Litterman on carbon finance

I just read a very nice article by Bob Litterman in CATO's "Regulation" on the finance of carbon taxes. It includes a review of some of the recent academic calculations.

(Related, Ronald Bailey at Reason.com takes on the Administration's latest cost of carbon estimates, and reviews Robert Pindyk's recent NBER working paper "What do the models tell us?" also covered by Bob.)

Like just about every economist, Bob favors a carbon tax or tradeable emissions right over the vast network of regulatory controls on which we are now embarked. I might add that getting rid of the large subsidies for carbon emissions implicit in many country's policies would help before we start taxing.

But let's get to business, how big should the carbon tax be?


It's a hard question. The economic costs of warming are hard to assess. Moreover, they come in a century or more, when presumably our descendants are much wealthier than we are, and hopefully have technologies we have not imagined. Or civilization will have collapsed so they have a lot more pressing problems. How do we trade off costs now and uncertain benefits in a century?  What discount rate should we use?

Bob has good points on this question that I hadn't thought of, and are good applications of finance thinking (as you'd expect from Bob) which is sort of my excuse for covering it here.

Carbon beta

First, climate costs are likely to have a strong negative beta, and thus climate investments have a large positive beta.

Here's the thinking. The rate of economic growth over the next century is a major uncertainty. Will the historically unprecedented growth of the post WWII era continue, say 2% real per capita? Or does our current scleroscis settle us into 1% growth? Or are the end-of-growth prognosticators right? When you compound over a century, these add up to truly major uncertainties over how wealthy our descendants will in fact be.

But they also add up to truly major uncertainties over how much carbon we will emit in the meantime. If growth stops, carbon emissions stop too. Yes, it's not one for one (a perfect correlation). Technology choice matters; everything from windmills to deregulated nuclear power to driverless cars and trucks makes a difference. But there is a strong positive correlation.

So, if carbon is a bigger problem, our descendants are more likely to have lots of money, technology, and resources to deal with it. If they are poorer, then carbon is likely to be a lesser problem. In finance language, projects with a strong positive beta require a much higher expected return, and a high equity-like discount rate. This consideration drives us to tax less now.

Catastrophes

But, Bob goes on, how do you price catastrophe risk? Though the central tendency of the present value of economic costs of carbon emissions are surprisingly low -- even moving all of Florida up to the Georgia border is only money after all, and you have a century to do it -- there is a chance that things are much worse.

We're all thinking about "black swans" and "tail risk" these days. Shouldn't we pay a bit more carbon tax now, though the best guess is that it's not a worthwhile investment, as insurance against such tail risks?

The problem is,

Massachusetts Institute of Technology economist Robert Pindyck... argues that too many non-GHG-related low-probability, high-damage scenarios exist. He writes, “Readers can use their imaginations to come up with their own examples, but a few that come to my mind include a nuclear or biological terrorist attack (far worse than 9/11), a highly contagious ‘mega-virus’ that spreads uncontrollably, or an environmental catastrophe unrelated to GHG emissions and climate change.” He concludes that society cannot afford to respond strongly to all those threats.

Indeed. (Fun for commenters: come up with more. Asteroid impact. Banking system collapse. Massive crop failure from virus or bacteria. Antibiotic resistsance....) If we treat all threats this way, we spend 10 times GDP.

It's a interesting case of framing bias. If you worry only about climate, it seems sensible to pay a pretty stiff price to avoid a small uncertain catastrophe. But if you worry about small uncertain catastrophes, you spend all you have and more, and it's not clear that climate is the highest on the list.

This thought fits nicely into the modern research on "ambiguity" and "robust control" (for example see Lars Hansen and Tom Sargent's webpages for a portal). This line of thought often argues that you should pay a lot of attention to unlikely catastrophes, especially when it's hard to quantify their risks. And Pindyck's point (as I see it) gets to the central problem with that line of thought: you have to draw an arbitrary circle about which unlikely events you pay a lot of attention to, and which ones you pay no attention to.

If you worry about anvils falling from the sky, maybe you miss the piano falling from the sky. And if you worry about anvils, pianos, dynamite, and so on,  you just don't get out of bed in the morning.

It's also related to the tendency people have, in Kahneman and Tversky's famous analysis, to overweight some small probability events -- nuclear reactors, airplane crashes, terrorism -- and to ignore others -- coal dust, cab crashes on the way to the airport.

The same observation: One of my skepticisims of the current almost exclusive focus on carbon and global warming in the environmental community is that we may miss the real environmental problems. Most of the world breathes awful air and drinks awful water. Climate change is not even on their list of environmental problems. And the environmental effects of social or economic collapse or another war might dwarf warming.

All in all, I'm not convinced our political system is ready to do a very good job of prioritizing outsize expenditures on small ambiguous-probability events.

Alternative investments

Once we reduce things to money, which is what economists do, a bunch of unconventional and unsettling analysis opens up. (This isn't in Bob's piece, mea culpa only.) The economic case for cutting carbon emissions now is that by paying a bit now, we will make our descendants better off in 100 years.

Once stated this way, carbon taxes are just an investment. But is investing in carbon reduction the most profitable way to transfer wealth to our descendants?  Instead of spending say $1 trillion in carbon abatement costs, why don't we invest $1 trillion in stocks? If the 100 year rate of return on stocks is higher than the 100 year rate of return on carbon abatement -- likely -- they come out better off. With a gazillion dollars or so, they can rebuild Manhattan on higher ground. They can afford whatever carbon capture or geoengineering technology crops up to clean up our messes.

Put that way, though, the first question might be why we are leaving our descendants with $18 trillion of Federal debt, and a bill for $70 trillion or so of unfunded liabilities. Once we reduce the question to investment now to benefit the economic well-being of our descendants, it's not at all clear that investing in carbon reductions is the best place to put our money.

The greatest thing we can invest in for the economic well being of our 100 year descendants is strong, decades-long  economic growth. Needless to say, the overall economic policy mix and especially the environmental policy mix is not pointing in that direction. A lot of environmental policy actively discourages growth.

Nonlinearities

Bob points out one good case against this analysis. It is possible that carbon abatement is a very special investment with very special state-contingent rate of return.

There is a very small chance that climate effects may not just reduce subsequent growth, but may cause it to plummet catastrophically. Such scenarios require positive feedbacks; for example, warmer temperatures cause the release of methane from the currently permanently frozen tundra, triggering catastrophic warming impacts beyond the ability of future generations to adapt. How should society today rationally price the possibility of such unknown, very-low-probability outcomes in the future?

In my investment context, reducing carbon emissions now has a very special property that alternative ways of investing money don't have -- it turns off this low probability but huge negative-return scenario.

That's a good point -- but it means the entire case for a strong carbon tax now relies on how likely such extreme nonlinearity is.

Economics after all? 

I suspect this sort of analysis will be profoundly unsettling -- how about infuriating -- to people who worry about carbon and other greenhouse gases. It's not just about money, I suspect they might say, it's not about giving our descendants wealth; it's about giving them a healthy planet. The economist might say, so what's that worth to you? Some finite number, no? Sure, we inundate Florida, but our descendants are $100 trillion richer, so they can afford to rebuild Florida on higher ground. Problem solved with $90 trillion extra in the bank. Somehow I doubt Greenpeace will go back to saving whales even if that argument were decisively proved.

As much of a died-in-the wool economist as I am, I have to admit some sympathy. (Or maybe "ambiguity?") Consider species extinction. Our short time on Earth coincides with a greater mass extinction than the asteroid that killed off the dinosaurs. And the extinction rate is not abating.

Now, I can't point to an economic cost, and people who hold up development projects to save some small species have a hard time doing the same. The best arguments I have read (admittedly not an expert) is of the sort that there might be some snake in the rain forest has a medically useful venom. More generally, "biodiversity is good." These is again, the  small probability of huge but unquantifiable benefit option-value argument.

Really, is that the best we can do when staring at the K-T boundary, and realizing that future alien geologists will see a more dramatic layer, with far more interesting chemistry, where we lived? The feeling nags that it can't be a good thing for us to move on from the dinosaurs to see if we can beat the Permian-Triassic extinction in the spectacular-geology department. (Global warming is a is a tiny component of extinction -- we got megafauna with spears.) I welcome suggestions on how to voice this view in economic terms.

Perhaps systematically worrying about small and unquantifiable probability events isn't such a bad thing. But paying attention to vague unquantifiable worries leads to a lot of stupidity, like banning genetically modified crops.

Back to carbon taxes

With all that in mind, where do I stand on carbon taxes? Usually, when something is this muddy, it means we're asking the wrong question, and I think that's the case here.

I think we're way too focused on the amount of the tax and way too unfocused on its operation.

I think we should be talking about a carbon tax in place of  all the rest of our rather calamitous energy policy. Subsidies for windmills, for rich people to buy Tesla cars, HOV lanes, fuel economy standards, subsidies for photovoltaic roofs, tax credit for energy efficient appliances, certified buildings, ethanol, high speed trains, low speed trains, and on and on. Throw out the whole department of energy, the EPA's ability to regulate climate emissions, and every other nagging energy regulation, and give us a carbon tax instead (and real-time tolling to eliminate congestion). Set the level of the carbon tax at the cost of all this other junk, and achieve better results at a fraction of the cost.

The first-order issue is the monstrous inefficiency and increasing corruption of our energy regulation. Get the clean carbon-tax system in place, then we can talk about the level of the tax. In that world, a tax rate twice or even three times too high will have much fewer distortions than what we have now, and will produce both better growth and a cleaner environment.

Alas, as with the consumption tax and any other perfectly obvious policy, we can't seem to trust that the deal will be kept.

Rajan to run the central bank of India

My colleague Raghu Rajan has just been appointed governor of the central bank of India. See Financial Times and Reuters. Congratulations Raghu!

Let me add two little notes to the songs of praise for this decision.

Traditionally, academic central bank governors come from the world of monetary policy, people who think about interest rates and inflation and all that. Raghu comes from the academic world that studies finance and banking. Look at his vita and you'll see great article after great article thinking about how banks work.

Just in time. Central banks are now all scrambling to understand banking and financial markets, regulating the financial system, avoiding crises, and so on. This is their central new task. (Or you might say, a return to their age-old task after a short interlude.) You can't ask for a person on the planet who has thought more clearly and productively about these issues.

His popular book “Saving capitalism from the capitalists” with Luigi Zingales is also revealing. Yes, he sees how over regulation and corruption are at the heart of India’s problems (and many of our own). But he also sees the strong political forces that keep the dysfunctional system in place. If anyone can understand and resist the political pressures that central bank governors face, it will be Raghu. And he won’t be tempted to think that any monetary magic or financial dirigisme from a central bank can fix all of India's problems.

He is also about the most polite person I know, while never shying away from standing for what's right. That means he will be far more effective than typical bull-in-a-china-shop academics like myself would ever be in steering a ponderous bureacracy.

Good luck, Raghu. I think you'll need it.

Reuters already expreses the view that it's too bad he's out of the running for the US Fed job.

Immigration

WSJ Op-Ed on immigration, with extra comments.  Original here.

Think Government Is Intrusive Now? Wait Until E-Verify Kicks In

Source: Wall Street Journal

Massive border security and E-Verify are central provisions of the Senate immigration bill, and they are supported by many in the House. Both provisions signal how wrong-headed much of the immigration-reform effort has become.

E-Verify is the real monster. If this part of the bill passes, all employers will be forced to use the government-run, Web-based system that checks potential employees' immigration status. That means, every American will have to obtain the federal government's prior approval in order to earn a living.


E-Verify might seem harmless now, but missions always creep and bureaucracies expand. Suppose that someone convicted of viewing child pornography is found teaching. There's a media hoopla. The government has this pre-employment check system. Surely we should link E-Verify to the criminal records of pedophiles? And why not all criminal records? We don't want alcoholic airline pilots, disbarred doctors, fraudster bankers and so on sneaking through.

Next, E-Verify will be attractive as a way to enforce hundreds of other employment laws and regulations. In the age of big data, the government can easily E-Verify age, union membership, education, employment history, and whether you've paid income taxes and signed up for health insurance.

The members of licensed occupations will love such low-cost enforcement of their cartels: We can't let unlicensed manicurists prey on unsuspecting customers, can we? E-Verify them! And while the government screens employee applications, they can also check on employers' compliance with all sorts of regulations by looking at the job applications they submit for verification.

E-Verify proponents imagine some world in which a super-accurate government database tracks each person's legal status, and automatically enforces straightforward rules. Maybe on Mars. In our world, immigration and employment law is a complex mess, and our government's website-building capacity (see under: "health-insurance exchanges") can't possibly handle millions of people who are trying to evade the law. Permission to work inevitably will rely at least in part on the judgment calls of an army of bureaucrats.

Political abuse is just as inevitable. Consider Catherine Engelbrecht, reportedly harassed by the Federal Bureau of Investigation, the Internal Revenue Service, the Bureau of Alcohol Tobacco and Firearms and the Occupational Safety and Health Administration, all for starting a tea-party group. But the E-Verify bureaucrats would never cause her trouble in getting a job or hiring someone, right?

Soon, attending a meeting of a group that is a bit too enthusiastic about the Constitution or gun rights—or being arrested at an Occupy Wall Street rally—could well set off a "check this person" when he applies for a job. If the government can stop you from working, how can you be free to speak out in opposition?

It's the need for prior permission rather than ex-post prosecution that makes E-Verify so dangerous. A simple delay in processing or resolving an "error" in your data is just as effective as outright denial, cheap to do, and easy to cover up.

Every tyranny silences opponents by controlling their ability to earn a living. How is it that so many supposedly freedom-loving, small-government Republicans want to arm our nation's politicized bureaucracy—fresh from the scandals at the IRS and elsewhere—with the power to do just that? Why are we so afraid of immigrants that we would jeopardize this most basic guarantee of our political liberties?

Many opponents of immigration worry that immigrants will overuse expensive social services. The fear is misplaced. The Congressional Budget Office estimates more than $100 billion of net fiscal benefit from the limited expansion of immigration that's allowed by the Senate bill. And this fear does not make any sense of the system's preferences for current citizens' family members—who are less likely to work and more likely to consume services—over workers and entrepreneurs.

Perhaps some Republicans worry that immigrants will vote Democratic. But then limiting entrepreneurs and workers makes even less sense. These Republicans should have confidence that their ideas on freedom will attract ambitious, hard-working migrants.

Others say they want to protect the wages of American workers. Like all protectionism, that is demonstrably ineffective. Migrants come for jobs Americans won't or can't do, and businesses build factories abroad if workers can't come here.

The Senate bill promises higher caps for "guest workers." Ponder what "guest worker" really means. Come to America, pick our vegetables, clean our bathrooms and tend our gardens at the invitation of a powerful employer. Pay taxes. And when your visa runs out, go back where you came from—there is no place for you here. This is how Middle East sheikdoms treat Filipino maids and Palestinian construction workers. Is this America?

In the current vision of immigration reform, millions will still be trying to sneak in, and millions more will remain here working illegally. E-Verify and the border security wall prove it. If people could work legally, there would be no need for a system that endangers everyone's liberty to "verify" them. And there would be no need to build a $45-billion monument to imperial decline— our bid to outdo the walls of Hadrian, China and Berlin—to stop them. [Only the ruins won't be pretty enough to attract Chinese tourists a few centuries from now.]

Here is the crucial question for genuine immigration reform: How do we respond when someone says, I have heard of your freedom. I am tired of the corrupt police in my country, the bought-off courts, the oppression of rulers, the tyranny of the religious or ethnic majority. I want to join the one country on earth defined by an idea, not by conquest, religion or ethnic identity. No, I don't have a special skill or a strong back useful to your politically connected employers. I want to come, drive a cab, open a convenience store in a poor neighborhood, work long hours, pay taxes, send my children to school and, eventually, vote.

The answer in the Senate bill and emerging House debate remains: Stay home. America is closed. [The question is, why?]

**************************

A few more comments.

Boiled down to one sentence, where this all started. Grumpy reads the news. Reaction: "You guys want every American to have to ask the permission of the Federal Government in order to get a job??? Have you lost your minds? How many founding fathers are rolling over in their graves?"

Space is at a premium in an oped so a lot of fun stuff got cut including the few [] above.

I know there is a serious empirical literature on how much immigrants do or don't affect wages here, and whose wages. Also, I said jobs that Americans "can't or won't do," and any economist should always ask "at what wages."  I had one sentence, so give me a break. (Though, from what I've read, the wages it would take to get Americans to work at a poultry processing plant or pick fruits and vegetables would imply pretty astronomical price increases - or wholesale movements of those industries abroad.)

But... If it raises the welfare of Texans to keep out workers from old Mexico, why does it not make sense for them to keep out workers from New Mexico? National borders have no meaning in economics.

And even if it did work, it would merely be a pure transfer, a zero-sum game. If we want to subsidize wages of some Americans, do we really to tax the wages of poor Mexicans to do it?  Is this America's place in the world, to engineer transfers form poor Mexican migrants to our workers? The tax also shows up on the prices Americans pay, often the same Americans whose wages we're trying to subsidize. A most basic principle of economics is: don't engineer wealth transfers by distorting prices. If you can understand that for ethanol, you can understand that for labor.

The one-sentence shot about moving factories abroad is serious. The studies showing some benefit from keeping out foreign workers typically document short-run effects.  We've been keeping out foreigners for two generations now, and it doesn't seem to have helped the wages of workers who compete with foreigners a lot! People also choose which occupations to enter.

I didn't have room to talk about the 11 million already here. One decent thing in the Senate bill is to recognize that we can't go on like this with 11 million people relegated to second-class status. However, making them wait another 13 years before they can become citizens... Didn't we once have a revolution about "taxation without representation?"

The "guest" worker visas only allow them to work in "qualified" industries and for limited amounts of time. That means e-verify is already set up to check that you're allowed to work in specific industries, and for specific time periods, not the simple in or out you might imagine.

"Soon, attending a meeting of a group that is a bit too enthusiastic about the Constitution or gun rights—or being arrested at an Occupy Wall Street rally—could well set off a "check this person" when he applies for a job" Besides the grammar getting a bit mangled in the edits, we lost sight of just how plausible this is. Of course "terrorists" shouldn't be allowed to work in the US, right? How many congresspeople would vote against a bill adding "potential terrorists and national security threats" to the e-verify system?  But of course bureacracies' idea of "terrorist" and yours and mine might be a bit different. Mark Steyn (a favorite of mine) is illuminating here

The other day, The Boston Globe ran a story on how the city's police and other agencies had spent months planning a big training exercise for last weekend involving terrorists planting bombs hidden in backpacks left downtown. Unfortunately, the Marathon bombers preempted them, and turned the coppers' hypothetical scenario into bloody reality. What a freaky coincidence, eh? But it's the differences between the simulation and the actual event that are revealing. In humdrum reality, the Boston bombers were Chechen Muslim brothers with ties to incendiary imams and jihadist groups in Dagestan. In the far more exciting Boston Police fantasy, the bombers were a group of right-wing militia men called "Free America Citizens," a name so suspicious (involving as it does the words "free," "America," and "citizens") that it can only have been leaked to them by the IRS. What fun the law enforcement community in Massachusetts had embroidering their hypothetical scenario: The "Free America Citizens" terrorists even had their own little logo – a skull's head with an Uncle Sam hat. Ooh, scary! The Boston PD graphics department certainly knocked themselves out on that.

Do you really want people like this deciding who can work -- and in what industries -- in America? The e-verify system is already connected to homeland security!

The opposite is just as worrisome. The big data miners at the NSA and homeland security will surely be interested to monitor every time a "suspected terrorist" applies for a job, no?

I had a lot more examples of past political persecution in this country.  Historically the left has been persecuted by the government a lot more than the right. The FBI harassed civil rights leaders. Remember the red scare, and the blacklist. Good thing we didn't have e-verify back then.

Henry Miller (also Hoover) had a lovely NRO post on Thursday with detailed accounts of politicized discretion at work in Federal Agencies. Read this and think about how e-verify will work.

The worry that Federal control of employment will  misused is not a new thought. See chapter 1 of Milton Friedman "Capitalism and freedom."

An economic e-verify consequence I didn't have space for: expansion of the underground economy. There will still be millions of people here trying to work illegally. If not, what's the point of e-verify? Many of the 11 million here who won't qualify for the rather strict program to stay, and the slightly looser caps will still leave many shut out.

OK, so there's this much more effective e-verify, you need a job, and your employer needs a worker. What do you do? Answer: go fully illegal. The current system, in which illegal (or maybe I should use the new word "unauthorized." I like that one!) workers can get fake social security numbers and continue semi-legally, paying taxes, paying social security and medicare (on which they will never collect), and enjoying some legal protection, goes down the toilet. Now it's cash under the table.

And once employers get used to cash under the table, why stop with the immigrants? Benefits, health care, taxes, red tape, unions, NLRB, OSHA, it's all getting to be such a pain. Why not pay the Americans cash under the table too?

It's one more step to a two-tier economy, like much of southern Europe. There are a few "good" full time legal jobs with benefits, pensions, etc. And a vast amount of black-market work. Especially for young people, recent migrants (authorized or unauthorized), minorities, and so on.  Even a true-blue libertarian wants work to operate with protections afforded by the legal system -- enforceable contracts and all that. And anyone with a vague soft spot for labor laws including safety, health, worker rights and so on, ought to worry about the consequences of expanding completely illegal labor.

Just because you pass laws against things doesn't mean they stop.

Oh those looser caps. A bureaucracy has to certify that economic conditions are strong enough before more people get let in. The lobbying on that one will be fun to see. Maybe they can import some retired Fed governors. My forecast: labor markets will be strong enough to admit immigrants when there is no American voter who wants a better job, i.e. when hell freezes over.

For a half century, we decried that the Soviet Union controlled who could work where, and ruining the lives of dissenters. We decried that they posted soldiers at the border with guns to stop people from leaving. "Mr. Gorbachev, tear down this wall!" Do we really want to set up the system that allows the former. And does it really matter which side of the border has the soldiers with guns? Certainly to the people trying to pass, it matters not one bit.

Thanks without blame to Tom Church at Hoover for a lot of help on facts.

If you're still reading, here's an earlier post with more

Update

Richard Sobel has a nice piece making an important point that I totally missed. E-verify will have to mean a national, biometric identity card. Now, you submit a social security number. What stops people from submitting false names and social security numbers? Hmm need to make sure they are who they say they are...

I also didn't think to point out another danger. Now the Federal government and its Big Data base know every time you apply for a job. Hmm, why is that guy Cochrane applying for a job again? Checking how often you apply for a job will naturally be an important way to check against false social security numbers.

Epstein on the IRS and more

Richard Epstein has a lovely essay, "The Real Lesson of the IRS Scandal" As lots of commentators left and right are realizing, this kind of outcome is baked in to our regulatory system. A small excerpt:

The dismal performance of the IRS is but a symptom of a much larger disease which has taken root in the charters of many of the major administrative agencies in the United States today: the permit power. Private individuals are not allowed to engage in certain activities or to claim certain benefits without the approval of some major government agency. The standards for approval are nebulous at best, which makes it hard for any outside reviewer to overturn the agency’s decision on a particular application.


That power also gives the agency discretion to drag out its review, since few individuals or groups are foolhardy enough to jump the gun and set up shop without obtaining the necessary approvals first. It takes literally a few minutes for a skilled government administrator to demand information that costs millions of dollars to collect and that can tie up a project for years. That delay becomes even longer for projects that need approval from multiple agencies at the federal or state level, or both.

The beauty of all of this (for the government) is that there is no effective legal remedy. Any lawsuit that protests the improper government delay only delays the matter more. Worse still, it also invites that agency (and other agencies with which it has good relations) to slow down the clock on any other applications that the same party brings to the table. Faced with this unappetizing scenario, most sophisticated applicants prefer quiet diplomacy to frontal assault, especially if their solid connections or campaign contributions might expedite the application process. Every eager applicant may also be stymied by astute competitors intent on slowing the approval process down, in order to protect their own financial profits. So more quiet diplomacy leads to further social waste.

Richard goes on to skewer the FCC, the EPA, and the FDA. The fight over approval of liquid natural gas exports, which Richard doesn't mention is a perfect example.

I think the point is larger still. The ACA (Obamacare) under Health and Human Services and financial regulation under the Dodd-Frank act are even more stark instances of the phenomenon.  The regulations are immense, vague, contradictory, and demand discretionary approval by regulators.  For a company to speak out against those acts is very dangerous.

India's sclerosis was once described as the "permit raj." That describes our future well.

But at least Americans are still outraged at this sort of thing. At least, unlike most other over-regulated countries, regulatory discretion is still traded for political support, not suitcases full of cash. However, what Epstein makes clear is, a witch-hunt at the IRS won't solve the problem.

The larger answer here seems pretty clear to me too. Why do we have tax-exempt status for any political groups? Actually, why do we have tax-exempt status for any groups at all? It's easy to be a non-profit -- just don't make any money.  When you look at what a lot of "non-profits" do, how efficiently their money is used, the idea that we should be subsidizing most of them seems pretty silly. If we chucked out the whole tax-exempt business entirely, and allowed people to give money to any group they feel like giving it to without tax preference one way or another, the whole temptation for the IRS to hand out this subsidy in nefarious ways would vanish.

The Role of Monetary Policy, Revisited

I am giving a talk Thursday May 30, titled  "The Role of Monetary Policy, Revisited."  The event is at Booth's Gleacher Center in downtown Chicago, reception 4:30 and talk 5:15. It's part of a series of talks sponsored by the Becker-Friedman Institute.

The talk is based on  an essay I'm working on, and will be presenting at a few central banks this summer. Once per generation we re-think what central banks do, can't do, should do, and shouldn't do. Milton Friedman's famous 1968 address marked the last big transition. I think, we are in a similar moment. I will look at the big picture in the same spirit. I'm aiming at a serious talk, grounded in academic research, but accessible.

Blog followers, students, colleagues, friends, and even glider pilots are most welcome. Please rsvp so they know how many people to plan for.

The event announcement invitation and rsvp links are here on the BFI webpage

There is also an event announcement and rsvp link on the Booth Alumni events webpage here.

Problems viewing this e-mail? View it in a browser.

The Becker Friedman Institute for Research in Economics of the University of Chicago cordially invites you to The Role of Monetary Policy Revisited A talk by John H. Cochrane, AQR Capital Management Distinguished Service Professor of Finance at the University of Chicago Booth School of Business Thursday, May 30, 2013 4:30 p.m. Reception 5:15 p.m. Talk and Q&A Executive Dining Room, Sixth Floor University of Chicago Gleacher Center 450 North Cityfront Plaza Drive Chicago, Illinois (map and directions) Please join us as University of Chicago Booth School of Business Professor John Cochrane reexamines Milton Friedman's 1968 presidential address to the American Economic Association. In this famous speech on the role of monetary policy, Friedman argued, "There is always a temporary trade-off between inflation and unemployment; there is no permanent trade-off." Starting from this perspective, Cochrane will reevaluate the role of monetary policy 45 years later. Is it effective? Can it fill all the roles people expect of it? How should monetary policy be conducted going forward? RSVP Please respond online by May 23. Please extend this invitation to others who might find the program of particular interest. Complimentary valet parking will be available at the Gleacher Center entrance. QUESTIONS If you have questions or require advance assistance, please contact Maria Bardo-Colon at 773.834.1898 or bfi@uchicago.edu. John H. Cochrane The AQR Capital Management distinguished service professor of finance at the University of Chicago Booth School of Business, Cochrane's scholarly work focuses on finance, monetary economics, macroeconomics, health insurance, time-series econometrics, and other topics. He is the author of Asset Pricing, a coauthor of The Squam Lake Report, a research associate of the National Bureau of Economic Research, a senior fellow of the Hoover Institution at Stanford University, and an adjunct scholar of the CATO Institute. He blogs as The Grumpy Economist. Cochrane earned a bachelor's degree in physics at Massachusetts Institute of Technology and PhD in economics at the University of California, Berkeley. He was a member of the University of Chicago Department of Economics before joining Chicago Booth.

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Capital not a lost cause?

Admati and Hellwig (my review here) (and fellow travelers) may be having some effect! From today's WSJ "Heard on the Street":

There is growing talk among regulators, for example, of forcing banks to issue a minimum amount of long-term debt, cap the size of their short-term liabilities or restrict activities that can be conducted within regulated bank subsidiaries.

At the same time, regulators seem to be focusing more on the need to pre-emptively address potential systemic risks.

Any such moves could further constrain banks' ability to juice returns through leverage while also limiting lucrative activities that fall outside a traditional lending function. That could subdue earnings growth already hampered by the superlow interest-rate environment.

The danger isn't lost on banks themselves. A number of banking groups recently joined together in a public attempt to rebut notions of a big-bank borrowing subsidy.”

OK, 3 out of 4 ain't bad. Admati and Hellwig (and I) take a dim view of asset risk regulation and the chance that regulators have any hope of seeing bubbles emerge. But more capital, and more people understanding that leverage and TBTF is a subsidy to banks, so banks are forced to fight about it... that's progress.

The banker's new clothes -- review

I wrote a review of Anat Admati and Martin Hellwig's nice new book, "The banker's new clothes" for the March 2 2103 Wall Street Journal.

Bottom line: Banks should issue a lot more equity, a lot less debt, especially short term debt, and a heck of a lot less nonsense.

I admire Anat and Martin. The rest of us read the gobbledygook in the newspapers, chuckle at the faculty lunch -- "Ha ha, xyz is CEO of a huge bank and has never heard of Modigliani-Miller! Ha Ha -- pdq is a senior regulator, and doesn't know the difference between capital and reserves!" -- and then we go about our business. Anat and Martin have admirably taken the bull by the horns. They write opeds, they go to interminable banking policy conferences, they fight it out with bigwig bankers, regulators, and their consultant economists, and endure their scorn. This nice book summarizes their arguments very clearly (without the foaming at the mouth ranting and raving that I would have had a hard time avoiding in their place!)

(Links: This review at the Wall Street Journal (html), in a pdf from my webpage. Admati and Hellwig have a book website with lots of extra material and response to critics.)

Enough preamble. The review: 

Four and a half years ago, the large commercial banks nearly failed, inaugurating our great recession. They were saved by the Troubled Asset Relief Program, Federal Reserve lending and other government support. If you think all that was bad, imagine the ATMs going dark. What has been done to avoid a repetition of these events? Sadly, and despite all the noise you hear about bank regulation, not much.

The central problem, at the core of Anat Admati and Martin Hellwig's "The Bankers' New Clothes," is capital.

In order to make $100 of loans, a typical bank borrows $97—from depositors, from money-market funds, from other banks, or from bondholders—and sells $3 of stock, its "capital." So if only 4% of the bank's loans fail, the shareholders are wiped out, and the bank cannot pay its debts. Worse, if there is a rumor that some loans are in trouble, creditors may "run," each trying to get his money out first, and force a needless bankruptcy. Think of Jimmy Stewart in "It's a Wonderful Life."

When banks are on the brink, all sorts of other pathologies emerge. Bankers and their regulators may try to keep zombie loans on the books, hoping things will turn around. Or bankers may bet the farm on very risky loans that either save the bank or impose larger losses on creditors and the government. Ms. Admati and Mr. Hellwig explain all this nicely in their first few chapters.

The solution seems pretty obvious, no? Banks should fund their investments by selling a heck of a lot more stock and borrowing a heck of a lot less, especially in the form of run-prone short-term debt, as most other companies do.

Far more value was lost in the 2000 tech bust, for instance, than in the subprime mortgages that sparked the 2008 crisis, but the tech bust did not cause a financial crisis. Why? Tech companies were funded by stocks, not short-term debt. Worried shareholders can drive down the price of a stock, but they have no right to demand that the company redeem shares at yesterday's price, so they can't drive the company to bankruptcy in a run. Depositors and other short-term creditors have a fixed-value, first-come-first-serve promise from a bank—they can run.

More capital and less debt would stabilize the financial system in many ways. If a bank wants to rebuild its ratio of capital to assets from 1% to 2% by selling assets, it has to sell half of its assets. Doing so can spark a fire sale, especially if all the other banks are doing the same thing. If the same bank wants to rebuild capital from 49% to 50% of assets, it only has to sell 2% of its assets. That bank will also have a far easier time issuing more stock, rather than selling assets, which is a better way to build equity in the first place.

The U.S. government has instead addressed the risks of banking crises by guaranteeing bank debt. Guaranteeing debts creates perverse incentives, so our government tries to regulate the banks from taking excessive risks: "OK, cousin Louie, I'll cosign the loan for your Las Vegas trip, but no poker this time, and be in bed by 10."

Ms. Admati and Mr. Hellwig show how this approach has failed, repeatedly, over the course of many years—in the 1984 Continental Illinois rescue; in the Latin American debt crisis and savings-and-loan crisis in the 1980s; in the Asian-currency crisis and the collapse of Long-Term Capital Management in the 1990s; and in the recent financial crisis. Each time, our government bailed out more and more creditors in a wider array of institutions. Each time, our government wrote reams of new rules that banks quickly got around.

Now pretty much all of the big banks' debt is guaranteed, explicitly or implicitly through the widely held expectation that a big bank's creditors will be bailed out. But our regulators promise that next time, trust them, they really will spot trouble ahead and do something to stop it—even though our massive bank-regulation machinery failed to notice that subprime mortgages might be a bit risky in 2006 and even though, as Ms. Admati and Mr. Hellwig note, Europe's regulators still consider Greek government bonds to be risk-free assets.

Most basically, Ms. Admati and Mr. Hellwig point out that current regulation is focused on a bank's assets: the loans, securities and other investments that bring money in (and sometimes don't). They want us to focus instead on the bank's liabilities: the ways banks get money and the promises banks make to depositors and investors. Bank assets are not particularly risky or illiquid. Apple's profits from selling iPhones or a mutual fund's portfolio of stocks are far riskier than any bank's portfolio of loans and mortgage-backed securities, or even their much-disparaged trading books. Bank liabilities—too much debt and too much short-term debt—are the central problem that causes financial crises.

What about those "tough" new capital regulations that you keep reading about? They are not nearly as tough as you think. At best, the new Basel III international bank regulation agreement calls for a 7% ratio of capital to assets by a leisurely 2019 deadline. But that is the ratio of capital to "risk-weighted" assets. Risk-weighting is a complex system in which some assets count less against capital requirements than others. A dollar of mortgage assets might count as 50 cents, but it might count as 10 cents or less if it is a complex mortgage-backed security, and zero if it is government debt. When Ms. Admati and Mr. Hellwig unravel those "risk weights," we're still talking about 2% to 3% actual capital.

Foreseeing the usual risk-weighting games, Basel III requires a backstop 3% ratio of equity to all assets. "If this number looks outrageously low," Ms. Admati and Mr. Hellwig write, "it is because the number is outrageously low." Indeed.

This simple truth has been met by howls of protest and layers of obfuscation and derision by bankers, their consultants and many of their regulators. "Oh, you just don't understand the complexities of banking" is the basic attitude. "Go away and let the experts fix this." Well, Ms. Admati and Mr. Hellwig, top-notch academic financial economists, do understand the complexities of banking, and they helpfully slice through the bankers' self-serving nonsense. Demolishing these fallacies is the central point of "The Bankers' New Clothes."

No, they write, it was not always thus. In the 19th century, banks funded themselves with 40% to 50% capital. Depositors wouldn't lend to banks unless the banks had a lot of skin in the game. Without a government debt guarantee—and, early on, without limited liability—shareholders wanted less risk as well.

"Capital" is not "reserves," and requiring more capital does not reduce funds available for lending. Capital is a source of money, not a use of money. When, as Ms. Admati and Mr. Hellwig gleefully note, the British Bankers' Association complained in 2010 about regulations that would require banks to "hold"—the wrong verb—"an extra $600 billion of capital that might otherwise have been deployed as loans to businesses or households," it made an argument both "nonsensical and false," contradicting basic facts of a bank balance sheet. Requiring more capital does not require banks to raise one cent more money in order to make a loan. For every extra dollar of stock the bank must issue, it need borrow one dollar less.

Capital is not an inherently more expensive source of funds than debt. Banks have to promise stockholders high returns only because bank stock is risky. If banks issued much more stock, the authors patiently explain, banks' stock would be much less risky and their cost of capital lower. "Stocks" with bond-like risk need pay only bond-like returns. Investors who desire higher risk and returns can do their own leveraging—without government guarantees, thank you very much—to buy such stocks.

Nothing inherent in banking requires banks to borrow money rather than issue equity. Banks could also raise capital by retaining earnings and forgoing dividends, just as Microsoft MSFT +0.54% did for years. Every dividend drains capital from banks and removes a layer of protection between us taxpayers and the next bailout. Ms. Admati and Mr. Hellwig are at their best in decrying U.S. regulators' decision to let banks pay dividends in 2007-08—amounting to half the TARP bailouts—and to let big banks begin paying out dividends again in 2011.

Why do banks and protective regulators howl so loudly at these simple suggestions? As Ms. Admati and Mr. Hellwig detail in their chapter "Sweet Subsidies," it's because bank debt is highly subsidized, and leverage increases the value of the subsidies to management and shareholders. To borrow without the government guarantees and expected bailouts, a bank with 3% capital would have to offer very high interest rates—rates that would make equity look cheap. Equity is expensive to banks only because it dilutes the subsidies they get from the government. That's exactly why increasing bank equity would be cheap for taxpayers and the economy, to say nothing of removing the costs of occasional crises.

And, in an all-too-short chapter on "The Politics of Banking," they show us how politicians and regulators like the cozy cronyism of the current system. Banks are, of course, "where the money is," and governments around the world use regulation to direct funds to politically favored businesses, to preferred industries, to homeowners and to the government itself. Politicians want to subsidize and protect their piggy bank. Regulators commonly become sympathetic to the interests of the industry they regulate, which advances their careers in government or back in industry. Last week's news coverage of Treasury Secretary Jack Lew's interesting career is only the most recent reminder.

Part of me wishes that Ms. Admati and Mr. Hellwig had been more specific in their criticisms: naming more names and quoting more nonsense, writing a gripping exposé dripping with their justified outrage. But their restraint is wise: Too much exposé would detract from the clarity of their ideas. So readers will have to recognize the arguments and add their own outrage.

Ms. Admati and Mr. Hellwig do not offer a detailed regulatory plan. They don't even advocate a precise number for bank capital, beyond a parenthetical suggestion that banks could get to 20% or 30% quickly by cutting dividend payments. (I would go further: Their ideas justify 50% or even 100%: When you swipe your ATM card, you could just sell $50 of bank stock.)

But this apparent omission, too, is a strength. A long, detailed regulatory proposal would simply distract us from the clear, central argument of "The Bankers' New Clothes": More capital and less debt, especially short-term debt, equals fewer crises, and common contrary arguments are nonsense. More capital would be far more effective at preventing crises than the tens of thousands of pages of Dodd-Frank regulations and its army of regulators, burrowed deep in the financial system, on a hopeless quest to keep highly leveraged and subsidized too-big-to-fail banks from taking too much risk. Once the rest of us accept this central idea, the details fill in naturally.

 How much capital should banks issue? Enough so that it doesn't matter! Enough so that we never, ever hear again the cry that "banks need to be recapitalized" (at taxpayer expense)!


(Update in response to a lot of comments. C'mon, this is a review of a book about banks. It's not my place here to expand the discussion to GSEs' CRA, the run on repo and broker dealers, money market funds etc. On the ATM card that sells bank stock: That card can also sell a share of your S&P500 index. And if you want stable value accounts, money market funds that hold only short term treasuries can provide all the fixed-value assets we could possibly want.)

Fiscal cliff video

I did a "Chicago tonight" segment on the fiscal cliff,


The other guest, Carl Tannenbaum, is a good friend as well as a thoughtful economist. We went to high school together. It was a pleasant surprise to run in to him in the foyer of WTTW's studios.

The intro segment is worth watching too. "Chicago tonight's" producers wisely got a real tax lawyer to explain what the "cliff" is all about.


How nice to start with a quick review of strategies that "the rich" will use to avoid the new taxes.

One year from now, the studies will start rolling in (I hope) documenting how much extra revenue the fiscal cliff tax hikes actually collected from their targets. My bet: less than half of the $60 billion advertised. I'll be surprised if it's positive, actually.

Who won the fiscal cliff negotiations? Democrats? Republicans? VP Joe Biden? No. Tax lawyers, accountants, and lobbyists.

In case you think any of this had to do with deficits, I sign off today with a lovely graph from a great piece by Yuval Levin:

And it will be less than that. Yuval uses the CBO forecasts, which assume rich people don't watch "Chicago tonight" and talk to their tax lawyers.

The Times on Taxes

The New York Times' Sunday lead editorial (12/30) is simply breathtaking. The title is "Why the economy needs tax reform." It starts well,

Over the next four years, tax reform, done right, could be a cure for much of what ails the economy...

OK, say I, the sun is out, the birds are chirping, my coffee is hot, and for once I'm going to read a sensible editorial from the Times, pointing out what we all agree on, that our tax system is horrendously chaotic, corrupt, and badly in need of reform. Let's go -- lower marginal rates, broaden the base, simplify the code.

That mood lasts all of one sentence.

Higher taxes,...

Words matter. "Reform" twice, followed by paragraphs of "higher taxes," with no actual "reform" in sight. The Times is embarking on an Orwellian mission to appropriate the word "reform" to mean "higher taxes" not "fix the system."

Let's be specific. What is the Times' idea of tax "reform?"

tax capital gains at the same rates as ordinary income.... a restoration of the estate tax, higher tax rates or surcharges on multimillion-dollar incomes, and higher corporate taxes..

That's just to get started. Since, as the Times refreshingly admits,

..the new revenue would only slow the growth of the debt in the near term..

before the health care entitlement deluge hits,

... Mr. Obama would be wise to instruct the Treasury Department to start work on tax reform now, exploring carbon taxes, both to raise revenue and to protect the environment; a value-added tax,... and a financial transactions tax...

That's "reform?"

What will all those taxes do? The Times has a little bit of deficit reduction on its mind,

 More revenue would also reduce budget deficits, helping to put the nation’s finances on a stable path.

But with "reduce," "help," and "stable path," you can tell that eliminating deficits and paying off the debt are not a real high priority here. The Times has bigger fish to fry, starting with a red herring and ending with a red whale.

Higher taxes, raised progressively, could encourage growth by helping to pay for long-neglected public investment in education, infrastructure and basic research...

We've been spending more and more on education for years. While performance steadily declines. The trouble with schools is not lack of money.

Yes, infrastructure is crumbling, as a few New Yorkers may have figured out when their power went off, while their politicians -- and the Times -- instead of talking about burying electric lines and putting in a modern grid, wished instead to stem the rise of oceans and sugar in their soft drinks. But infrastructure spending is a tiny component of the Federal budget; we could support anyone's wish list without a Federal income tax.  Basic research spending could be doubled on about 10 minutes worth of Federal spending. Red herring.

The whale comes last:

Greater progressivity would reduce rising income inequality, and with it, inequality of opportunity that is both an economic and social scourge. 

The Times is arguing forthrightly for confiscatory taxation of income and wealth, in order simply to  reduce post-tax incomes. This isn't "redistribution," it's "off with their heads!"

Inequality of opportunity? No, President Obama's kids should not go to Sidwell Friends, they should go to DC public schools like everyone else?  Mayor Rahm Emanuel's kids shouldn't go to the University of Chicago Lab school (mine go there too, but I don't preach this stuff), they should have to go to Chicago public schools like everyone else? These are "economic and social advantages" arising from unequal income. Big ones, that motivate a lot of parents to work hard so they can afford the tuition.  French President Francois Hollande has a better idea: ban homework, so kids with smart parents can't get an advantage because they get help on homework. Too bad you can't ban homework in China and India. No concierge medicine either. Stand in line for medicaid like the rest of us.

And to accomplish this leveling, we'll just take money from "the rich" until all are equally impoverished.

Am I being alarmist? No. Read the sentence again, carefully. Words matter. What else can it possibly mean?

It's just astounding. When has a society ever grown, become prosperous, and raised opportunities for its citizens--of any background--by confiscatory taxation, transferring wealth to the State, with the deliberate aim of reducing the opportunities of a segment of its population? The examples I can think of -- French and Russian revolutions, the whole communist world -- ended rather badly.  Even more modest attempts, say postwar Britain, do not augur well. The evidence of Europe's current high-tax "austerity" (another word Orwellianly appropriated to mean "high taxes") and the weight of academic research (most recently from the IMF and Alberto Alesina) stand before us: Fiscal retrenchment led by higher marginal tax rates simply does not work.

Moving from outcome to opportunity, as the Times does, when has a society ever accomplished equal and plentiful opportunities by confiscatory taxation and heavy regulation? I can think of lots of societies that by these means became much less equal, with opportunity dependent on political and family connections, and thus out of reach of even the most talented and industrious people without connections. 

What of us naysayers? On taxing "capital gains at the same rate as ordinary income,"  

That is an indefensible giveaway to the richest Americans. Research shows that the tax breaks do not add to economic growth but do contribute to inequality. Currently, the top 1 percent of taxpayers receive more than 70 percent of all capital gains, while the bottom 80 percent receive only 6 percent.

Three more fish and a whopper.

We might start with the interesting assertion that any tax rate is a "giveaway." Who gives what to whom, dear Times?

"Research shows" is another fascinating choice of words.  "Research shows" means "all research shows," or "the consensus of research shows," without actually saying it. The facts are "some research shows," or in this case, really, "two unpublished papers we found on the web claim."

The links point to a report by the Congressional Research service and a one-page screed from the Urban Institute.  Both pieces of "research" simply plot the usual pointless correlations ignoring the hundreds of other causes, effects, and things not held constant. Aspirin causes colds you know: Look, there is a strong correlation between asprin-taking and colds. Neither one is even submitted let alone published in a refereed journal, which is no guarantee of anything but at least it's the minimum standard for "research." If this were indeed what constitutes "research,"  and "science,"  vast new funding for fundamental research in economics might well be warranted.

Fortunately, that is not the case.  What real research concludes, as much as anything in economics concludes, is that capital gains taxes are about the easiest to avoid (see Buffett, Warren).  Real research shows that when capital gains rates were reduced in the 1980s, revenue increased. Real public finance, the rest of the world's tax systems, and the broad conclusion of just about everybody until the world lost its head in 2008, was that capital gains taxation is a bad idea.

And the whale: "Receive" capital gains? Dear Times, capital gains are not a check sent by great-grandma's trust fund. Let me educate you on where capital gains come from: People work, and earn money, and pay taxes on that money.  Rather than blow it all stimulating consumption demand, they save some of it, invest in stocks, or start businesses. When those investments pay off, they sell, and receive capital gains. A vast swath of retirees lives off capital gains, especially from their houses.Small business owners are "high income" in the one year they sell their businesses.

Words matter, again. "Receive" paints capital gains as passive receipts form a mysterious ill-gotten mountain of gold, ripe for plucking with neither tax avoidance, behavioral change, or economic consequence. That's just not how our world works, but very revealing of the Times' zero-sum, class-warfare worldview.

What about 

...higher corporate taxes..

Once again, one of the few things real "research shows," and  economists agree on pretty heartily, is that corporate taxation -- already higher in the US than the rest of the world -- is a silly idea. All corporate taxes are passed on to people, through higher prices, lower wages, or lower returns to investors, primarily the former two. Tax people when they get the money. And corporations are much better at evasion, lobbying, moving abroad, and structuring operation in silly ways to avoid taxes.

The value added tax -- the economist's favorite, if coupled with elimination of other taxes -- is famously "regressive," the modern term (here are those important little words again) for "everybody pays the same rate."  Value added is, in Europe (along with 30-40% payroll taxes) the middle class tax that pays for middle class benefits. What about that, dear Times?

a value-added tax, coupled with provisions to protect lower-income taxpayers from higher prices, to tax consumption and encourage saving;

This is just incoherent. If you're "protected from higher prices," you're not paying the tax. If we couple the VAT with a vast new income transfer program, adieu revenues.

At least we close with some humor. The VAT is there to encourage saving, while heavy taxation of interest, dividends, capital gains and estates, says just the opposite.

What about spending?

The big obstacle to comprehensive tax reform is the persistent Republican myth that spending cuts alone can achieve economic and budget goals. That notion was sounded rejected by voters during the election. Yet it still has adherents among many Republicans, which will make it that much harder for Congress to grapple with the bigger and more complex issue at the heart of tax reform: how to pay for government in the 21st century.

....All that [long list of taxes] would only be a start, because the new revenue would only slow the growth of the debt in the near term. After 10 years, the pressures of an aging population and health care costs would cause the debt to accelerate again.

Oh those evil Republicans, standing against "reform," and reusing to grapple with "how to pay for government." The size and scope of which is not under discussion. No, dear Times, it's not "the pressures of  an aging population and health care costs." It is the Federal Government's promises to pay for it all. Which are, apparently, fixed stars.

Technical regress in any area is sad. Once upon a time, when we talked about taxes, there was a modicum of economics involved. When we thought about raising or lowering a rate, we thought seriously about the inevitable avoidance and distortions.  The first question was, "if we pass this law, will x actually pay more money, or will he simply change behavior to avoid the tax?" The second question was, "will his change in behavior hurt the economy?" Before we talk about what's "fair" we talked about "what works."

And we knew the sign of the answer: distorting taxation raises less revenue than you think, and reduces economic prosperity. The only question is how much. We did not indulge in magical thinking that appropriating anyone's income would actually improve the economy, all on its own. We understood the damage, and tried to carefully balance the benefits of spending against that damage. This is how we got, for a while, to low marginal rates with a broad base (the latter since loopholed away), low capital gains, estate, and corporate taxes, and were headed messily towards a system that taxed consumption more than rates of return. 

As one glorious counterexample of all the Times' monstrous confusions:

a financial transactions tax, to ensure that the financial sector, whose profits have substantially outpaced those of nonfinancial corporations, pay a fair share

A transactions tax is the easiest thing in the world to avoid with financial engineering.  How do you begin to figure out the "fair share" that financial vs nonfinancial corporations should pay? How about mutual funds whose beneficiaries are impoverished union schoolteachers? 

Orwellian language, blatant mistruths, and magical thinking aside, however, I want to applaud this editorial. No, I'm not kidding.

The Times is saying, out loud, that if we are to have the regulatory and welfare state we have enacted, it must be paid for with huge middle class taxes, as well as confiscatory taxes on anyone who dares to save, invest, or start a business. This is refreshing honesty. Up until about November 3, all we heard from them is that reversing the Bush tax cuts on the rich would pay for it all. At least a few of its readers may wake up and say, "wait, we voted for this?"

Really, my main complaint is that they left out the "if," and its logical consequence, and any doubts that raising tax rates so massively might not produce the needed long-run revenue growth they hope for.

It is a mistake to dismiss this clear editorial. This isn't the Village voice, or the Berkeley Free Press. This is the New York Times. This is how a wide swath of our fellow citizens, and majority of our fellow voters, see the world.   This is the agenda. They could not have been clearer if they had said "first we annex Austria and move against Czechoslovakia. Then we invade Poland and swing North and West." Heed them.

ECB dilemma

It was announced yesterday that  Europe will have a new, central bank supervisor run by the ECB, much as our Fed combines monetary policy and bank supervision. Be careful what you wish for, you just might get it.

One big unified central agency always sounds like a good idea until you think harder about it. This one faces an intractable dilemma.

Here's the problem. Why not just let Greece default?" is usually answered with "because then all the banks fail and Greece goes even further down the toilet." (And Spain, and Italy).

So, what should a European Bank Regulator do? Well, it should protect the banking system from sovereign default. It should declare that  sovereign debt is risky, require marking it to market, require large capital against it, and it should force banks to reduce sovereign exposure  to get rid of this obviously "systemic" "correlated risk" to their balance sheets. (They can just require banks to buy CDS, they don't have to require them to dump bonds on the market. This is just about not wanting to pay insurance premiums.) It should do for the obvious risky elephant in the room exactly what bank regulators failed to do for mortgage backed securities in 2006.


Moreover, it should encourage a truly European market. Greek, Spanish, Italian banks failing is no problem if large international banks can swoop in, pick up the assets, and open the doors the next day. Bankruptcy is recapitalization.  Greece needs a national banking system as much as Chicago (same population) does.

All well and good. And all diametrically opposed to the ECB's "crisis-fighting" agenda. The right arm of the ECB should be protecting the banking system in this way. But the left arm of the ECB is using banks as sponges for sovereign debt.

In trying to manage the sovereign debt crisis, the ECB has bought huge amounts of sovereign debt. It has lent  euros to banks that in turn have bought large amounts of sovereign debt (often, I gather, with not so subtle pressure from their governments).  It has lent more euros to the same banks to replace deposits that are quite wisely fleeing out of those banks.

How can the right arm protect the banking system from sovereign default, while the left arm wants to stuff the banking system with sovereign debt?

Converesely, how can the left arm do anything but print euros like mad, now that the right arm has responsibility for the banking system?  Lending to banks who buy sovereign debt was always excused by the idea that the bank shareholders bear the credit risk and national supervisors take care of that problem. Now it's in the ECB's lap. Politically, can the ECB really shut down national banks, stiff the creditors, and let them be taken over by big pan-european banks?

I bet on the outcome: print euros like mad, keep pretending sovereign debt is risk free, and prop up existing banks. Let's hope I'm too cynical. For once.

Taxes and cliffs

(Update: John Batchelor show radio interview on this blog post)

The whole tax debate is supremely frustrating to anyone who survived econ 1.

The ill effects of taxation -- the "distortions" -- depend on the total, marginal rate including transfers. If I earn an extra dollar, how much more stuff do I get, or how much more of someone else's services can I receive? That calculation has to include all taxes, federal, payroll, state, local, sales, excise, etc. and phaseouts.

And, if you receive a benefit from the government that phases out with income, so every dollar of income above (say) $30,000 reduces your benefit by 50 cents, then you face a 50 percent marginal tax rate even if you pay no "taxes" at all. Taxes and benefits -- both in level and on the margin -- need to be considered together.
 
I've been looking for good calculations of marginal rates.  The CBO has just issued a nice report titled "Effective Marginal Tax Rates for Low- and Moderate-Income Workers" that begins (begins!) to shed some light on the right question.  Here's one important graph, titled "Marginal Tax Rates for a Hypothetical Single Parent with One Child, by Earnings, in 2012";

The CBO's headline (first page) says these low-income workers

face a marginal tax rate of 30 percent, on average, under the provisions of law in effect in 2012. ... Over the next two years, CBO estimates, various provisions of current law will cause marginal tax rates among this population to rise, on average, to 32 percent in 2013 and to 35 percent in 2014.

30% and rising to 35% is already news. (A lot of the rise reflects means-tested insurance subsidies under the ACA). But digging a bit deeper I see a more chilling story in the CBO report

...CBO also finds that under provisions of law in effect between 2012 and 2014, marginal tax rates vary greatly across earnings ranges and among individuals within the same earnings range.

Consider again the graph on the top. The marginal tax rate is not an even 30%. There are slices of income where the marginal rate approaches 100%. And, the graph is really misleading because it doesn't graph the "cliffs."  The figure caption says

The dotted lines indicate income limits for Medicaid and CHIP where taxpayers face “cliffs.” Similar spikes in marginal tax rates when the taxpayer loses eligibility for TANF and SNAP are not illustrated.

The CBO's artists apprently did not want to graph the vertical spikes in an honest solid line. (The CBO's "average" is, as far as I can tell, an average across taxpayers. No taxpayer reported income at exactly the cliff income, not one dollar more or less, otherwise the "average" would have been infinite. The CBO is not taking an "average" across income, which would include the cliffs.)

Another figure gets at the situation better, I think, though it takes more sophistication to digest

Now the "cliffs" show up. Overall, disposable income is very flat from $0 to $30,000 of income, and there are swaths where a discrete jump in income produces no increase in overall income.

Cliffs are particularly pernicious incentives. Even if people overlook marginal incentives for a while, "if you take this job you'll lose your health insurance" really focuses the mind.
 
And, this is only the start. Single parents with one child who are going to work need childcare, transportation, clothes, and so on. The calculation leaves out sales taxes and a range of additional means-tested programs and social services.  It  only represents marginal tax rates by people who actually do work and file taxes. The jump from out of the labor force, illegal work, or disability to employment is higher. (Box 3 p. 17 cites a 36% marginal tax rate for the jump to employment and 47 percent from part time to full time.)

Even within the same income group, there is a  tremendous variation in marginal tax rates.

 The CBO' introductory graph makes somewhat the same point. The huge spread in effective tax rates is as interesting as the average value

These estimates are also  understatements, as they only scratch the surface. The actual marginal tax + loss of benefit rates people face is very complex. A quick poll of faculty at the Booth lunch table showed the usual range of opinion but no serious calculations. Maybe it's deliberately complex so people will not make the obvious responses to big marginal tax rates!

And, in the name of simplicity, the CBO left out dozens if not hundreds of additional means-tested programs. As the CBO says (p. v) "Including additional programs would generally increase estimates of marginal tax rates." Yes, it would.

Why is there so much variation in tax rate across people of the same income? (p.v) The CBO here is looking at actual taxpayers, and

Survey data show that the majority of lower-income families do not receive means-tested transfers, either because they do not meet additional, nonfinancial eligibility requirements or because they are eligible but do not apply for benefits. Of those who receive transfers, the majority participate in only one program.  

This is both heartening and chilling. Written into law is a much larger welfare state than we actually have. Americans don't fully play the game. Yet. Witness the recent ad campaign to get more people to use food stamps. Once more people take more full advantage of the programs available to them, first the budget explodes. And second, they start to feel larger and larger marginal tax rates against growing out of the programs.

All of this  is official confirmation of the point Casey Mulligan has been making in his new book: Our system imposes huge disincentives for low-income people to move up. 
Greg Mankiw (H/T this is where I learned about the report) suggests

What struck me is how close these marginal tax rates are to the marginal tax rates at the top of the income distribution.  This means that we could repeal all these taxes and transfer programs, replace them with a flat tax along with a universal lump-sum grant, and achieve approximately the same overall degree of progressivity. 

The spread in tax rates means Greg is much more right than he knows. A $20,000 "universal lump sum grant"  and 30% flat tax rate would indeed be a better system -- not because it would approximate the current system more simply, as Greg implies, but  because it would dramatically lower marginal tax rates for so many low-income families.

The idea is worth pursuing. A "lump sum grant" means $20,000 voucher for food, housing, health insurance, and eliminating all the programs and their administering bureacracies. I didn't know Greg was such a radical!  However,  $20,000 x 100 million households = $2 trillion, on top of the military and all other federal spending. It's not clear a flat 30% even with no deductions at all is going to pay for it.

Perhaps we keep the $20,000 as provided benefits, as they now are, just lousy enough that rich people abandon them voluntarily as they bail out of public schools. That limits the budget impact a bit, though it will be pretty hard to explain to a $50,000 wage earner now paying next to nothing in Federal income taxes that they'll be writing a check for $15,000 next year, but don't feel bad because now they get to use food stamps and be on medicare.

We're going decidedly and inevitably in the other direction, which is the CBO's point in its gentle and understated  admonition that the "average" marginal rate is going to rise to 35%.

The response to our budget woes is more means-testing: Leaving deductions in place but capping them, adding to the phaseouts in the tax system,  more means-testing for Social Security, Medicare, and Medicaid, all of the low-income subsidies for the ACA which phase out with income of hours on the job.

It all sounds great if you don't understand margins.  Why should the government help rich people? But every time we do cap something or means-test it, we introduce another marginal tax. And some of the biggest marginal taxes hit the poor.

This is a deeply important point so let me reiterate it. If you means-test any benefit, you introduce a steep marginal tax rate at means-testing point. If you don't means-test a benefit, you blow out the budget. It's a hard nut, that you can't get around.

This is not a little problem. We worry about the distribution of income in the US, and how low-income people seem stuck. Well, faced with these barriers of course they're stuck. And the barriers are going to get worse. 

What to do?  To some extent this is why economics is called the dismal science. Draw the line any way you want, subject to the budget constraint that all redistributed money has to come from somewhere. If you make it high at the left end it has to have a low slope. Compassion breeds "dependency," a pejorative word for the simple fact that poor people are smart and respond to incentives.

But we can do a lot better!  At least we can measure and talk about total marginal tax rates including phaseouts and benefits -- and the CBO study is only a beginning -- rather than the silly Warren Buffet vs. his Secretary stories about average personal Federal income taxes in isolation.

And, we can avoid the big variation and the cliffs. We can avoid some people facing 100% or more margins and others facing no margin. We can  bring everyone closer to the "average" 30% rate.  The costs of a high rate are larger than the benefits of a low rate (and varying rates cause people to clump up on the high rates.)

Finally, perhaps more time limit as well as income limit will work as a sensible compromise. Unemployment benefits are limited in time, which is what has kept the US from developing the permanent underclass on the dole of some European countries.

Half-joke:  the Republican response to the Democrat's desire to raise the high bracket of  Federal income taxes to 39.5%, and raise the taxes on dividends and capital gains should be: Fine. You can have the Warren buffet lower limit. In return, we get the Greg Mankiw upper limit: (named after Greg's 90% marginal tax rate) If any taxpayer can show that his total marginal tax rate, including payroll, Federal, phaseout, state, local, excise, share of corporate, sales, property, and removal of benefits exceeds 75%, then his Federal income tax rate shall be reduced to that level. Well, maybe we should take this seriously on the low end of the income distribution.

Personal story: This is how I became an economist. Taking econ 1 as my humanities distribution requirement at MIT (pause for laugh), the professor showed the budget constraint for people on welfare, which at the time reduced benefits one for one with income, and kicked people out of public housing. For years I had felt at sea in the moral and cultural arguments about welfare dependency. In a flash, I saw it, there but for the grace of good fortune go I.

Next topic. In week 2 of econ 1 you learn that the distributional effects of taxation also are not read off the headline rates of the Federal income tax, but also depend on all taxation, all spending, and the burden of taxation through higher prices and wages, not who actually pays the taxes. That political argument is even sillier.

Update:

An excellent comment arrived by email:

Dear John... Regarding your post on marginal tax rates, the best paper I’ve seen on the subject is by Larry Kotlikoff and David Rapson, “Does it Pay, at the Margin, to Work and Save? Measuring Effective Marginal Taxes on Americans’ Labor and Saving.” This includes state programs (in Massachusetts, if I recall correctly), which add even more phaseouts. (Link to the NBER version). The chart on page 45 of the file is particularly striking. [reproduced below]

[Kotlikoff's abstract is great: 

The paper offers four main takeaways. First, thanks to the incredible complexity of the U.S. fiscal system, it's impossible for anyone to understand her incentive to work, save, or contribute to retirement accounts absent highly advanced computer technology and software. Second, the U.S. fiscal system provides most households with very strong reasons to limit their labor supply and saving. Third, the system offers very high-income young and middle aged households as well as most older households tremendous opportunities to arbitrage the tax system by contributing to retirement accounts. Fourth, the patterns by age and income of marginal net tax rates on earnings, marginal net tax rates on saving, and tax-arbitrage opportunities can be summarized with one word -- bizarre.]

 This anecdote from Jeff Liebman also illustrates the issue in a way that Kotlikoff’s charts might not:

Despite the EITC and child credit, the poverty trap is still very much a reality in the U.S. A woman called me out of the blue last week and told me her self-sufficiency counselor had suggested she get in touch with me. She had moved from a $25,000 a year job to a $35,000 a year job, and suddenly she couldn’t make ends meet any more. I told her I didn’t know what I could do for her, but agreed to meet with her. She showed me all her pay stubs etc. She really did come out behind by several hundred dollars a month. She lost free health insurance and instead had to pay $230 a month for her employer-provided health insurance. Her rent associated with her section 8 voucher went up by 30% of the income gain (which is the rule). She lost the ($280 a month) subsidized child care voucher she had for after-school care for her child. She lost around $1600 a year of the EITC. She paid payroll tax on the additional income. Finally, the new job was in Boston, and she lived in a suburb. So now she has $300 a month of additional gas and parking charges. She asked me if she should go back to earning $25,000.....

[Thanks! I also am not a specialist in this literature and am glad for pointers to good work.] 

Update 2: Another graph, thanks to MG.

Source, a great presentation by Gary D. AlexanderSecretary of Public Welfare Commonwealth of Pennsylvania at the AEI