Relevant and even prescient commentary on news, politics and the economy.

Dropping $100 Bills on the Sidewalk, or Even More on Excess Reserves

The sarcasm of the title of my recent post notwithstanding, there are some things economists understand to be true that are. Among those:

  • People respond to incentives

As with the Supreme Court, economists extend this principle to organizations, on the (generally correct) idea that organizations are made up of people who act in their own best interest.  (It isn’t, pace the old joke, that they wouldn’t pick up a $100 bill lying on the sidewalk; it’s that they would never believe someone would drop one there in the first place.)  This is how you get to teach courses in “Organizational Behavior” and the like—it’s not the madness of crowds if they all act “rationally” on an individual basis. (More Skinner than Ballard, but I sidebar.)

In economic models, as I obliquely ,mentioned last post, there is no risk-free arbitrage: if there were, “the market” would eliminate it, because it would mean someone was dropping $100 bills on the sidewalk, and the “the market” would make certain that person (or organization) was bankrupted, or at least suffered enough of a loss to change its behavior.

If you need proof of that:


Note that there were a nominal amount of excess reserves being held by some institutions even before interest was paid. We can treat them basically as rounding errors and systemic inefficiencies; given the skewness of the risk-reward, it has always been safer to put an extra $20,000 or so “in reserve” for late transactions, counterparty failures to deliver, or just plain calculation errors. Think of it as the equivalent of taking $60 out of the ATM when you only expect to need $40; the ability to pay taxes you forgot to calculate, upgrade a shirt from poly to cotton, or buy a bottle of water “on impulse” is more valuable (utile) than the day’s interest on that $20 (currently, just over 1/100,000th of a cent from one of my TBTF financial institutions; half that from the other). And so it goes for reserves.

But in September of 2008, the Fed decides to pay interest on reserves—including Excess Reserves. The banks can now make 25 times what they pay in interest, risk-free, just by holding onto money.  The Fed is, essentially, leaving $100 bills on the sidewalk.

Hasty disclaimer: it’s doing so for all the right reasons: the banks need to rebuild strengthen their balance sheets, and nationalization is off the table.  Every little bit helps. Conceptually, economic theory indicates that one should pay “interest,” in some form, for the right to use another’s capital. (That this breaks down in the details is subject for a discussion over tonics.)

I’m using monthly, blended data—nothing so clear as the BarCap analyst examined in the last post—but it’s fairly easy to see what happens even on that trend. Excess Reserves in October are two orders of magnitude higher than they were a few months. They more than double for November, and then stay in a fairly narrow band until around the time the “recovery” began. From August of 2009 until the end of the year, they rise again, just missing the magic $1 Trillion mark in October, breaking it in November and not dropping below again.

It’s free money; why wouldn’t the people who run the banks take it?

And they do.  So the number of $100 bills being dropped on the sidewalk would be expected to decline—save that the Fed has no liquidity constraint, even if we’re ignoring a right of seignorage. And the participants come by each night, picking up more.

The externalities of such a situation are obvious.  The most direct solutions are two: either (1) stop dropping the bills or (2) show the banks that there are better investment opportunities on a risk-adjusted basis.

Joe Gagnon (h/t Brad DeLong) advocates the former.  It is unclear (to me) whether Gagnon is advocating the full cessation of paying 0.25% on reserves or just a temporary cessation until market rates rise, but in either case he recognizes the perils of risk-free arbitrage. (Bruce Bartlett is shriller—and possibly more extreme—than I am on the matter.)

The other option is rather more problematic, not so much because the pump hasn’t been primed as that the water used was rather dirty, with a significant underestimation of the amount of rust that needed to be addressed only compounding the issue.

The result is approximately what one might have reasonably predicted in the goods and non-financial services economy: the Federal G(f) barely compensated for the State –G(s), and only the multiplier effect of that spending actually happening “expanded” anything. (Or, more accurately, some businesses did not fail so rapidly and the cost of some services did not rise so quickly as they would have ex-“stimulus.”)  The good news is that there was a barrel of water between the diving board and the ground; the bad news is that the barrel wasn’t full, so the dives had to be better than excellent, with minor injury virtually a best-case scenario.

The non-financial private-sector, in short, has not been able to recover, while the financial sector—propped up by those $100 bills—shows evermore “strength” on the back of dicey assets being held by the Fed, higher fees and lower interest rates for their “customers,” and—of course, $2.5 Billion a year in from the taxpayer.

Sooner or later, we’ll be talking about real money. For now, though, we’re just talking about the real economy.  What we have here isn’t (quite) a dead shark—as I said earlier, the private sector has performed amazingly well in the face of opposition to it from the Fed and the banks—but it has a diving tank in its mouth and Tim Geithner et al. taking shots at it will a high-powered rifle. We can only hope that former NYC “financial cop” Geithner isn’t as good a shot as another former NYC cop transplanted to a land he doesn’t like or understand.

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When S != I

As Brad DeLong has noted, Tim Geithner believes it is time for “the economy has now recovered sufficiently for government to begin to make way for private business investment.”  In short, he expects “the private sector” to do the heavy lifting in these joyous times of economic recovery.

Cynics among us—why, yes, that might well include me—would note that the private sector has had to do much of the heavy lifting for the past several quarters, in the face of what is varyingly described as “a precipitous decline in Aggregate Demand” or “a rise in unemployment.” (You say overextended credit, I say bankrupt.)  And that its performance has been, not to put too fine a point on it, exemplary in the face of the constraints presented.

Yes, I’m praising the efforts of the private sector.  Not just because small businesses especially are trying to sustain current levels of production and services in the face of tightened credit and the aforementioned AD decline, but also because they, as LBJ once observed in another context, have been put into the position of trying to run a race when the shackles are just being removed from their ankles.

I blame the banks.

Now you know it’s me.  The problem is, the evidence is on my side.  Recall that the alleged reason we needed to “save” the banks is that they are Financial Intermediaries, taking a slice out of the matching between Investors (Savers, in most economics models) and Capitalists, who borrow to recombine Capital (K) and Labor (L) into a new product that presents a better return than the old one.

Call it “creative destruction.” Call it “capitalism.” Call it “economic growth.”

Let us ignore—though it Abides, like Earth or a steaming pile of elephant dung—that the “intermediaries” were making somewhere between 30 and 40% of the total profits in the U.S. for the past decade. We can (1) pretend that those were all payday lenders, (2) be a “first-best economist” and claim that is the way things should be, or (3) realize it’s a problem and leave addressing it for another time.*

But let us not ignore that capital supply is essential to growth possibilities. With labor abundantly available, the limitation on creating new product is essentially The Big K, and it’s “Main Street” proxy, money.

As noted above, in most models of economic growth, we treat Savings as being equal to Investment.  This makes sense: even when the Financial Intermediaries were making $3 or $4 of every $10, they were reinvesting in better systems, better technology, better analysis, and better methods.  Low Latency leads to High-Frequency Trading (HFT) which leads to…well, let’s be nice and just say “greater firm profits.”  Even if only 50% of those profits are being directly reinvested, they are being reinvested, while the rest produces at worst greater paper investments and at best a higher velocity of money and/or a multiplier (“trickle-down”) effect from increased spending.**

Put your money in a Mutual Fund, it’s Invested. Buy a stock, it’s invested.  Put it in a Demand Deposit Account (what used to be a “Savings” or “Checking” account), and it’s invested (“swept”) by the Financial Intermediary, who gives you a share of the profits in the form of interest.

Not to sound like a broken record, but Excess Reserves put a spanner in that last one.  Don’t believe me, ask economists Bruce Bartlett or Joe Gagnon.  Or just look at a graphic of M2 and what I’m calling “Intermediary Private Investment” (M2 minus the Excess Reserves maintained by Financial Intermediaries).



As Excess Reserves are not Seasonally Adjusted, I used the NSA version of M2.  As noted in my previous post, up until September of 2008,  the Fed did not pay interest on Excess Reserves (or Reserves, for that matter), so that excess reserves were essentially a rounding error—funds kept because of the asymmetric risk-reward of a miscalculation, or “precautionary savings.”  They tended to total about $1-2 Billion on average, rather minor in the context of $7-8 Trillion.***

But once you hit September of 2008, the growth in M2 is more than negated by the growth in Excess Reserves. Indeed, the horizontal line on the graphic above is the level of Intermediary Private Investment in August of 2008—nine months into the “Great Recession.”—isn’t exactly reaching for the skies.  But it’s also significantly higher than the current I, as opposed to S.

(Note that the NSA trend is also downward since the alleged beginning-of-recovery months of June-July, 2009. That the performance has been as good as it has been in such a context is amazing.)

When Savings=Investment, there is potential for growth. When savings go into mattresses—for good reason, especially in the pre-FDIC days—intermediaries cannot do their job so efficiently as the models presume.

What are we to call it when Intermediary Private Investment is significantly less than Savings—when not the people, but the intermediaries themselves, are stuffing money into their own, interest-bearing mattress?

I would suggest “bad economics,” but that term seems too applicable to more general conceits.

*I would rather lose what is left of my eyesight and hearing than take the second position; others, from Scott Sumner explicitly to Brad DeLong implicitly, have significantly variant mileages, which is why there’s a horserace for describing economic policies in the past decade or so. They are winning, while I received several decent paychecks over the time.

**It is left as an exercise whether the “trickle-down” effect is positive or significant.

***Another sign of improved technology is that the growth in reserves decelerates—funds are used more efficiently by the intermediaries—after ca. 1990/1991; the trend moves slightly upward in the Oughts, though that is both relatively minor and possibly due to complications related to the expansion of products offered.


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Crisis? What Crisis?

As I should have noted yesterday, and as Arnold Kling discusses today, sometimes the questions are as revealing as the responses. And sometimes, the answers are suspiciously inconsistent.

Below is the graphic from my question for the Q2 Kauffman Economic Outlook: A Quarterly Survey of Leading Economics Bloggers. Link to the survey press release here, graphic results for the questions from Bloggers here, and the general Kauffman Institute blog site, Growthology, here.

I’m failing miserably at developing a Macro model that supports the majority answer for all the questions.

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Macroeconomics: en route

The Institute for New Economic Thinking (INET) hosted its inaugural conference this weekend at King’s College Cambridge, an experiment of sorts. I had the pleasure of attending the conference, my first time to Cambridge. John Maynard Keynes wrote his *General Theory* at King’s College. And as if that wasn’t enough, I dined with blogging legends, Mark Thoma and Yves Smith! The photo was taken at the conference by another attendee, Pierpaolo Barbieri: “Lord Skideslky, easily Keynes’ finest biographer”.

The conference was a spectacular fireworks display of economic panels, featuring experts across a broad spectrum of applied macroeconomic theory and policy, including banking and development. (You can see the speaker list, presentations, and video here). Definitely read other conference pieces by Marshall Auerback, Mark Thoma, and Yves Smith.

Through INET, George Soros is funding a vision: that new and innovative macroeconomic theory prevent, rather than fuel, future “Superbubbles”. INET’s goal is the following:

“to create an environment nourished by open discourse and critical thinking where the next generation of scholars has the support to go beyond our prevailing economic paradigms and advance our understanding of the economic system as a tool to meet social objectives.”

That’s a tall order, and likely not the intended output from the inaugural conference. But what Rob Johnson, Executive Director of INET, probably did have in mind was something of a declaration of war against outdated, disproved, or even deleterious macroeconomic policy and research. And there, I believe that he succeeded.

There was no shortage of criticism at the INET conference.

  • Joseph Stiglitz reiterated the sharp divergence between representative agent models and reality.
  • James Galbraith went the even more aggressive route by suggesting that REH (rational expectations hypothesis), EMH (efficient markets hypothesis), RAM (representative agent models), and DSGE (dynamic stochastic general equilibrium models) be buried beneath a bed of garlic below Keynes’ quarters with guards standing atop the burial site. (This was not a direct quote but very close.)
  • Simon Johnson pressed the need for more action to relieve the systemic pressures coming from the still top-heavy US banking system.
  • Dominique Strauss-Kahn charged global policymakers of being complacent with monetary and fiscal policy over the last decade. They were lured in by ostensibly stable growth, when in fact the financial foundation was crumbling below (after, of course, he was disrupted by a globalization protest with the catch phrase “the IMF is the Problem not the solution”).

In my view, the fact that economists were in some sense accepting blame for policy ignorance is a step in the right direction. So what’s the next step? What will it take to move macroeconomic theory and policy in a truly innovative and novel direction? I don’t know; but I do see two issues that will likely drag the process.

Problem #1: the financial crisis has rendered much empirical and theoretical research obsolete; clearly, this is a solid chunk of what I refer to as the “aggregate Curriculum Vitae”. There’s a host of refereed and published literature with now documented spurious results, or entire literature reviews citing papers with theses that tread water at best.

It’s going to take time to break through the concrete wall of neo-classical macroeconomic denial (among other types of denials). This is the “old boys club”, where careers and prestige are on the line. It’s the true sense of economics as a falsifiable science: some disproved and obsolete macro theory remains ingrained in the profession as some academics, some policymakers, and some politicians cling to their reputations. This “enables” bad economic policy.

The good thing, though, is with funding and support from Institutes like INET, this enabling behavior cannot last forever. The aggregate may enable the profession now; but if the foundation starts to crack, i.e., the next wave of graduate students and new tenure track researchers break the mold, the profession will rebuild. I hope.

Problem #2. Talented researchers, early in their tenure careers or currently registered in Ph.D. programs, need incentives and professional support to publish alternative views in top journals. It’s so easy to be shunned from the academic community; just take on an unorthodox research agenda, and bang, you’re bright and shiny career may be over before you know it. So what’s the incentive to rock the boat before establishing tenure? If tenure, by definition, is conditional on top-journal peer-refereed publications?

The new thinking must come from within the Ph.D programs. Building a base of new and sometimes controversial macroeconomic research that is accepted within the top academic community requires funding, but more importantly, a shift in the construct of the labor force. Macro Ph.D. programs across the world need restructuring and innovative teaching that includes an even stronger collaboration between student and adviser than existed before.

They say that lightning never strikes twice. Let’s hope that the economics profession avoids the second strike…this time around.

Rebecca Wilder

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The Other Rule

Brad DeLong’s famous rule (Originally: “If you think Paul Krugman must be wrong, you severely overestimated Niall Ferguson“) needs a corollary.

If Olivier Blanchard says your macroeconomic policy doesn’t work, and that you should double your inflation target to make it reasonable, it’s worth trying:

The International Monetary Fund’s top economist, Olivier Blanchard, says central bankers should consider aiming for a higher inflation rate than they do currently to lessen the chances of repeating the recent severe recession.

…[T]he global economic downturn revealed flaws in macroeconomic policy, especially the reliance primarily on interest rates to manage economies. Although Japan had fallen into a decade-long funk despite low inflation and low interest rates, “most people convinced themselves that the Japanese didn’t know what they were doing,” Mr. Blanchard said in an interview.

In particular, [Mr. Blanchard’s new paper with two other IMF economists, Giovanni Dell’Ariccia and Paolo Mauro] suggests shooting for a higher-level inflation in “normal time in order to increase the room for monetary policy to react to such shocks.” Central banks may want to target 4% inflation, rather than the 2% target that most central banks now try to achieve, the IMF paper says.

At a 4% inflation rate, Mr. Blanchard says, short-term interest rates in placid economies likely would be around 6% to 7%, giving central bankers far more room to cut rates before they get near zero, after which it is nearly impossible to cut short-term rates further.

None of the major Macro work ever done, from Barro forward, has ever found damage to economic growth from 4% inflation.

The paper is available here (PDF).

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In Honor of the Super Bowl

Favorite papers from the 2008 AEA in New Orleans (all PDF, ungated):

Emily Haisley on lottery tickets and perception. I heard about this paper before reading it. Such a simple idea, such a direct experiment.

Michele Tertilt: Women’s Liberation: What’s in it for Men (with M. Doepke). The next step is to figure out why so many rulers started having a significant number of female children. But that’s for sociologists, whose work is harder than that of economists.

Dean Yang and Sharon Maccini: Under the Weather: Health, Schooling, and Socioeconomic Consequences of Early-Life Rainfall. The paper that convinced me that Economics really is a good field in which to work.

Marcellus Andrews, “Risk, Inequality, and the economics of disaster.” This was much better live, where he prefaced it by taking about coming the hotel as an insurance inspector and pointed to the “sh*t line.” After the presentation, people were coming out, talking about how if they had wanted a sermon, they would have gone to church. Only person I went out of my way to thank for his talk, interrupting him conversation with Jamie Galbraith in the process.

Acemoglu and Finkelstein, Input and Technology Choices in Regulated Industries: Evidence from the Health Care Sector. Two future Nobelists collaborate. What’s not to like?

Dani Rodrik, Second Best Institutions. The best of a set of presentations.

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Today in "Economists Are NOT Totally Clueless" (Part 3 of 4)

Pete Davis:

Treasury Secretary Hank Paulson initially sold Congress in the fall of 2008 on emergency intervention to purchase “toxic assets,” but quickly reversed course in favor of direct capital injections. Those favored financial institutions revived more quickly than most thought possible and most of those injections have already been paid back. However, most of the toxic assets remain on bank balance sheets, impeding new lending. [emphases mine]

At the end of the last post, I was ready to discuss “deadweight loss.” But a brief detour seems in order.

We used to talk a lot at this blog about DSGE models. Economists talk a lot about Equilibrium, even if they don’t fully understand it. At its core, saying “equilibrium” is saying “this is the best of all possible worlds.”  You can’t improve on equilibrium unless you choose a non-Pareto-optimal solution (i.e., a solution in which at least one person is affected negatively).

Equilibrium doesn’t mean you have achieved ideal social welfare. (Anyone who has looked at Game Theory for more than a minute can tell you that.)  But it does mean that things are “hitting on all cylinders.”  Or, more accurately, if the economy is not at equilibrium, the odds are better that people making choices will make mistakes.

Which is why I pointed to Brenda Rosser and especially this

“The way out of this thing is a shift in the way we treat the LDC debt,” Coldwell argued. “The banks would have to take a big hit on their balance sheets, but then it’s over. If you give them a definitive hit, then they could say it’s behind us. If you get down to a crisis stage, the banks would accept that. They would have no choice.” — William Greider. ‘The Secrets of the Temple – How the Federal Reserve Runs the Country’ Touchstone 1989. Page 549

If the banks take that hit, we’re back at equilibrium.  If they don’t, they continue to make suboptimal choices.  Which brings us back to the graphic.

There were several good suggestions for refinement in the comments, none of which can I do at the moment, since I’m working solely from FRED data. (General response: those acquisitions, especially WaMu, were made on terms that were agreeable to all acquiring parties. Which doesn’t mean those acquisitions may not be affecting the flow, but it’s likely more a question of acceleration than velocity, especially given the relative sizes of the institutions.)

But the FRED data is damning enough.  The risk management procedures at larger institutions were significantly worse than they were at smaller ones.  And the bigger they are, the worse they are becoming:

With several waves of doubt still to come, we are (choose one) (a) far from equilibrium or (b) still making suboptimal choices.

So let’s do a finger exercise.

Mortgages Outstanding approx. $11 trillion (Q4 2008)

Amount at risk (SWAG)25%

Expected Losses $2.75T

Fed Holdings (TARP, TALF, CPLF, etc.) approx. $2.2 T

Remaining Balance Sheet Exposuren approx. $550B

25% at risk seems about right.  Slightly over 10% of that $11T was Home Equity Loans, and the outstanding household debt at that time was about 123% of national income while equity was around 40%.

But note that this assumes that all of the special facilities remain in place. For instance, per Hamilton’s graphic, the Fed now owns about $1T worth of MBSes. CR notes that this program “is scheduled to be complete by the end of Q1.”

Of course, there are some cures that would be worse than the disease.  Via alea’s Twitter feed, I see that either the headline writer or the speaker made a slip yesterday:

“There ought to be government-backed ABS,” said Fed economist Wayne Passmore in a presentation to the American Economic Association.

Note that the quote is not (just) MBS but ABS—asset-backed securities, including credit-card receivables, car loans, basically any form of consumer (or other) debt that can be securitized.  The result of this would be that your tax dollars would pay a bank for your default on a credit card that charged you 30% interest, despite the risk-free rate being something near 0%—and almost always in the 5-8% range.

The reason we like equilibrium is that people who make mistakes do so because they are “being irrational.” When we’re not at equilibrium, we realize that they make irrational decisions all the time.  In what I hope will be the last of this series, we’ll look at irrational and rational decisions—and why irrationality may be the best survival strategy.

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Today in "Economists Are NOT Totally Clueless" (Part 3 of 3 or 4)

This is taking longer than it should. For now, here is a “teaser” graphic, which I suspect is worth much more than 1,000 words:

Meanwhile, other (mostly related) thing you may want to read:

  1. Brenda Rosser find that everything new is old again.
  2. Steve Randy Waldman tells the truth about banks, and Shames the Devil, not to mention Tim Geithner
  3. Menzie Chinn discusses types of unemployment, and, implicitly, suggests that those who are arguing that structural unemployment (and, therefore, NAIRU) has risen are incorrect.
  4. James Hamilton notes that TARP was not the only program of support for financial institutions, nor will it likely be the last.
  5. Linda Beale finds Amartya Sen discussing “Rational Choice.”
  6. Rick Bookstaber raises a point Brad DeLong made a while back: inflation can be a very good solution to a true macro disaster.
  7. Mark Thoma finds David Cay Johnston’s examination of marginal rate data and economic growth.

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In Good News, the Race to the Bottom Got Harder

Remember the argument that we shouldn’t tax people because they’ll just move elsewhere?

The British government appears not to believe it.

Will the Geithner/Summers axis continue lying that “we can’t do that”? Since it really is a Windfall Profit, taxing it seems a reasonable idea. And now we won’t even be able to pretend that workers will just “move to the U.K.”

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So Did Lucas Create HyperRational Expectations?


Lots of people appear to be forgetting this one or getting it wrong…the central model of The General Theory of Employment, Interest and Money is a rational expectations model.

The difference with the soi-disant “rational expectations” school is over the expectations-forming process with respect to the effect on price and output of monetary policy, not anything else. Hope that’s cleared up now. [emphasis, style change mine]

I think I see the problem now. Everyone obsesses over every aspect of fiscal and monetary policy. When do they work—and, more importantly, how do they develop skill sets and core competencies (“competitive advantages”)—in the Lucas model?

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