Occupy locations, you haven’t read and seen enough Jacobean drama.

**Whether we replace my wife’s three-year old mobile with either a “free” Droid or a “free” iPhone 3GS probably doesn’t have a significant effect. Economists pretend that the “steak-chicken” model is similar.

***Short version: You think the tempest-in-a-teapot that is Solyndra is getting discussion? Try that times ten when three or four REITs and a few companies go under. (Amazingly, those who complain about the “low” return on Government securities also loudly complain when the Government invests in non-risk-free securities.)

****It is left as a side-note that increasing the Velocity of Money is yet another way to reduce tax rates, all else equal. It is also left as a side-note that people who talk about “double taxation” of (voluntarily disbursed) dividends are economic ignoramuses, and that there are many economists who talk in that manner in no way invalidates the first half of this sentence.

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PSA: Steve Keen at the Roosevelt in NYC tonight at 5:00/6:00

Talk is called “Neat, Plausible, and Wrong: the Deluded Discipline of Economics.”

I have to quibble with the “plausible” portion: there is no possible way to rationalize contemporary Microeconomics with any reasonable conceit that the Macroeconomics produced are “first-best” or anything similar.*

I doubt I’ll be there at 5:00, but certainly by 6:00. Hope to see some of you there.

Any questions for Professor Keen can be emailed to me or put in comments.

*This may be the root of my disagreement with Brad DeLong, who learned Macro and Micro when it was still possible—barely—to envision a GUT of Economics, even in a (weak form, as it were) Arrow-Debreu world. In the past thirty years, the strange delusion that Arrow-Debreu actually reflects the world has come to dominant Micro—with the rather predictable adverse consequence that Macro has to be more-than-the-sum-of-the-parts—i.e., include a positive social aspect—to be the best of all posible current worlds. But a positive social aspect is not part of the NeoKeynesian** cant, so you end up, effectively, declaring (for instance) that Gary Becker is wrong and discrimination is a beneficial business practice.

**As I have noted before, in economics the phrase “neo” is added to the front of a word if you are putting forth a belief set that is diametrically opposed to what came before: neoClassical and neoKeynesian are the most obvious examples of this.

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Who Cares About Nominal Rigidities?

Tyler Cowen doesn’t much.

I tend to agree with Cowen. Nominal rigidities were quite the thing just before I arrived, so I think they are over rated. However, there are two points one of which is totally twitty and the other of which is a dead horse still being beaten by Paul Krugman.

OK twitty: By definition for there to be unemployment there must be three agents, an employer, an employee and an unemployed person. The unemployed person must be eager to work as the employee does at the employee’s wage. The employer must consider the unemployed person qualified. This means that unemployment can certainly be eliminated if wages fall. At some point, either the employee decides to quit and just live off savings till social security kicks in or the unemployed person decides he or she doesn’t want the job. By definition, wage rigidity is needed to explain unemployment. This is true even if lower wages do not at all cause higher employment. If nothing else super low wages can convince people to leave the labor force eliminating unemployment that way. In this case wage flexibility doesn’t help the unemployed — it makes the alternative of working worse so they consider their horrible predicment the best they can hope for. I said it was twitty.

Second, things are unusual because we are in a liquidity trap. The reason nominal rigidities usually matter is that the real money supply could increase if the nominal money stock staid the same and wages and prices fell. From 1940 through 2008 this meant that wage and price flexibility should have prevented output from fallin. N ow, however, the money supply doesn’t matter since we are in a liquidity trap. In the IS-LM model (M/P) (money divided by the price level) appears. If P is free to adjust, then there can be no problem with insufficient aggregate demand. Therefore in all of the macro literature from 1940 through 2008, nominal rigidities were considered important. The idea here is wages go down so the firms cut prices (to maximize profits they would) so real balances (M/P) goes up so aggregate demand goes up so GDP goes up. There is no need for real wages to fall.

Right now this doesn’t matter as M/P doesn’t matter. But for decades and decades it mattered a lot, so nominal rigidities mattered. In practice, wages and prices are sticky so all reality based macroeconmists (“that’s not enough I need a majority” — Adlai Stevenson) agreed that nominal rigidities mattered. Now not so much. M/P doesn’t matter so P only matters because of debt deflation (lower P makes nominal mortgage debt an ever worse problem) so wage and price flexibility won’t save us so Keynesians don’t talk about it.

As always, don’t confuse “Keynesians” with Keynes. Keynes was not interested in nominal rigidities The General Theory through “The General Theory Restated” included nothing on nominal anything.

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No One Else Is Happy with BarryO and Some Random Notes

Economists for Obama suddenly showed up in my RSS reader again. It’s not a pretty sight:

I suppose I might change my mind, but after watching the President give in to the Boehner-McConnell blackmail axis, I don’t imagine I’ll be spending much of my time advocating his re-election. Assuming he’s the Democratic nominee, which I do, I’ll vote for Obama, because the alternative will still–somehow–be worse. But I really can’t see how, in good conscience, I could defend the economic policies of a guy who has signed on to fiscal contraction in the midst of a major downturn. And that’s leaving aside the President’s apparent lack of understanding of the importance of bargaining from strength. So much for all that poker expertise he’s supposed to have.

What a shame.

See also The Rude Pundit, who is gracious:

I got into this relationship without any illusions about who you were. I never listened when others told me that you were perfect. I never listened when some told me you weren’t worth my time. I got together with you because I believed in us. You and me. Somewhere along the way, you stopped caring. Somewhere along the line, you started believing in others more than you believed in me.

I loved you as a smart, principled man. I worked at this relationship. Even when we fought, I still sought out the good in you. Now, finally, after watching you have affair after affair, saying each time that it was just a one-time thing, I have to allow myself to feel bitter and angry and more than a little foolish. And I have to do that by myself.

I’m sure many of my friends will be upset. “What are you going to do now?” they’ll say. “You’re not going to date Mitt or Michele, are you?” What that implies is that I should settle, that I should compromise myself and my dreams just to keep us together. No one deserves that kind of power. And they never considered a third option between staying with you and being with someone else. They never considered that I could just be alone.

So this is a separation, and I’m sure you’ll be dating again quickly. But I need a break. I need to remember why I loved you. I need to miss you. I need to see if I miss you. Sure, sure, you’ll say, I’m being a drama queen, that nothing has changed, that I don’t live in the real world, that everything you’ve done has been for me, that I just don’t understand what it’s like to live with the pressure that you have. No, but I have to live with the results of what you do. And after you’re done, in 2013 or 2017, you’ll still be a rich moderate conservative and I’ll still be a middle-class liberal trying his best to clean up all the messes.

I’m gonna pack up my stuff and head out now. I wish you well, truly, for everyone’s sake. But I think if there’s anything you can take away from this, it’s simple:

It’s not me. It’s you.

When even Larry Summers gives up on you, it’s time to pack your bags. Which is undoubtedly what several of the more politically-aware appointees started doing around twenty-four hours ago, making getting anything done all the more improbable.

Three notes:

  1. It’s not a repeat of 1937. It’s closer to 1882. Economists who know their history, speak up.
  2. Quick compilation of expected drag from the “deficit agreement”:
    1. J.P. Morgan: “we continue to believe federal fiscal policy will subtract around 1.5%-points from GDP growth in 2012”
    2. Tim Duy’s “simple model”: “0.6 and 0.7 percent, respectively, for the final two quarters of [2011],” and getting worse in 2012.
    3. Macroadvisers (h/t Brad DeLong): “a modest 0.1 percentage point of GDP growth in FY 2012,” with the damage to be done by the Gang of 12 “No Revenooers” to cause death and destruction as Obama prepares to leave for Bachmann-Perry Overdrive (the MA graphic shows about 1/8th of 1%).
    4. Ryan Avent (on his Twitter feed yesterday): “Assuming no extension of the payroll tax cut or UI benefits, the US is looking at a 2% of GDP effective fiscal tightening over the next year.” (NOTE: Later details appear to be that this is basically 2.6% decline from tightening, 0.5% cyclical gain, netting to around 2%. Reference also made to JPMC survey above.)


    I can’t speak for anyone else, but I know which is the outlier in that set.

    And, finally:

  3. Dear Greg Mankiw (h/t Mark Thoma):

    If you claim the Federal Reserve Board is an independent entity, why do you argue that “a higher inflation target is a political nonstarter” (even while conceding that “economists have argued, with some logic, that the employment picture would be brighter if the Fed raised its target for inflation above 2 percent”)?

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Notes Toward Modeling a Risk-Free Rate with Default Possibilities

Brad DeLong asks why it hasn’t been done, if it hasn’t been done.  The biggest problem I can see is that you don’t know how insane the participants are—and that will have a major effect on how much damage is done when.

Don’t get me wrong; the damage is already being done; it has been since at least May, and if Barack H. Obama weren’t an idiot, he would have been mentioning that over the past two months.  Unfortunately, the sun is yellow on our world, and counterfactuals are masturbatory, not participatory, acts.

So let’s start with what we know:

i= r + πe

Nick Rowe apparently would have us believe his (completely understandable) claim that i would not be directly affected by a short-term default. This strikes me as absurd.
Even when the economy is working on all cylinders–where G contributes something around 10-15% of growth at most—reducing G to zero for a week is about 2% of 15% or 0.2%-0.3%—noticeable, but arguably rounding error against the difference between π and πe. So, if you assume a short-term issue, you get something like those legendary two weeks from 11-22 September 2001, when only the Saudi Royal Family was spending anything, writ somewhat smaller only because Gunderstates the effect on r.)

We can concede that inflation expectations themselves aren’t going to go up independently: any additional borrowing cost will be a drag on r, so it’s not unreasonable to assume that i will be fairly steady—again, working a very short-term issue.

But, as often happens, we leave out a variable in our assumptions, simply because we define i as the risk-free rate of return.  Let’s put it back in:

i= (r + πe)*(1+ Pd)

Where (1+Pd) is 100% plus the probability that there will not be a default. (Note that in a model environment, Pd=0, otherwise, we would not call it risk-free: actors have the power to make and manage budgets, including the power to tax to pay for services desired by their plutocrats constituents.)

Finance people will recognize this reduced form equation:.  (1+ Pd)= β, the risk of the stock or portfolio in excess of the risk of the market.  For convenience, let’s just call this version Ω. So,

i= (r + πe)*Ω

Next comes the hard part: term structure.  Or, as Robert said in a similar context, are you talking about the Federal Funds rate, or the rate on three-month Treasury Bills?

Well, that depends on how long we expect the issue to be an issue.  If Barack “I’m an idiot who stands for nothing and you’ll vote for me anyway because my opponent will be insane” Obama treated this “crisis” the way he treated the last (real) one, he would insist on getting a clean bill raising the debt ceiling passed through both Houses and on his desk for signing by the end of next week.  If he takes it as another chance to blow Cass Sunstein and the rest of his University of Chicago buddies, then it’s a complicated bill that will get a few Congressmen killed* and several others de-elected, and we might be talking weeks.

Right now, the markets are assuming the former.  Let’s be optimistic and assume they’re correct.

Four weeks ago, there was a Treasury Bill auction that produced a yield of  0.00%.  Extending that bill does no harm at all—not even to expected debt totals. (Investors mileage may vary, but they bought it with full knowledge of the timing.  And there were 10% again behind them bidding at the same rate.)

Some specific Notes and probably Bonds—it is August—will have coupon payments due on the 15th. But those are coupons, not principal repayment, so again we’re not talking much value of the Note or Bond itself, once you hit five years or so.

Bills will be a problem.  Short-term notes will be a problem.  Fed Funds is uncharted territory.  Tripartite Repo specifically, and Repo in general will be a major problem due to questions of collateral value.  And guess who uses those the most?  Hedge fundsThe people who have been financing John Boehner’s and Eric Cantor’s campaigns.

So the term structure looks like it would if you’re going into a recession: short-term rates rise significantly, while the longer term securities shift upward a bit. (Select Notes and Bonds with near-term coupons kink the curve, but there’s no certain arbitrage there, especially with transaction costs.  Cheapest-to-deliver calculation is also affected in the futures market. I could go on, but let’s just pretend—correctly—that these are minor issues.)

Because now our “baseline” rate is no longer risk-free—and we’re not certain what Pd is over time.  We know it will return to zero at some point, and we presume (at least at the beginning) that it will be soon. But we also know that there already are follow-on effects, and that they will only get worse. Even if we ignore the effect on G (and therefore i) of a short-term default, we lose our bearings for a while.

So the big question is collateral and spreads.  Been posting Treasuries to borrow against?  Yields up due to Pd > 0, so prices down, so less flow. And probably haircuts due to uncertainty of any return to “risk-free.” Posting Treasuries with a coupon due?  Haircut! Posting Treasuries with a near-term coupon?  Haircut! Posting Munis?  Think Michael Jordan (or Telly Savalas, if you’re Of a Certain Age).  So you can borrow less, and probably have to sell some of your assets.

Which ones?  If we’re lucky, it’s longer-term Treasuries, and some of the yield curve inversion mentioned earlier is reduced.  But the market is going to be less liquid than usual, so maybe some of those other bonds get sold—corporates, for instance.  The bid-offer on Munis is basically going to be zero-coupon bonds at a high discount. (Think fast about how many state and local municipal projects depend on some form of Federal funding.  Then realize that your estimate is probably low by an order of magnitude.)  Or corporations that are dependent on government funds (DoD providers, automobile fleets, interstate paving contractors, power supply and distribution companies, etc.)

In a ridiculously oversimplified model, the spreads simply expand by Ω, with a possible adjustment downward based on direct exposure to government financing. This, again, probably understates the effect.

So, in a closed economy, everyone gets to pretend things are close to the same—just more expensive, with a lot of damage to hedge funds and municipalities and borrowing costs and credit lines. So money supply drops significantly (multiplier effect reduction) even without Fed intervention.  You get an Economic Miracle: reduced supply and higher yields.

But we don’t live in a closed economy.  So there’s another factor.  And I’m running out of Greek letters, so let’s just use an abbreviation everyone knows:

i= (r + πe)*Ω*d(FXd)

where d(FXd) is the change in the FX rate due to the default adding uncertainty to cash flows.

That’s right: we get not one but two economic miracles:  (1) domestically, a reduced supply of risk-free securities produces higher yields and (2) internationally, higher yields lead to a depreciation of the domestic currency.

Anyone still wonder why no one wants to build the full model?

*No, I don’t want this to be the scenario.  But if you offered me the bet, I wouldn’t take the under at 0.99.

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A Tense Problem

Mark Thoma begins with a hilarious typo, but eventually gets to the Quote of the Decade (if not century) from Alan Blinder:

If we economists stubbornly insist on chanting ‘free trade is good for you’ to people who know that it is not, we will quickly become irrelevant to the public debate.

As Rusty can (and will, at length) tell you, the thing that is wrong with that sentence is the tense. We have had free trade agreements for decades, China has had MFN status since the 1990s, and permanently since 2000. The pieces of the former Soviet Union, including the current oligarchy that is called Russia, have had that status since 1992. NAFTA, including its abhorrent Chapter 11, has been in force since 1994.

There has been a generation that has lived under “free trade.” While an economist might successfully argue that the overall social benefit has been great—millions of Chinese parents become estranged from their children to make a better life, as it were—the retraining, redevelopment and all of the other assumptions economists make about ameliorating the transition to a new economy have been eschewed.

The example of Boeing (h/t Felix) bodes large: the valuable work was outsourced, the menial work was kept (or spun off into bankruptcy), and the new “higher-value” jobs and opportunities that were expected by idiots economists never materialized, replaced instead by growing income inequality and the retraining money lined the pockets of the CEOs who produced (to borrow a phrase used by the brilliant McGarrysGhost on Twitter) “failure masquerading as vision.”

And any microeconomist worth his paycheck can tell you that increasing inequality leads to suboptimal production.

Blinder is wrong in only one thing: the tense he uses indicates that the results are still, somehow, in doubt. The ability of Chinese peasants to eat a bit more is nice, but the externalities—poisoned toothpaste, dog food,* defective tires—make it rather impossible to claim that the “advantages of free trade” have trickled down in any way except as a ureotelic (mp3 link).**

The first thing we were told by our veterinarian about the new puppy is that we need to make certain that any food she eats was made in either Canada or the United States. Fortunately, pet food—unlike its human equivalent—is required to be labeled with origin information.

**You better believe I’m doing The Snoopy Dance on having discovered this site, which saves me from trying to find a way to transfer my old cassette to a usable format. But that’s fodder for Skippy, not here.

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Why the Economy Stubbornly Insists on Growing More Slowly When Taxes are Lower

by Mike Kimel

An Economic Theory That Uses Micro Forces to Explain Macro Outcomes: Why the Economy Stubbornly Insists on Growing More Slowly When Taxes are Lower

Cross-posted at the Presimetrics blog.

I’ve been writing for years about the fact that a basic piece of economic theory does not apply to real world US data: unless one engages in the sort of assumptions that can justify eating ceramic plates as a cure for leprosy, there is simply no evidence that lower taxes lead to the good stuff we’ve been led to believe over non-cherry picked data sets. Recent examples include this look at the effect top federal marginal rates on various measures of growth, this look at the effect of top federal marginal rates on tax revenues, a different look at federal marginal rates and growth, and this look using state tax levels. I’ve also shown that effective tax rates also have fail to cooperate with theory when looking over the length of presidential administrations – examples include myriad posts and Presimetrics, the book I wrote with Michael Kanell.

I think the reason a lot of people have trouble accepting this is that they see some sort of conflict between this macro fact and and what seems to be a self-evident micro truth – if tax rates get high enough, people will work less. Now, such micro-macro conflicts have existed in the past, and are certainly aren’t unique to economics. One obvious example we all live with is that to each of us, from where we’re standing, the Earth does a pretty good job of appearing to be flat, and yet we know that its actually round(ish). For most applications, from running a marathon to building a house to making toast, assuming that the earth is flat doesn’t hurt, and even simplifies matters. That is to say, for most applications facing critters roughly our physical size, a flat earth is a good model. On the other hand, we’d be much impoverished by sticking to that model at all times, as we’d lose out on satellites, our understanding of weather and geology, a great deal of transoceanic shipping, and Australia.

The same thing is true when it comes to the economy – failing to understand and account for the dichotomy between micro and macro truths is harmful. It has cost us, all 6.8 billion of us, economic growth and wealth, which is to say, it has cost us in quality and length of life. But nobody is trying to explain that dichotomy, in part because so few people see it. There is a profession that should be trying to explain this dichotomy, and that is the economic theorists. However, they seem to be pretending the data isn’t there, so waiting around them to explain it means more loss of quality and length of life. So let me take a crack at it.

In addition to explaining the real world reasonably well, a good theory, in my opinion, should not rely on crazy assumptions. After all, a theory that doesn’t make any sense simply isn’t going to get used even in the unlikely event that it works. So I came up with a theory that relies on only a few assumptions, all of which are sane and which hew pretty close to the real world. My assumptions are these:

1. Economic actors react to incentives more or less rationally. (Feel free to assume “rational expectations” if you have some attachment to the current state of affairs in macro, but it won’t change results much.)
1a. The probability that an economic agent will choose to do any work is inversely related the tax rate. At 100% tax on income, work drops, but not to zero – many of us do some charity work, after all, for which we aren’t compensated at all. On the other hand, not everyone is going to work even if tax rates drop to 0%.
2. Economic actors do not have perfect information about the economy, and are not homogeneous. They have different skillsets and different size, and that limits their opportunities at any given time. On the other hand, some economic actors are sufficiently similar to other economic actors that they could occupy similar economic niches, albeit they wouldn’t necessarily produce identical output.
3. Economic actors come in different sizes. Small players cannot compete with large players on economies of scale. (I get really irritated with the oft-repeated assumption that everyone is the same size, or that any unemployed person can walk into a bank and borrow $1.2 billion to build a chip fab.)
4. Economic actors are at least somewhat risk averse.
5. Many parts of the economy are characterized by economies of scale. At some point those economies of scale may reverse themselves, but economic actors rarely work at points where the diseconomies of scale have become strong.
6. Many parts of the economy are characterized by lumpiness. If an economic player is into hot dog stands, for instance, it can buy one hot dog stand, or two, or three, but it can’t buy 2.7183 hot dog stands.
7. Among the the pieces of the economy characterized by economies of scale and lumpiness are tax evasion/avoidance, which economic actors will engage in due to assumption number 1. That is to say, $1,000 spent on attorneys, accountants and economists in the course of a $100,000 project will gets you less tax evasion/avoidance than the same amount (or even a proportionately larger amount) spent in the course of a $100,000,0000 project.
8. There is a government that collects taxes. (Note – In a nod to the libertarian folks, we don’t even have to assume anything about what the government does with the taxes. Whether the government burns the money it collects in a bonfire, or uses it to fund road building and control epidemics more efficiently than the private sector can won’t change the basic conclusions of the model.)

I trust there aren’t any assumptions on this list that seem particularly heroic or which contradict the real world in any important way. Additionally, I don’t think there’s anything here that a conservative or libertarian would object to either. So I figure we’re good to go.

Let’s focus on one particular economic actor (or entity or firm or player), and let’s put some numbers down for simplicity of keeping track of going on. Say this one actor has $100 million (whether debt or equity is irrelevant to the model) which it can invest – and it can invest all, part, or none of that $100 million. To keep things really simple, say this actor must decide how to allocate its funds between a single $100 million investment and five $20 million investments, each of which has an expected return of X% a year before taxes.

Essentially, this player has four forces acting upon its decision making process.

1. Risk aversion. That makes the actor lean away from the one big project and toward some number of the smaller projects, both to avoid having all its eggs in one basket, and because by avoiding the one big project it doesn’t have to invest the full $100 million. Instead of investing in five small projects, for instance, it can invest in four at a cost of $80 million, and keep $20 million cash.
2. Economies of scale. That makes the actor lean toward the one big project over the five smaller projects.
3. The marginal tax rate. If its too high, that actor will simply sit on its hands. If not, it will invest some amount of its $100 million.
4. Economies of scale in tax avoidance/evasion. That tends to lead toward the one big project over the five smaller projects, since the net benefits of tax avoidance from one big project exceed the net benefits of tax avoidance from several small projects.

Now, forces 1 and 2 push in opposite directions. Force 3 is orthogonal to 1 and 2, and force 4 is parallel to force 2. All of which means it is easy for a player who chooses to invest rather than sit on his hands, and who otherwise is evenly balanced between one large and multiple small projects (or even tilting slightly toward multiple small projects) by forces 1 and 2 to be pushed toward the one big project by force 4. Let me restate – under some circumstances, marginal tax rates are low enough not to preclude investment altogether, but are high enough that due to scale economies, the gains of tax avoidance/evasion from large projects so exceed the gains to tax avoidance/evasion from small projects to make a single large project more desirable than a group of small projects, even though the latter would have been more desirable in the absence of taxes. Furthermore, there is some positive probability that shrinking marginal tax rates reduces force 4 enough to keep this story from being true.

This follows in a straightforward way from the assumptions, and looks a lot like real world situations. I assume its not objectionable even if you’re fortunate not to have ever worked for a Big 4 accounting firm. But, it has important implications. See, by taking the single big project rather than the multiple small projects, our player increases economic growth several ways. These include:

1. Because of project lumpiness, by going the big project route, it has to invest the full $100 million. Had it gone the small project route, there is a positive probability that risk aversion would have led it to invest $80 million (or $60 million) instead, meaning $20 million (or $40 million) would not have been put to work in the economy.
2. It spends less on tax avoidance/evasion services with the single large project than with multiple small projects. Since these services produce a private gain but don’t actually generate output, that reduces the drag on the economy.
3. As noted previously, small players are reluctant to take on big players – sure, it happens, but in general, small players prefer to go up against other small players than against big players. (Think Walmart and the centipede game.) But small players are priced out of the big projects. So if small players find bigger guys entering their potential space, they are more likely to sit on their hands (or focus on what amounts to the smaller, more wasteful projects among options available to them, potentially forcing out the even smaller guys, etc.).

But that is one single player. In a big enough economy, there can be many, many companies and/or individuals of many different sizes in just such a situation. With 310 million people and who knows how many companies in the economy, probabilities add up. (I note that the second benefit of biasing companies toward their largest available projects goes away when you consider the whole economy. After all, while company X saves on accountants/attorneys and economists by picking the larger projects, by leaving the smaller projects to smaller players, those players will be hiring accountants/attorneys and economists as well.)

Note that relaxing a few assumptions makes it even easier to understand why US macro data shows a positive correlation between marginal tax rates and real economic growth. For instance, it isn’t difficult to imagine that the government actually does something useful (i.e., growth generating) with the some of the tax money it collects. Additionally, smaller firms are often more innovative than larger firms, even within the same space (one has to compete somehow). Our little story is one where under many circumstances, smaller firms are more likely to enter the market when tax rates rise than when tax rates fall.

Thus, this little story, while requiring only a few realistic assumptions, does something that as far as I know is unique in the field of economics: it explains why US macro data shows a positive correlation between the top marginal tax rates and economic growth for all but the most cherry picked data sets, and it does it by sticking to micro foundations. I’m sure it could be improved, but but I think its a good start. Your thoughts?

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Everything Old is New Again, The "Value" of Active Investment Managers Edition

First, there was Fred Schwed’s Where are the Customer’s Yachts?, which is still the standard bearer for why Money Managers are overpaid.

Now (via the NYT) there is The Investment Answer (preface here [PDF]).

The Prologue opens more Matt Taibbi than Jason Zweig:

Wall Street brokers and active money managers use your relative lack of investment expertise to their benefit…not yours

Of course, they have a method That Will Work to solve this, which looks suspicuously like what those Active Money Managers say they do. And what you would think Economic Theory would tell you to do, which may be why they have the endorsement of Eugene (“the markets are too efficient”) Fama among many others.

Perhaps it’s time for economists to model why economic theory doesn’t work?

The last time people realized their money managers were taking them for a ride, the market basically sat still for a generation. Whether this dying text is a leading indicator is left as an exercise, though not an academic one.

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In Which I Worry about the swimming pools of Casey Mulligan and Greg Mankiw

Tim Duy takes a gracious lead pipe to silly analysis:

It really makes one understand why the public often dismisses academics as out of touch in their ivory towers. One has to imagine that neither Mulligan nor Mankiw ever held a real summer job. Nor, apparently, have they looked at any other nonseasonally adjusted data. Nor do they appear to have much understanding of the basic ebb and flow of US economic activity over the course of the year….

It seems to entirely escape them that aggregate demand has a very predictable season pattern – a seasonal pattern that exists in a recession or expansion.

These seasonal patterns in demand activity are not new. Indeed, I imagine that if the data existed, we would see the pattern has remained virtually unchanged since the dawn of human existence, as least in parts of the world where seasonal weather patterns govern economic life. Indeed, it is the reason we have an influx of teenage labor in the summer. It is a throwback to the days of America’s agricultural past, when the DEMAND for additional labor in the summer months necessitated closing schools for the summer.

As sure as the sun rises each day and winter turns to spring, sales spike at the end of the year as the holiday season approaches, collapse at the beginning of the year, rise in the summer, and then decline in the fall…

You can set your clock to this trend. Every retail analyst knows this trend. Every teenager who has ever held a summer job knows this trend. And a huge swath of data follows similar trends, albeit usually without the pronounced end of year impact. Building activity, waste disposal, tourism, you name it, it has a seasonal demand pattern. I only have to look out my ivory tower to see it – stuff grows faster in the summer, and the city hires crews of teenagers to cut it back. The pool down the road is open and staffed by teenage lifeguards only in the summer. Not because the lifeguards are available, but because there is no demand for an outdoor pool most of the year in Eugene.

Read the whole thing. Especially you, Tyler.

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