Thursday, September 18, 2014

Guest Post at Miles Kimball's on Wallace Neutrality in Theory and Practice

University of Michigan economist Miles Kimball was kind enough to ask me to comment on a recent Twitter discussion he had with Berkeley economist Brad DeLong and Stony Brooke economist Noah Smith on Wallace neutrality. He was specifically concerned with how I would answer the question, Does Wallace neutrality result from (in theory) fiscal policy canceling out the Fed, or many private agents (the minnows) canceling out the Fed (the whale)? My answer, and more, is here.

Thursday, September 4, 2014

Am I taking crazy pills?!



In 2010 I first asked publicly what I thought was a crucial question on health care, that I thought was not that unobvious, that no one was asking. Since then, I've periodically re-asked it (recently at Noah's), and not only has no one answered it, no one else anywhere ever asks it! I read widely and deeply the economics and politics blogosphere and other media almost every day, thousands of pages per year, from Paul Krugman to Stephen Williamson, the Atlantic, the New Republic, Fed websites, major newspapers, Jonathan Chait, Jonathan Cohn, the links in Economist's View, the links in the Plum Line, on and on. And no one, no one, ever asks it! Why? Why does no one else ask this?!

Am I taking crazy pills?!

Here it is, reprinted from a January, 2010 post; maybe you can tell me if I am:
We spend about $100 billion per year on medical research, public and private combined (see here).

We spend about $2 trillion per year on health care delivery, the doctors, hospitals, administration, etc. If we adopted a European style system, cutting our spending per person in half, as in European countries (that I think the evidence shows have about as good or better health care and results anyway; see for example here), then we would save about $1 trillion per year.

Now, what if we spent that $1 trillion in savings on medical research? It would increase medical research spending more than 10 fold.

Even if delivery did get a little worse, even if we did get a little bit less of our brightest and best becoming doctors due to lower pay, it seems like this would be totally outweighed over the long run by tremendously more advanced medical understanding and treatments due to the 10 fold increase in medical research spending (or more, as some advanced universal healthcare countries provide comparable health care to the US at about a quarter of the cost per person) .

So it looks like if you want better medical results, better treatment, breakthroughs in rejuvenation, better odds of surviving cancer, you name it, you should support going to a European style system, and using the immense savings to increase medical research more than 10 fold.

So if our health care system really is more efficient than the Europeans, then why is it possible to make such a vastly favorable trade?

If the Republicans really care about our children and grandchildren so much why don't they do this, so in 50 years they could have medicine as advanced as it would take perhaps 150 years to achieve with our current system. I don't care how bad you imagine European health care to be, you cannot think a European medical center of today is less effective than even the Mayo Clinic of 100 years ago, when penicillin and polio vaccines hadn't even been invented.

Sunday, August 10, 2014

The Intuition behind Wallace Neutrality, Attempt 3

Ok, if I might make another attempt to explain the elusive intuition behind Neil Wallace's model, and why Wallace neutrality doesn't work in the real world. The issue recently re-arose in the econoblogosphere. I have two earlier attempts that I think are interesting and show some good intuitions. Here's try three:

Please consider this:

With Miller Modigliani (MM), if the firm borrows more, it increases the overall debt level of its shareholders. Since we're assuming at the start that everyone's a perfect optimizer, with perfect expertise, public information, etc., and since we're assuming we start at equilibrium, then everyone is already at their optimal debt level, that they want to stay at.

So, when the firm borrows more, the shareholders just borrow less, enough less so that their overall debt level remains unchanged.

In MM, it's a partial equilibrium model, in that the interest rate is taken as given, exogenous, to use the term of the biz; the people in the model can't change it. But even if it weren't, the total demand for debt in the debt market doesn't change, because it all comes down to the fundamental demanders: the people. The firm is just an intermediary for them. The firm demands more debt? Well, they just demand less by an equal amount. Total demand in the market as a whole remains the same, and thus, so would the market interest rate, even if this were a global equilibrium model.

So, now we go to Wallace's 1981 AER paper, “A Modigliani-Miller theorem for open-market operations”. You look at it, and it's a wall of very terse math. I have the dreaded ABD in finance. But at least I took all the courses and passed all the written exams, plus a whole lot of study on top of that. I think I'm pretty good at decoding the intuition behind math. And I spent about 50 hours on this two years ago, a giant amount for me. Still, I would love to have two months uninterrupted to just study this paper. Ah, a man can dream… Some want to pet turtles in the Galapagos when they retire, some want to get jiggy with Wallace…

Oh, oh, ok, wake up. Anyway, I think I got, nonetheless, a substantial amount of intuition out, and I would venture this:

In Wallace's model, the government is like a big MM firm. And the citizens are shareholders of the government. When the government does the Wallace version of a QE, it basically is like it borrows more money (really lends, but let's look at the converse for now). That would make its citizens overall debt level higher than they like, so they want to borrow less by an equal amount to stay at their optimal overall debt level. The total demand for debt in the market remains unchanged. Government demand goes up by X, and private demand goes down by X, so the interest rate remains the same.

In Wallace, all people are perfectly expert, with perfect public information, can do all analysis and information gathering and digesting instantly, at zero cost, and are perfect rational optimizers. They start the model in equilibrium with their optimal level of debt, and if the government, that they're "shareholders" in, borrows more, then they just instantly borrow less by an equal amount. So, interest rates don't change.

More specifically in Wallace, as I remember it, there is a single consumption good. I called it C's. People save some of their C's for period two of their two period lives. The government's "QE" is to print dollars and exchange them for C's, which it will store for one period. Then it will sell all of those C's back again out into the market for dollars – with 100% certainty. That's their plan, everyone knows it, and they're going to stick to it.

The people own the government. They're its shareholders; they get dividends in the form of government transfer payments, so when this government "firm" saves more C's, by selling newly printed dollars to get C's, and puts them into storage, then the people's overall savings goes up – up above their optimum that they had settled on in equilibrium.

So they sell C's out of their private stores in an equal quantity to compensate. The total demand overall for the market to save C's for the future does not change, and so the interest rate doesn't either. And that's the thinking; that's why it works in Wallace's model. That's why you can prove no change when you do the math in this model.

But why wouldn't this work in the real world?

Well, first off, people are far from perfectly expert (especially in the super complex modern world), with perfect public information that they can gather, digest, and analyze at zero time, effort, or money cost. This should be like, duh, but then you hear some of the things some freshwater economists imply, and you're stunned. Partly to sell their ideology, partly to make the models they're top experts in more valued, partly, perhaps, just detached from reality from selling, and smelling, their own B.S. for so long. But for whatever reasons, obviously the vast majority of people are far from this.

So, when the government "firm" starts to lend a lot more, almost no one thinks, MM style, or Wallace style, I want to start selling some of my bonds to compensate in equal measure as I see them doing that. And so total lending in the market does, in fact, go up, and market interest rates drop. People just don't react that way. And it won't be nearly enough if a savvy minority do. They won't control enough money to drive us to Wallace neutrality.

It's like in Miller and Modigliani's model if the firms start borrowing a lot more, but the shareholders are mostly not really paying attention, and/or don't know well the implications, so, for the most part, they don't want to borrow any less to compensate. In that case, aggregate demand for borrowing would not remain unchanged. The aggregate demand curve for borrowing would, in fact, shift out, and the interest rate would rise.

Other issues: In the real world there are a lot more different kinds of financial assets than just money, and borrowing and lending the single consumption good risk-free, like in Wallace's model. So, if the government does a QE in just some types of assets, people, even if they are perfect at optimizing, won't be able to funge their portfolios to relieve completely price pressure on those assets. Markets are not complete, and far from it, so that you could construct a synthetic for any asset. I talk about this in an earlier post on Wallace neutrality when I ask what if the government did a QE where they printed up a dollars and used it to purchase 100 million ounces of gold.

Next, Miller-Modigliani irrelevance doesn't hold if investors face different borrowing costs and liquidity constraints than the firm. Likewise, Wallace irrelevance will not hold if individuals and firms face different borrowing costs and liquidity constraints than the federal government. Do they? 

Finally, Wallace's model assumes that with 100% certainty the central bank will completely reverse the QE one period later, and everyone knows this. All of the C's purchased with the newly printed dollars will be sold back. In the real world, investors cannot be completely certain a QE will be 100% reversed in the future.

From UCLA economist Roger Farmer:
A wealth of evidence shows not just that quantitative easing matters, but also that qualitative easing matters. (see for example Krishnamurthy and Vissing-Jorgensen, Hamilton and Wu, Gagnon et al). In other words, QE works in practice but not in theory. Perhaps its time to jettison the theory.

Sunday, May 4, 2014

Always rule out all options but the two libertarian ones, Pareto and nothing, is value-free?

Oxford macroeconomist Simon Wren-Lewis has a great post on how economics' extreme bias towards Pareto optimality is, of course, not value-free. 

I'll add this: You often hear from economists that Pareto optimality is value-free and no one can object to it because no one is hurt by the Pareto option.

But here's the huge problem with that. What you're immediately doing when you say that is saying we will consider only two options, and rule out as unacceptable every other. We decide every other option is unacceptable except the two libertarian options, Pareto and nothing. THAT's value-free? That's positive and unideological? To rule out all of the many other options, including the utilitarian one, immediately as unacceptable, and only consider permissible for analysis the two libertarian ones? That's positive value-free? You can't even positively state, without endorsement, this is what the total societal utils optimum is, so people can know it and consider it?

This is a source of extreme, pervasive, and profound bias in economics toward libertarianism, as well as plutocracy.  And I discussed this in a 2012 post, which Simon cited.

Tuesday, March 25, 2014

Guest Post at Carola Binder's on The Second Machine Age

My thanks to Carola, Berkeley economics PhD student and excellent blogger. The post tackles one of the biggest issues of the day, Will the explosion in computer/robot/machine ability result in mass unemployment this time, even though previous technological revolutions haven't? I make use of insights from MIT professors Brynjolfsson and McAfee's important new book, as well as their first book on this subject, Race with the Machine.

Sunday, March 16, 2014

It's not just growth, it's also absolute level

Paul Krugman writes today:
Some people seem to think that something like Spain’s slight recovery this year — the best estimates now are that it may grow 1.5 percent — are as big a failure for the critics of austerity as the kind of thing I show above is a failure of the finance canon. But lots of stuff can cause the economy to grow a percentage point or two more or less than your forecast.
I'll add that also current absolute level, of course, matters, not just growth. If your economy gratuitously shrinks by 15% over four years because you chose austerity, then it grows 1.5%, it's still at least 13.5% smaller than it was, and could have been. Especially with an unemployment rate of 25%, that's a horror, not reason to claim victory and vindication.

If, as an investor, you lose 90% of your family's life savings, then you get a 1.5% return, do you say, Yea! See, my strategy was right! Or do you say that if I had followed a smart strategy I'd be at 110% of where I started, not at 10.15% of where I started -- and claiming victory and vindication. 

Sunday, March 2, 2014

Private student loans, so important, so often unmentioned

Cornell professor of government Suzanne Mettler has a great New York Times article on the horror of for-profit colleges. I urge everyone to read it. These predators do tremendous harm to our young and our country, and of course they should at least be severely regulated. In fact, the problem may be so profound, the asymmetric and poor information so bad, and they may be so hard and expensive to regulate, that it may be best to require all colleges to be (true) non-profits or government. But want I want to focus on in this post is another problem that's also very important, and rarely noted, the private student loans heavily used by these companies.

This is the big flaw in Mettler's otherwise excellent article. She writes, "Nearly all of their students take out loans to attend, and the amounts are staggering.", but never notes the crucial point that these student loans are much more likely to be private than with government colleges. This is just enormously important. And sadly almost everyone misses this, a tragic flaw of our system, and of a very dominant paradigm of writing that overly stresses smoothness, brevity, and simplicity over accuracy, non-misleading, and not leaving out very or crucially important detail and specificity.

Because of the 2005 BAPCPA bankruptcy law private student loans are never escapable in bankruptcy, with extremely rare exception -- something like you now have full body paralysis. And these loans are usually for large amounts, often at very high interest rates. I've heard as high as 19%, where due to the awesome power of compound interest at a high rate, debt grows 5.7 fold every decade! 

These unsuspecting young people are at serious risk of being made into lifetime indentured servants with no escape ever (other than trying as best they can to avoid wage garnishment and seizing of any substantial assets they will ever achieve in life by things like moving to one of the states that restricts this the most). This is their reward for doing the right thing, trying to improve their education and skills to become more productive citizens. Yet the Republican response is good! More prey for the plutocrats to feed off!

Federal government student loans, by contrast, are a completely different story. They also cannot be escaped in bankruptcy, but they have powerful income based repayment and loan forgiveness protections that make them completely safe, in fact one of the safest major loans in history. For example, the vast majority of federal student loans today qualify for a program called Pay-as-you-Earn. Under this program the most your payments can ever be is 10% of your family's discretionary income (which is usually much less than total income). And it's very progressive, so it's usually much less than 10%, and can easily be zero. Yet after 20 years of payments (including when the payment drops to zero), no matter how much you still might owe, the balance is 100% forgiven. And there are programs even much better than that if the student takes a job that's defined as "public service". For more, see this article I did with the help of student loan expert, advocate, and attorney Heather Jarvis.

So it's huge that with for-profit schools the loans are much more private, and this – and the reasons why it's important – should always be noted, but rarely are.