Archive for the Category Financial system


It made good sense for America to build lots of homes around 2002-06

Follow-up to previous post (read that first.)

When the tech bubble burst the Wicksellian equilibrium real rate fell to very low levels.  In that situation, the Fed must cut interest rates sharply to prevent a sharp fall in NGDP and a depression.  They did so.  Whether they then raised them fast enough in the middle of the decade is a harder issue, and there are good arguments on both sides.  But I’d like to focus on arguments for a housing boom in 2002.

In a classical world (on the PPF) less business investment should lead to more residential investment.  Some commenters object when I call housing construction “investment.”  Just like real men eat steak and not sushi, real investment is supposed to be factories and infrastructure, not houses.  They see houses as a sort of consumption.  America consumes too much, and houses are exhibit A.  I think this is totally wrong; there is almost no entity that is more “capital-like” than houses.

A can of beer is a capital good that depreciates rapidly as you drink it.  Hence we call it a “consumption good.”  The longer-lived an asset, the more capital-like it is.  In a recent comment section Mark Sadowski made this point:

Isn’t the real consumption of useful capital taking place right now? Menzie Chinn recently alluded to the fact that growth in potential RGDP has probably slowed in the face of a persistent and massive output gap. And I keep reading local news stories about well maintained manufacturing facilities that were highly profitable until just three years ago being torn down because no one expects sufficient demand to come back anytime soon.

This reminded me of just how short the useful life of many so-called “capital goods” really is.  Think computers.  Or factories.  Or even stadiums and basketball arenas.  They actually tear down perfectly good arenas that I recall being touted as new and modernistic in the 1970s.  (Meanwhile the Roman Coliseum is still standing.)  In contrast, my house is 90 years old and perfectly fine.  Around me are many houses 100, 150 even 250 years old.  All still in good shape.  All still producing housing service “output.”

Suppose you were a central planner, deciding what America should do in 2002 to keep people busy (idle hands are the devil’s workshop.)  Business investment is out because of the tech crash.  Two percent of Americans can feed us all.  It used to take 30 percent to make manufactured goods, but even without imports we’d need a far lower number today due to technology.  Soon only about 5% of Americans will be able to produce all the manufactured stuff we need.  Most Americans already have the refrigerators and washers and cars they want.  If I were a central planner, I suggest two uses of labor; more houses and more fun.  People love nice houses with granite countertops (when I remodeled in 1997 I put in formica, and I bitterly regret it every day of my life.)  We all see pictures of dream houses we’d love.  And if we have the things we need, then more services.  Restaurants, hotels and hospitality.  Service jobs.  More houses and more services would seem to have been the best way to keep people busy and boost living standards after business investment crashed in 2002.

It boggles my mind that so many people wring their hands that we might have built a couple of million too many houses over a few years, in a country with 120 million units.  In the grand scheme of this does it really matter all that much if a house built in Phoenix is only occupied for 145 years of its 150 year life, instead of 150 years of its 150 year life?

Some would say “what about the banking crisis, the recession?”  What about them?  Yes, those are the big problems we should worry about.  But they have little to do with building a few too many houses.  Those failed mortgages were mostly re-fis, as people used their houses as ATMs.  Or mortgages on the purchase of existing homes.  The losses to the financial system from people not paying back their mortgage on a newly-built house are way too small to explain the great financial crisis of 2008.  And I already showed the housing slump doesn’t explain the recession, as it occurred way too soon.

It seems like the misallocation of capital into housing construction was a disaster.  Actually it was a minor problem that was correlated with two major disasters, horrible mis-regulation of our financial system that allowed risky loans with tax-insured dollars, and really bad monetary policy that allowed NGDP expectations to fall sharply in 2008.

Those are some really nice new houses out there.  Now let’s print some money so that people can enjoy them.  (But only enough money to get proper NGDP growth, not enough to bail out all the bad investments.)

Cameron on monetary policy in late 2008

A few weeks back I linked to a Louis Woodhill article that showed stocks fell very sharply after the Fed announced interest on reserves, and also fell very sharply the two times the Fed raised the IOR in late October and early November.  Given the unusual size of the stock market declines, it is extremely unlikely these changes could all have been due to chance.  Now Cameron Blank has graciously allowed me to reprint an entire blog post where he fully documents just how powerfully monetary policy news seemed to impact US stock prices during late 2008.

Many of my critics, even some sympathetic to my overall argument, have found it hard to believe that monetary policy was the problem in late 2008.  It seems (so they argue) that the financial crisis was the focus of everyone’s attention.  I agree that economists were not paying attention to monetary policy, but there’s no doubt in my mind that markets were.

BTW, the TIPS spreads for December 1st that he reports are distorted by a change in the type of TIPS being used, so he is right to be skeptical of that observation.

Everything that follows this sentence is from Cameron’s blog; for ease of presentation I do not indent as is usually done with quotations:

More Evidence that Monetary Policy was Important in late 2008.

(A more concise version of this post with fewer examples is available here)

Here I present evidence that markets responded sharply to monetary policy during the late 2008 financial crisis.

Perhaps most notably, I find that markets tended to cheer traditional monetary policy (policy aimed at increasing aggregate demand) and snub fed policies aimed at fixing credit markets. This certainly flies in the face of the mainstream explanation for the recession.

The Data

As a general rule, during late 2008, increases in stock prices were correlated with increases in nominal yields, inflation expectations, and expected future Fed funds rates. This isn’t surprising. If the correlation  between expected future fed funds rates and other asset prices breaks down however, it should give some kind of an idea of impact of monetary policy.

Note: This means that it is possible that monetary policy was still the cause of certain declines in equity prices and that although fed funds futures fell they didn’t fall enough. The data I use only makes use of days in which the markets moved in “opposite” directions and so my case may actually be stronger than it looks.
October 6, 2008
The S&P, nominal rates, and inflation expectations all tumbled while the dollar rose 1%.  Basically all of the 4% decline for the day took place immediately after the market opened. The likely cause?
Scott Sumner has long argued this policy greatly sharply tightened monetary policy during late 2008. So even though the expected FF rate fell (although note that 3 month treasury yields rose slightly), perceived policy was much tighter and markets responded.
(See October 7 for data)
October 7, 2008
A day later on October 7, Bernanke announced a plan to loosen credit markets. Stocks initally rose slightly, but went south during the Bernanke speech, and further declined when a hawkish Fed Minutes report (“The minutes showed the bankers were equally worried about growth and inflation at the Sept. 16 meeting”) was released.
It seems likely these events were what they were responding to. Stocks fell dramatically, nominal rates actually rose (but especially at the short end of the curve) along with expected fed funds rates, while inflation expectations plummeted.
October 13, 2008
October 15th, 2008 
And the biggest losing day of the period? Two days later on October 15th. Guess what sent the market tumbling.

The selloff seems like exactly the type of reaction one might expect if markets thought the Fed would do what was necessary to prevent NGDP from falling the 13th, only to realize it was hopelessly focused on the financial crisis (and not aggregate demand) two days later. And why would a Fed Chairman ever say continued weakness was certain? If that was the case shouldn’t they ease policy?

October 20, 2008

The 4.7% rise in the S&P during October 20 serves as more proof that the U.S. faced an aggregate demand problem more than a financial one. Stocks rallied as Bernanke endorsed a second fiscal stimulus plan. Now admittedly, markets may have been reacting simply to a bigger fiscal stimulus with a better chance of passing, but it could also be argued that Bernanke’s support reassured markets the Fed wouldn’t offset the fiscal stimulus.
My guess is it was a mix of both, but still the rally that day certainly serves as more evidence that the primary issue in late 2008 was low AD.
October 22, 2008.
Again, even though 3 month treasuries and fed fund futures signaled slightly lower future fed funds rates, overall policy was likely seen as tighter. Even though this policy helped the Fed increase its balance sheet they were essentially trading AD enhancing policies for ones which helped financial markets. Equities, nominal rates and inflation expectations all fell sharply while the dollar rose sharply.
October 28, 2008
One of the strongest pieces of evidence that monetary policy mattered a great deal during late 2008.
Equities, nominal yields and inflation expectations all rallied sharply while 3 month treasury yields and FF futures fell. Had this been some non-monetary shock, FF futures and 3 month treasury yields should have risen.
I expected that there may have been some bailout or financial news that pushed up markets, but when I looked there was nothing of the sort. News that day noted that…“Stock analysts struggled to make sense of the gains”  but also acknowledged that the Fed may be partly behind the rally.

October 30, 2008
A smaller, but similar market reaction as October 28th.

This article noted expectations had increased for the Bank of Japan, the ECB and the Bank of England to ease policy as well.

November 4, 2008
Again all the signs of easier expected monetary policy boosting AD expectations show up once again. Equities, oil and inflation expectations rose while fed fund futures, 3 month treasury yields and the dollar fell. CNN attributed the rally to the election, but this was the day of the election not the day after (no results were in yet) so that explanation makes no sense to me.

November 5, 2008
Again a day when the Fed raised the interest paid on reserves. A bad ISM services report also came out that day, but markets didn’t seem to clearly be reacting to that. Note also that fed funds futures actually increased slightly despite a sharp fall in stocks, nominal yields and oil prices (down 8% according to the NYT article).

November 7, 2008
Another rally with seemingly no explanation, except for easier money.

A trader remarked “The lesson people have to learn is they can no longer look for rational reasons for why short-term moves are happening,”

Hmm. Maybe, but I like my explanation better.

December 1, 2008
Another really notable day when stocks, nominal yields and oil fell dramatically while 3 month treasury yields, fed fund futures and the dollar rose.

(Something bizarre seems to have been going on with TIPS yields data that day but 5 year inflation swaps show a more plausible decline in 5 year inflation expectations)

December 16, 2008
The day of the all important Fed announcement. although it wasn’t seen as all important (by the media at least) at the time.
The Fed surprised markets by cutting more than expected (to 0-0.25%), downplaying inflation risks, and hinting at possible quantitative easing. Stocks and inflation expectations rose significantly and the dollar fell. Nominal rates fell as well (probably in response to potential QE purchases) but overall the response was obviously very positive.
Conclusion : 
Obviously if you are only looking at days in which monetary policy and markets moved it opposite directions it will, by definition, look like monetary policy matters a lot… but the magnitudes are what are impressive. The two biggest increases, as well as the two biggest declines in equity prices during the period seem to be strongly correlated with changes in expected monetary policy.
I think this data strongly supports the belief that monetary policy mattered a great deal in late 2008. It also supports the idea that insufficient AD was a bigger problem than the financial crisis (which were indeed being fed by AD problems). Markets could of course always be wrong, but from today’s standpoint (deflation and high unemployment in despite a relatively normal financial sector) they seem to have been quite correct.
(Data for the S&P was acquired form Google Finance, Fed Fund Futures data was acquired from the Cleveland Fed, Oil data was recovered from daily CNN Market report articles, and all other data was downloaded from FRED)”

Nonsense on stilts

It turns out that my recent post on finance did not satiate my urge to make counter-intuitive arguments.  So today I’d like to argue that happiness is unrelated to utility, that you should try to purchase a house next door to a child molester, and that the US government first impoverished our banking system, and then took advantage of its weakened state with predatory lending.  (After all, if Michael Pettis can sell out his blog readers for a cushy job in banking, why can’t I?)

Part 1.  What if utility and happiness are unrelated?

Imagine a country called “Lanmindia,” where much of the population has seen its legs blown off in horrible accidents.  Does that sound like a pretty miserable place?  Happiness research suggests not.  The claim is that there is a sort of natural “set-point” for happiness, and that after winning a lottery one is happy for a short time, and then you revert right back to your natural happiness level.  I find that plausible.  They also claim that if someone loses a limb, then they are unhappy for a short period and then revert back to normal.  I find that implausible, but if the evidence says it is the case then I guess I need to accept that.

My claim is that although Lanmindia is just as happy as America, it has much lower utility.  Let’s define ‘utility’ as “that which people maximize.”  People very much don’t want to have their legs blown off, and hence emigrate from Lanmindia in droves.  People behave as if they care about utility, not happiness.

Do I have any proof?  No, but I’ll provide two pieces of evidence, one macro and one micro.  The Economist recently did an absolutely heartrending story about the plight of undocumented farm-workers in California.  I wish I could quote the entire piece, as the cumulative effect is very powerful, but space constraints limit me to a shorter passage:

Farm work has, for most crops, become no easier since Steinbeck’s day. Strawberries, the crop the Vegas started out with, are nicknamed la fruta del diablo (the devil’s fruit) because pickers have to bend over all day. “Hot weather is bad,” says Felix Vega, but “cold is worse” because it makes the back pain unbearable. Even worse is sleet or rain, which turns the field into a lake of mud. The worst is picking while having the flu.

Every crop exacts its own particular discomfort, as this correspondent discovered on an August day picking grapes in the very part of the San Joaquin Valley where Steinbeck’s Joad family looked for work. Working with two Mexican brothers and a young Mexican couple, he cut the grapes, collected them in tubs and periodically dumped them into a wagon pulled by a tractor.

The lanes between vines are exactly as wide as the tractor, so the little group had to duck into and underneath the vines all day long. They crawled alongside the tractor, trying to avoid having their feet run over. Within hours this correspondent’s shins were bleeding as the wagon’s metal protrusions slammed into them, which seemed unavoidable. With an encouraging smile, a co-worker pulled up a trouser leg to reveal his own scarred shin.

Because the pickers were squatting or kneeling under the vines and twisting to reach up for the grapes (the low-hanging fruit proving the trickiest), their necks and shoulders were soon in agony. Standing up to relieve their backs thrust their heads into the vines, which are covered in pesticides. There are many cases of birth defects and cancer in the families of farmworkers. But as the heat climbed above 100°F (about 40°C), the vines, soaked in toxins or not, became allies. The air underneath them is stagnant, as in a sauna, but their foliage is the only available shade.

Just as the heat threatened to overwhelm this correspondent, the woman in the group broke into a slow Mexican song, which somehow helped. But heatstroke is common in the fields. In 2008 Maria Isavel Vasquez Jiminez, a 17-year-old Mexican girl who was pregnant, collapsed while picking grapes and died two days later.

Hungry amid food

As Tom Joad in Steinbeck’s novel discovered, many farmworkers, even as they spend their waking hours picking food for others, can barely afford to eat. Between harvests they have no work. When they do work, their wages are meagre. The workers picking grapes with this correspondent got $8 an hour. That is vastly superior to the $9 a day””not hour””which the tractor driver says he used to get at home in Mexico. But costs in the United States are higher too.

You should read the entire piece, as there is 5 times more of this woe.  At the end, the reporter asks the following question:

Teresa, Felix and Gonzalo Vega only nod sadly when asked about the rancour, the Arizona law, the politics. They feel they had no choice in coming illegally. Would they do it again? “No, not if I had known what lay ahead,” says Felix. But after a silence, he corrects himself. Yes, he would, because even though he doesn’t think he’ll ever get papers, he has two sons who are American and could be lawyers or writers one day, living openly.

Teresa Vega is the most reticent. She admits that her “plan didn’t work”. She hears that Erminio, at home in Oaxaca, is not doing well. He is often ill. “He needs love” and doesn’t get enough, she says. But then she, too, reverses herself. She always thinks of her first son, the one who died because she had no money to save him. Yes, she would come again.

If the life described in this piece is accurate, then life in Mexico must be an absolute living hell.  Why else would millions of desperate Mexicans endure the following to try to reach those California fields?

Once they walked all night through the desert of Arizona, slashing themselves on fences of barbed wire and running out of water, before border-patrol agents ambushed them. The agents tied them up, shouted at them, threw them into a van and then into a freezing jail, where they slept on a bare floor for several nights until enough migrants had been rounded up to fill a bus that took them back to the Mexican side.

On another crossing Mexican bandits waylaid them. They pointed guns, stole their food and stripped them naked. Because the Vegas speak an indigenous language called Mixtec and understand little Spanish (and no English), Mr Vega’s wife and the other women did not understand the bandits and feared they would be raped. They were not, but then had to cross the frigid night desert without clothes, food or water, until la migra caught them again.

Gonzalo Vega, yet another cousin, made the trip with his wife, five months pregnant, and his two younger brothers, who were seven and ten at the time. He carried all their water and food, but the children struggled. After a day and two nights of walking they were desperate for sleep, but Gonzalo didn’t let them rest in the freezing cold lest they not wake up again. He could not light a fire, because la migra would have seen it.

They threw themselves into ditches whenever the border patrol’s SUVs approached. Once Mr Vega’s wife fell hard onto her bulging belly. The worst moment came when la migra caught them again, beat Gonzalo and threatened to take his brothers away from him. When the family was allowed to remain together, even the cold jail floor felt good, he recalls. Gonzalo’s group succeeded on the fifth try.

So just imagine how bad Mexico must be.  Even worse, income in Mexico is highly unequal, with a tiny elite of wealthy and many poor people.  Yet it turns out that if Mexico is a living hell, it is an extremely happy living hell.  Robin Hanson recently cited research that shows Mexico is the second happiest country on Earth.  I claim that Mexico is a country with very low utility, full of very happy people.  Think of ‘happiness’ as “personality,” and think of ‘utility’ as “living conditions.”

Many bloggers have been commenting on a NYT piece where a Chinese mom explains the rigorous upbringing she imposed on her children.  Bloggers as diverse as Matt Yglesias and Bryan Caplan suggested that this type of mother was quite cruel.  Define ‘cruelty.’  My hunch is that these mothers lower their children’s utility, but don’t make them unhappy.  My evidence?  My daughter has a Chinese mom who makes her take all sorts of lessons, and she seems 10 times happier than I was as a kid with enormous freedom.  How’s that for a scientific study?

So what are the policy implications, should government officials try to maximize happiness or utility?  I’m a utilitarian, so naturally I favor utility.  Do you really want to defend a policy goal that implies there’s little point in clearing land mines from Cambodia, Afghanistan, and Iraq, because happiness always reverts to a set-point?  I dare you to see the movie Turtles Can Fly, and then insist happiness matters more than utility.  (Note that this view doesn’t really conflict with Caplan and Yglesias, although I probably left that impression above.)

One last point.  It is true that richer countries tend to be happier.  Does that disprove my set-point theory?  No; countries full of happy people tend to be more civic-minded, as depressed people are resentful of others.  Civic-minded cultures tend to produce governance that is relatively free market and non-corrupt.  Denmark is the happiest of all developed countries, the most civic-minded of all developed countries, the least corrupt of all developed countries, and the most free market of all developed countries.  Coincidence?  I don’t think so.  And yet my theory doesn’t work for developing countries, and I have no idea why.

Part 2.  Why you should move next door to a child molester.

Economists have known for years that deaf people should move right next door to an airport.  The noise won’t bother them, and the house will be much cheaper.  Recent research by Scott Wentland, Raymond Brastow, and Bernie D. Waller Jr. suggests that families without children should move next door to child molesters.  Why?  Because houses are much cheaper, indeed $14,340 cheaper if within 0.1 miles of a child molester in rural Virginia.  I met Scott at the recent AEA meetings, and he talked me into attending his presentation.  I’m glad I did, as I had no idea such bargains were available.  Afterwards Scott told me that he had also been surprised by the large effect, but when he started talking to other people he found that women were especially likely to check the registry of sexual offenders before buying a house in a given neighborhood.

Of course if you actually have young children you might want to live somewhere else.  And even if you don’t, you might want to move two or three houses away from the molester–at least if it gives you a creepy feeling to look out the window and see him (it’s usually a man) barbecuing in the back yard.

Part 3:  Poor, poor, pitiful banks.

Consider the following.  The Fed spots a weakened banking system in mid-2008, and then pounces in for the kill.  They engineer the biggest drop in NGDP since 1938.  More importantly, they drastically reduce NGDP expectations for the out years.   This sharply reduces asset prices and causes a severe banking crisis.  Then in late 2008 and early 2009 they snap up all sorts of financial assets from the weakened banking system at rock bottom prices.  Between early 2008 and early 2009 IMF estimates of banking losses nearly triple, as NGDP growth expectations plummet.  But the worst doesn’t happen and we don’t have another depression.  Instead the Fed begins QE in March 2009, and NGDP expectations start rising.  As they do so the estimated losses to the banking system fall back to more modest levels (again using IMF data.)

Then reports start coming in that the Treasury may actually make a profit from the TARP program, as they forced banks to pay interest on the loans received from the government.  Those banks that did not want to participate were given an “offer they could not refuse.”  At first is seems impossible that the government could profit from these “bailouts,” and people looked for other possible losses outside of TARP, such as the Fed’s purchases of toxic assets.  But then it’s is reported that the Fed made record profits of $47.4 billion in 2009.  It looks like the Fed made some great deals.  Then the doubters claimed that the Fed’s losses would show up once the economy started to recover.  But just yesterday the following obscene profits were reported by the Fed:

WASHINGTON (AP) — The Federal Reserve is paying a record $78.4 billion in earnings to the U.S. government, reflecting gains from the central bank’s unconventional efforts to lift the economy.

The payment to the Treasury Department for 2010 is the largest since the Fed began operating in 1914. It surpasses the previous record $47.4 billion paid in 2009, the Fed said Monday.

The bigger payment mostly came from more income generated by the Fed’s massive portfolio of securities, which includes Treasury debt and mortgage securities.

My more progressive readers will notice that the US government committed almost every imaginable financial sin:

1.  Insider trading.  The Fed waited until things looked very bad, and asset prices were at rock bottom before pouncing.  They knew that they were not going to allow a depression, and then engineered a recovery right after the purchases, through a policy of QE.

2.  They charged usurious interest rates in the bailout, taking advantage of the weakened position of impoverished and desperate banks, just like payday lenders.

Here’s my question:  What should we taxpayers do with this huge windfall received from the banking industry?  Should the Fed profits of nearly $80 billion be used to pay off the national debt, or fund new entitlement programs?  And is it fair to extract so much wealth from the banking industry at a time when they were already seeing a sharp increase in loan defaults?  The Finreg bill has a consumer protection agency, how about a banker protection agency to protect banks from predatory lending by the government?  And is there a moral hazard problem here, with the government not vigilant enough in preventing financial crises, knowing it can profit handsomely during a crisis by taking advantage of weakened banks.

PS.  I was just kidding about Michael Pettis, he is doing great work nurturing alternative rock bands in Beijing, such as The Carsick Cars.  I’m glad he found extra funding.

PPS.  I am actually serious about two of these three posts, can you guess which ones?  (The other is just to annoy people.)

PPPS.  I’ll do another post soon describing my panel (with DeLong) at the recent AEA convention.

PPPPS.   Traumatic events make people say and do some really foolish things.  (I know; I’ve been there myself.)  Exhibit A is the attempt by some progressive bloggers to blame loudmouth Republicans for the recent tragedy in Tucson.  They did the same in 1963, until it was discovered that the killer of JFK was a leftist, not a conservative.  It would not surprise me if we eventually find out that the nut in Tucson was not a loyal fan of Rush Limbaugh.  The populist right should be held accountable for bad policy, not political violence.

Invisible Martians and Occam’s Razor

Say I’ve got a crazy uncle.  He tells me that there are Martians in his closet.  When I go to look I don’t see any.  “There invisible,” he replies.  I suppose that’s possible.  Or the closet might be empty.  Which alternative seems more plausible?  Occam’s Razor says you should go for the simplest explanation.

My recent post on finance produced some strong reactions.  Many were very good; indeed the comments by Ashwin were extremely good—better than my post.  But I still think Occam’s Razor’s on my side, and I’d like to explain why.  Having said that, I don’t mean to suggest my opponents are seeing invisible Martians.  Ashwin might well be correct.  I’ll let you decide.

The basic idea was that the structure of the economy had changed in such a way as to make financial skills far more valuable than in the 1960s.  I define “finance” as the business of allocating capital, which is a bit different from how it shows up in the national accounts.  For instance, I believe the CEOs of major non-financial companies are being paid (in part) for the decisions they make in allocating capital.  I argued that two changes in the economy had made skill at allocating capital much more important; high tech, and globalization.  But the way, I think these are also the two forces that did in communism.  Remember that the 1960s were the golden age of the Soviet economy.  If all you have to do is churn out iron and steel and washing machines and apartment buildings, it can be done passably well with central planning.  Of course even then the American economy was superior to the Soviet economy, but less superior than later on, when the decisions were about whether to allocate capital to Google or Genzyme, or whether to build that auto parts plant in Detroit or Mexico or China.  It’s no longer about simply mobilizing capital to mass produce clearly defined output of stuff we all know consumers will want.

I argued that those with great skill in spotting good investments would be expected to earn much higher incomes in the modern economy than in the economy of the 1960s.  And that you’d expect income to become more unequal, with some particularly big incomes going to the top.  The strongest arguments against me (and you should look at the comment section, because I won’t be able to do them justice) revolved around the fact that finance is distorted by all sorts of government intervention, which allow the big investment banks to earn enormous profits.  I’ll call this the subsidy argument; although later I’ll address more sophisticated versions that involve market power.

As an analogy, it would be like me claiming that the fast rising salaries of athletes (since the 60s) is due to growing TV money, and my opponents claiming that it’s due to public funding of stadiums.  I used the analogy of farming, which receives lots of government subsidies, but still sees rather modest average incomes, due to competition.  My opponents accepted the fact that this analogy applied to the smaller banks, but not to the big banks, hedge funds, and billionaire investors.  They argue that there are barriers to entry; that certain types of trading are effectively controlled by oligopolies, and that insiders have other related advantages.  I don’t completely dismiss their arguments, but for the following reasons I’m not convinced either:

1.  I’ve always believed that oligopolies are more competitive than they look.  It’s still a dog eat dog world out there, a real struggle to survive.  Lehman and Bear Stearns recently went bankrupt (or almost bankrupt, in the case of Bear Stearns.)  Yes the creditors of BS were bailed out, but the shareholders lost a lot of money.  The most oligopolistic industry in the world might be big jets, where two firms split the market.  And yet Airbus and Boeing seem to compete fiercely for sales.  In contrast, there are dozens of big banks competing in a globalized market.  I must defer to my opponents on the specifics of big banking, as I am not an expert, but are the areas where only a few banks dominate, such as trading certain types of securities, really enough to explain the extraordinary fortunes being earned by the wealthiest financiers?  I’d like to see some data on earnings from market making as a share of GDP.

2.  Hedge funds are much less regulated than big banks, and yet some of the most spectacular earnings go to the managers of top hedge funds.  So that would seem to undercut their argument that it’s all about barriers to competition.  It’s been argued that some of the profits that hedge funds earned came from activities involving the big banks, which are effectively subsidized by the Treasury (as Too Big to Fail means they can borrow at very low rates.)  Here’s Ashwin:

Let me try a simpler explanation – big banks are implicitly protected in scenarios of significant systemic risk. This incentivises them to seek out bets which explode in such scenarios but provide them with small premiums in more normal times (negatively skewed tail bets). Hedge funds such as Paulson, Magnetar etc take the other side of this bet which is a positive NPV trade. Again, at least in the cases of UBS and Magnetar this is not conjecture but based on publicly available information.

Yes, but that doesn’t really undercut my competition argument.  Why don’t others try to get those investments in subsidized markets?  Competition should still drive down the rates of return earned by hedge funds.  The only counterargument I can see here is that only a few hedge fund managers know how to find these easy pickings created by government subsidies.

But now we are veering dangerously close to the world of invisible Martians.  I claimed that the big earnings of rich financiers reflect their skill at allocating capital.  Others say they are benefiting from government favoritism.  I point out that competition should eliminate those gains in industries like hedge funds.  They say the hedge funds are dabbling in subsidized areas.  I ask why others don’t get rich doing this.  Perhaps only a select few have the skill to do these types of investments.  But for me to be wrong it also has to be true that those managers mostly lack the skill to spot socially beneficial investments, they concentrate on socially harmful ones.  Isn’t that one assumption too many?  To be clear, I never said that financiers never benefit from government subsidies, indeed my whole post had a completely different focus.  I argued that one would expect the recent structural changes in the economy to greatly enrich finance.  Either the gains to hedge fund managers come from talent, or they don’t.  And if the returns come from investment talent, then why wouldn’t one expect them to be able to make large amounts of money allocating capital in our dynamic modern economy.  And if they don’t have any special talent, why aren’t we all so rich?

Here’s what I think is the simplest explanation:

The return to hedge fund managers, CEOs, billionaire investors, and Goldman Sachs employees has soared in recent decades because their skills are far more socially valuable than the 1960s, when the biggest decision was whether GM should put tail fins on Cadillacs.  This dynamic, fast changing environment is like a big playpen for the shrewd and savvy investor.  We all know how the founders Microsoft and Google and Facebook got really rich because their “product’ can be produced at ultra-low marginal cost.  Or how great cost savings can be achieved by moving capital overseas.  In that sort of world it’s no surprise that investors who allocate capital to profitable ventures also get much richer than in the world where big corporations raised capital to make predictable products using American labor.

It seems to me that this should be the standard explanation, and any alternative explanation should have the burden of proof.  Instead it usually seems like the opposite is true.  I constantly read opinion pieces that seem to simply assume that the big earnings in finance are unwarranted.  Partly this is a backlash against the behavior of banks in the recent crisis.  I’m just as outraged by our financial system as the next guy.  But those are completely separate issues; one issue is secular trends in financial income, the other is bad regulation in banking.

Some commenters accused me of defending the financial system, which is absurd given that I have been a strong critic of the entire system.  The big bankers would be horrified if I was given dictatorial power over regulation.  I’d get rid of all the moral hazard.  But the investment banks and the hedge funds would still make boatloads of money in a completely free markets.  Perhaps a tad less, but the profits still would have soared in recent decades.

Others pointed out that my description didn’t match the Wall Street they knew.  Yes, lots of managed mutual funds rip off investors, and add little social value.  But that’s always been true, and with the rise of indexed funds is actually becoming less true over time.  Commissions don’t explain the huge growth in income to Buffett or Soros or the big hedge funds.  I doubt it even explains Goldman’s success.

Others argue my hypothesis is inconsistent with my belief in the EMH.  But I’ve never argued the EMH is true for everyone.  I’ve argued it’s a useful theory for regular investors like me, for regulators, and for academics.  But someone has to be doing the work of figuring out where capital should be allocated, and I presume they are rewarded for their efforts.

Some pointed out that my argument seemed to fit venture capital best, but their earnings are modest.  No, the reason the VC earnings are modest is because VC is only a tiny part of capital allocation.  And many investors in VC are not particularly sophisticated.  Others argue that trading shares in secondary markets doesn’t fit the description of allocating capital.  But I say it does, indeed even short selling plays a role in allocating capital.

Some accuse me of defending the wealth of financiers.  But I’m not making a moral argument here.  Because I’m a utilitarian I don’t pay any attention to the concept of “deserving” the money you make.  Our tax policy should redistribute money in the way that best maximizes aggregate utility, and pay no attention to whether it looks like various people’s incomes are “earned.”  Unfortunately I used the term ‘deserve’ in my post title, so I “deserved” that criticism.  🙂

Because of lack of time I will fall behind in my comments.  I’ll catch up eventually.

PS.  Some people talk about the big profits trading currencies, T-bonds, etc.  This is probably a naive question, but precisely who are these profits being extracted from?  If it’s companies that trade, why don’t the companies lean on their own bank for a better deal than GS can provide?  What am I missing?  It’s a learning process for me as well.

Does finance deserve its earnings?

Many economists (even some relatively free market economists) have begun to question the high returns flowing to the financial industry in recent years.  It’s not that people don’t understand that finance is important, or that it plays a critical role in our economy, but rather the claim is that finance is much more generously rewarded than in the past, and that those extra earnings are at least partly unmerited.

Today I’d like to defend finance.  Not the role it played in the housing debacle (in that specific case I agree with the critics.)  Instead I’ll try to show that even in the absence of policies such as Too Big To Fail, you would expect the share of income going to finance to be rising sharply, as compared to earlier decades.

Let’s start with a simple economy that produces lots of wheat and a little bit of iron.  The income distribution in society mostly reflects differences in productivity in farming.  Stronger farmers can produce somewhat more than weaker farmers, but not a lot more.  Hence income is distributed fairly equally.

Suppose productivity in the mining industry mostly depends on skill at noticing iron deposits.  Let’s also assume that this skill is distributed very unequally–some people are much better at spotting iron deposits than others.  The next assumption is crucial.  Once iron is found, it can be mined very easily.  The hard part is finding the iron in the first place.  In that sort of economy, income will become less and less equally distributed as iron becomes a larger and larger share of GDP.

In the 1950s and 1960s it wasn’t that hard to figure out where capital needed to be allocated.  Capital was allocated to produce steel, and the steel was used to produce cars and washing machines.  Capital was allocated to the production of aluminum, and the aluminum was used to make airplanes. The most productive members of society were those who made things, and Michigan was near the top in per capita income.

Today the most productive members of society are not those who produce things, they are those who discover the things that need to be produced.  Once you have the blueprint, it is easy to produce many types of software and pharmaceuticals.  The big money goes to those who figure out the blueprint, but also to those who allocate capital to the guy who has the idea for a Google, or Facebook, or Twitter.  In contrast, the technicians who actually implement the vision often earn modest salaries.  Thus companies are “discovered” in much the same way as an iron deposit is discovered by a skilled geologist.

And then there’s globalization, which means decisions about allocating capital can vastly improve productivity even in the old-line industries that were dominant in the 1960s, when the rest of the world hardly mattered.  Finance is not that important in an agricultural economy or even in an economy where the mass production of goods can be done with almost military precision.  It becomes extremely important in an economy where it is not at all clear what should be produced, or on what continent that production should take place.

I’m not sure if I’m saying anything new—this analysis is sort of related to the “economics of superstars.” But if it is well-understood, why do people seem so perplexed by the fact that finance earns much bigger incomes than in the 1960s?  Finance now plays a much more important role than in the 1960s.

Perhaps people are drawing the wrong conclusions from the housing fiasco.  Finance made a serious mistake in allocating so much capital to housing, but that’s not what caused the recession.  In a country with 100 million houses, the damage from adding two million a year for a couple years instead of one million a year for a couple years is modest.  The reason we have a severe recession is because of tight money, not too many houses.  Otherwise we would have had a severe recession in 2006-08, when housing construction collapsed, rather than 2008-09, when we actually had a big downturn.  And of course much of the sub-prime mortgage fiasco had nothing to do with housing construction, it was refinancing.

As long as we have an economy that is increasingly dominated by “idea companies,” where the idea is really, really hard to discover and really easy to implement once discovered, finance will earn huge gains.  In my model economy the iron spotters were highly productive and the iron miners had a relatively low marginal productivity.

Right now, those who develop new ideas are being highly rewarded.  More importantly, those who spot good ideas developed by others, and allocate capital to implement those ideas, are also highly rewarded.  Get used to finance earning obscene profits, it isn’t going away.  But if it makes you feel any better, they are producing something of great value (except when they screw up and allocate money to sub-prime mortgage borrowers.)

Some might point to the fact that finance also earned high incomes in the years right before the Great Depression.  And yet we obviously did not yet have high tech economy.   But those high incomes merely reflected the extraordinary bull market.  Today finance earns large incomes even during years where stock prices are not soaring.  In others posts I’ve argued that income is a pretty meaningless metric, as it is distorted by the mixing wage income and capital gains.  Whenever stock prices soar income will temporarily look much less equal.  But our recent move toward greater inequality is not just driven by stock gains during bull markets; it’s a secular trend that isn’t going away anytime soon.