Macro-Finance

A new essay "Macro-Finance," based on a talk I gave at the University of Melbourne this Spring. I survey many current frameworks including habits, long run risks, idiosyncratic risks, heterogenous preferences, rare disasters, probability mistakes, and debt or institutional finance. I show how all these approaches produce quite similar results and mechanisms: the market's ability to bear risk varies over time, with business cycles. I speculate with some simple models that time-varying risk premiums can produce a theory of risk-averse recessions, produced by varying risk aversion and precautionary saving, rather than Keynesian flow constraints or new-Keynesian intertemporal substitution.

Rajan on cash transfers and corruption

Raghu Rajan, who just announced he is stepping down as Governor of the Central Bank of India, gave a very interesting speech, that bears among other things on the question of social programs vs. cash transfers.

A big problem with government provided assistance in India is that the provision is corrupt:

Our [India's] provision of public goods is unfortunately biased against access by the poor. In a number of states, ration shops do not supply what is due, even if one has a ration card – and too many amongst the poor do not have a ration card or a BPL card; Teachers do not show up at schools to teach; The police do not register crimes, or encroachments, especially if committed by the rich and powerful; Public hospitals are not adequately staffed and ostensibly free medicines are not available at the dispensary; …I can go on, but you know the all-too-familiar picture.

Raghu has a thoughtful observation on what keeps this system going:

This is where the crooked but savvy politician fits in. While the poor do not have the money to “purchase” public services that are their right, they have a vote that the politician wants. The politician does a little bit to make life a little more tolerable for his poor constituents – a government job here, an FIR registered there, a land right honoured somewhere else. For this, he gets the gratitude of his voters, and more important, their vote.

...perhaps the system tolerates corruption because the street smart politician is better at making the wheels of the bureaucracy creak, however slowly, in favour of his constituents. And such a system is self-sustaining. An idealist who is unwilling to “work” the system can promise to reform it, but the voters know there is little one person can do. Moreover, who will provide the patronage while the idealist is fighting the system? So why not stay with the fixer you know even if it means the reformist loses his deposit?

So the circle is complete. The poor and the under-privileged need the politician to help them get jobs and public services. The crooked politician needs the businessman to provide the funds that allow him to supply patronage to the poor and fight elections. The corrupt businessman needs the crooked politician to get public resources and contracts cheaply. And the politician needs the votes of the poor and the underprivileged. Every constituency is tied to the other in a cycle of dependence, which ensures that the status quo prevails. 

The Mafia may have had a similar equilibrium

What to do? Cash transfers are an attractive option

... money liberates. Could we not give poor households cash instead of promising them public services? A poor household with cash can patronize whomsoever it wants, and not just the monopolistic government provider. Because the poor can pay for their medicines or their food, they will command respect from the private provider. Not only will a corrupt fair price shop owner not be able to divert the grain he gets since he has to sell at market price, but because he has to compete with the shop across the street, he cannot afford to be surly or lazy. The government can add to the effects of empowering the poor by instilling a genuine cost to being uncompetitive – by shutting down parts of the public delivery systems that do not generate enough custom.

Much of what we need to do is already possible. The government intends to announce a scheme for full financial inclusion on Independence Day. It includes identifying the poor, creating unique biometric identifiers for them, opening linked bank accounts, and making government transfers into those accounts. When fully rolled out, I believe it will give the poor the choice and respect as well as the services they had to beg for in the past. It can break a link between poor public service, patronage, and corruption that is growing more worrisome over time.

...if there is evidence that cash transfers are being misspent – and we should let data rather than pre-conceived notions drive policy -- some portion could be given in the form of electronic coupons that can be spent by the specified recipient only on food, education or healthcare.

 A good summary

 One of the greatest dangers to the growth of developing countries is the middle income trap, where crony capitalism creates oligarchies that slow down growth. [Just developing countries?!] ... To avoid this trap, and to strengthen the independent democracy our leaders won for us sixty seven years ago, we have to improve public services, especially those targeted at the poor. A key mechanism to improve these services is through financial inclusion, which is going to be an important part of the government and the RBI’s plans in the coming years.

Raghu's efforts to reform India's banking and financial system deserve more notice.

(PS: Blogging will be a little spotty for the next week and a half, as I'm off at a glider competition.)

Equity-financed banking

My dream of equity-financed banking may be coming true under our noses. In "the Uberization of banking" Andy Kessler at the WSJ reports on SoFi, a "fintech" company. The article is mostly about the human-interest story of its co-founder Mike Cagney. But the interspersed economics are interesting.

SoFi started by making student loans to Stanford MBAs, after figuring out that the default rate on such loans is basically zero. It

has since expanded to student loans more generally and added mortgages, personal loans and wealth management. Mr. Cagney says SoFi has done 150,000 loans totaling $10 billion and is currently at a $1 billion monthly loan-origination rate. 

Where does the money come from?

SoFi doesn’t take deposits, so it’s FDIC-free. ... Instead, SoFi raises money for its loans, most recently $1 billion from SoftBank and the hedge fund Third Point, in exchange for about a quarter of the company. SoFi uses this expanded balance sheet to make loans and then securitize many of them to sell them off to investors so it can make more loans

Just to bash the point home, consider what this means:

• A "bank" (in the economic, not legal sense) can finance loans, raising money essentially all from equity and no conventional debt. And it can offer competitive borrowing rates -- the supposedly too-high "cost of equity" is illusory.
   
• There is no necessary link between the business of taking and servicing deposits and that of making loans. Banks need not (try to) "transform" maturity or risk.
   
• To the extent that the bank wants to boost up the risk and return of its equity, it can do so by securitizing loans rather than by borrowing. (Securitized loans are not leverage -- there is no promise of your money back when you want it. Investors bear any losses immediately and without recourse.)
   
• Equity-financed banking can emerge without new regulations, or a big new Policy Initiative.  It's enough to have relief from old regulations ("FDIC-free").
   
• Since it makes no fixed-value promises, this structure is essentially run free and can't cause or contribute to a financial crisis. 

More. SoFi does not use the standard methods of evaluating credit risk:

Instead of relying on notoriously inaccurate backward-looking FICO scores, SoFi is “forward-looking.” That means asking basic questions—“Do you make more money than you spend?”—and calibrating where applicants went to college, how long they’ve been employed, how stable their income is likely to be over time.

Why can’t banks do this? Because if you use depositor money for loans, as all banks do, you fall under the jurisdiction of the Federal Deposit Insurance Corp. and the Community Reinvestment Act,...

And Basel and the FSOC and the Fed and so forth. FICO score based mechanical lending standards are also demanded by government-backed securitizers Fannie and Freddie.

Yes, bank "safety" regulations demand that banks purposely lend to people that one can pretty clearly see will not pay it back, and demand that they do not lend money to people that one can pretty clearly see will pay it back.

Now, what will the regulatory response be to this sort of innovation? The right answer, of course, should be hosannas: You have introduced run-free banking, that solves all the financial-crisis worries that 90 years of bank regulation could not solve. Let this spread, and the army of bank regulators, lobbyists, lawyers, and associated politicians can all go, well, drive for Uber.

Somehow I doubt that will be the response from foresaid army. And SoFi might well want to invest in its own lawyers, lobbyists and politicians in today's America.

Rather than by the FDIC, SoFi is monitored by the Consumer Financial Protection Bureau. The overbearing regulator that was Elizabeth Warren’s brainchild thus far hasn’t come down on SoFi—the CFPB is perhaps too preoccupied with using “disparate impact” analysis of old-school auto-loan businesses to focus on a relatively exotic, app-based form of banking. But Mr. Cagney should watch his back.

Indeed he should. In today's rather rule-free environment, the CFPB -- or Department of Justice -- might just discover it doesn't like the demographics of Stanford MBAs as target borrowers.

He’d like to get a national lending license, but that would entail federal-oversight entanglements he’d rather avoid.

If he can.

A little puzzle crops up at the end. For now, I gather SoFi does not issue public equity. The plan for expansion is

insurance companies and sovereign-wealth funds might rent him their balance sheets. 

I'm not sure what "rent a balance sheet" means, but it sounds a lot like private equity or long term debt.  It would be even better for stability and low cost to issue public equity, which is liquid -- investors who need money fast can sell. But public equity comes with its own regulatory scrutiny, and perhaps even that is too much for innovation these days.

MetLife

What does "systemically important" mean? How can an institution, per se, be "systemically important?"  The WSJ coverage of Judge Rosemary Collyer’s decision rescinding MetLife’s designation as a "systemically important financial institution:" gives an interesting clue to how our regulators' thinking is evolving on this issue:

The [Financial Stability Oversight] council argued — bromide alert — that “contagion can result when relatively modest direct, individual losses cause financial institutions with widely dispersed exposures to actively manage their balance sheets in a way that destabilizes markets.”

It's not a bromide. It is a revealing capsule of how the FSOC headed by Treasury thinks about this issue.


"Actively manage balance sheets" is a fancy word for "sell assets." So there you have it. "Systemically important" now just means that an institution might sell assets, because selling assets might lower asset prices. "Contagion" and "systemically important" are no longer about runs; you see one bank in trouble and go take your money out of a different one. "Contagion" and "systemically important"  is no longer the (false, but plausible) domino theory, that if I default and owe you money, you default.

Policy is no longer just about stopping runs. Policy is not just about stopping any large bank from failing, or ever just losing money. Policy is about  stopping asset prices from falling, and stopping even the small marginal additional fall in prices that might accompany one  large institution's sales.  (Except that leverage and capital ratios now force institutions to sell even if they don't want to, a delicious case of contradictory regulatory commands.)

Owen Lamont's classic characterizatiion of policy-maker's attitude toward selling short, now applies to selling at all.

 Policymakers and the general public seem to have an instinctive reaction that short selling is morally wrong. Short selling has been characterized as inhuman, un-American, and against God

The journal nails the basic problem

For eight years, federal regulators have failed to define precisely the “systemic risks” they claim they can identify across the financial landscape.

But no definition makes it easy to endlessly expand the word's meaning.

NBER AP

On Friday I attended the NBER Asset Pricing meeting (program here) in Chicago, organized by Adrien Verdelhan and Debby Lucas. The papers were unusually interesting, even by the high standards of this meeting. Alas the NBER doesn't post slides so I don't have great visuals to show you.


Lars Hansen started with the latest in the Hansen-Sargent ambiguity / robustness work,Sets of Models and Prices of Uncertainty. Stavros Panageas gave a beautiful discussion,  complete with power point animations. He characterized the paper as a major advance, for reducing the range of models over which an ambiguous agent looks for the worst case scenario, and for making that range state-dependent.

In the application, the agent worries that the mean growth rate of consumption and the AR(1) coefficient might be wrong; a more persistent consumption growth process is hurtful, and that pain is more in bad times.

I haven't followed this work closely enough. I still wonder what the testable implcations are -- how different is the asset pricing model from one in which the true consumption growth process is just a bit different from our estimate, in the worst possible way?

Still, it's nice to see a Nobel Prize winner leading off a conference, and with easily the most technical paper at that conference, with another one (Rob Engle) in the audience. That tells you something about the seriousness of this group. Also, this is serious behavioral finance by any metric -- a disciplined model of probability misperceptions, which is nice to see.

Robert Novy-Marx presented  Testing Strategies Based on Multiple Signals, discussed by Moto Yogo. We're all familiar with the phenomenon that if you try 10 characteristics and pick the best few to forecast returns, t statistics are biased and performance falls out of sample.

Robert pointed out that if you put those best 3 in a portfolio, they diversify each other, reducing the in-sample variance of the portfolio, and boosting Sharpe ratios and t-statistics even further.

Many ``smart beta'' funds are doing this, so the fall-off in performance from backtest to real money is relevant beyond academia.

The extent of this bias is impressive. Here is the distribution of t statistics that results when you pick the best three of 20 completely useless signals, and put them in a portfolio. Critical values of 4 and 5 show up routinely in Robert's calculations.

Laura Veldkamp presented her work with Nina Boyarchenko, David Lucca, and Laura Veldkamp,  Taking Orders and Taking Notes: Dealer Information Sharing in Financial Markets. Discussed ably (of course) by Darrell Duffie. Is it a problem that the dealers who are the prime bidders at treasury auctions have been caught talking to each other ahead of the auction?  Surprisingly, no: The Treasury can come out ahead when dealers share information with each other, and investors can potentially come out ahead too.

This warms my contrarian economist heart. We know so little about how markets work, and regulators are so quick to jump on supposedly bad behavor, it's lovely to see a clear and convincing model, that explains the kind of second-order and equilibrium effects that economists are good at.

Brian Weller presented Measuring Tail Risks at High Frequency, discussed nicely by Mike Chernov. Brian's basic idea is to run cross-sectional regressions of bid/ask spreads, normalized by volume and depth, on the cross-section of factor betas. Since spreads are larger when dealers are more worried about big jumps, this produces a measure of time-varying probability x size of such jumps. The measure correlates well with the VIX.

Michael Bauer presented his paper with Jim Hamilton Robust Bond Risk Premia discussed very nicely by Greg Duffee. (My discussion of a previous presentation). This paper is really about whether macro variables help to forecast bond returns. We're used to "Stambaugh bias:'' if you forecast returns with a persistent regressor, and the innovation in the regressor is strongly negatively correlated with the innovation in the return, then the near-unit-root downward bias in the regressor autocorrelation seeps over into upward bias of return predictability. But macro variables forecasting bond returns have innovations nearly uncorrelated with the returns, so that's not much of a problem. Michael and Jim show another problem: with overlappping returns, t statistics can be biased down too.

This led to a pleasant reassessment of bond return forecasts. Some points that came up: econometrics aside, many return forecasters don't do well out of sample. Many of the issues are specification issues orthogonal to this econometric point. For example, evaluating the huge forecastability of bond returns from a combination of level and inflation documented by Anna Cieslak and Pavol Povala, where the forecasters look a lot like a trend, is really about specification and interpretation, not econometrics. I held out the view that the important part of my paper with Monika Piazzesi is the single-factor structure of expected returns, not whether small principal components help to forecast returns. We had a pleasant interchange on whether it's a good or terrible idea to run one-year horizon forecasting regressions. I like them, because they attenuate measurement error. Raising a weekly autoregression to the 52nd power yields junk. Greg likes them, and gave a stirring reminder of Bob Hodrick's point that you can include lags of the forecasting variables instead.

Nick Roussanov presented his paper with Erik Gilje and Robert Ready, Fracking, Drilling, and Asset Pricing: Estimating the Economic Benefits of the Shale Revolution with Wei Xiong discussing. They track the reaction of stock prices to the shale oil boom. In particular, they showed that stocks which rose on a huge shale announcement subsequently rose even more as more good shale news came in. Until, as Wei pointed out, prices collapsed.

Nick also used stock market value to try to get at an estimate of the economics benefits of fracking. It's a worthy effort, but let's remember the difficulties. In a competitive no-adjustment cost world, profits are zero and there are no abnormal stock returns. Stock capitalization may rise, as firms issue stock to invest. But that measures the value of capital invested, not the consumer surplus of shale. Still, the general idea of mixing asset pricing, energy economics, and making economic measurements from stock prices is intriguing.

Jonathan Sokobin, Chief Economist, FINRA presented "An Overview of FINRA Data" which I alas had to miss. I'm delighted anyone from the government wants us to use their data!

The AP meeting has a nice tradition. Usually the most boring part of a conference is the author's response to discussant. The AP meetings do away with this -- or rather, the author can respond if someone in the audience raises his or her hand and says "I'd like to hear your response to x." That actually happened! But by and large the AP meetings preserve time and a tradition of very active participation and discussion, and this one was no different.

Central banks as central planners

Two news items cropped up this week on the general topic of central banks as emergent central planers.: a nice WSJ editorial by James Mackintosh on QE extended to buying corporate debt, and the Fed's proposed rule governing "Macroprudential" countercyclical capital buffers. The ECB also has a new Macroprudential Bulletin with similar ideas that I will not cover because the post is already too long. (Some earlier thoughts on the issue here. As usual, if the quotes aren't showing right, come back to the original of this post here.)

The WSJ editorial:

..as the central banks become more desperate to boost inflation and growth, they are starting to break one of the modern tenets of the profession by funneling that cash directly to what they regard as “good” uses.

The Bank of Japan’s conditions for companies to qualify for central bank funding include

offering an "improving working environment, providing child-care support, or expanding employee-training programs".... increasing capital spending, expanding spending on research and development or boosting what the Bank of Japan calls “human capital.” The latter means pay raises for staff, taking on more people or improving human resources.

The ECB

... plans to pay banks to borrow from it for up to four years so long as they use the money to help the “real” economy, meaning that they don’t simply pump up the housing markets by offering more mortgage finance.

The ECB is also causing a ruckus by stating plans for which private bonds it will buy and which it won't.

What's wrong with this?

“It’s a massive politicization of credit: Here are the legitimate things for lending, and here are the illegitimate things,” said Russell Napier,...“It’s capitalism with Chinese characteristics.”

Indeed. But just "politicization" or "central planning" is not the real danger. Our governments do all sorts of highly politicized credit allocation and subsidization -- energy boondoggles, student loans, export financing, housing housing and more housing, community reinvestment act, and so forth. On that scale, it seems hard to get excited about a little more.

But central banks so far don't, at least in well run countries. Why not? Independence. The deal for central banks has been: The bank gets great independence. In return, it accepts sharply limited powers. It handles money and interest rates, but it does not funnel credit to specific borrowers, nor does it target asset prices.  Branches of government that handle such political decisions are subject to quadrennial electoral wrath.  So, though any expansion of financial meddling is unwelcome, the big danger is the inevitable politicization and loss of independence of the Central bank.

And that will happen sooner than you think. Congressional hearings and bills to contain the Fed are already in Congress.

A bit more under the radar, but needing much more attention, the Fed has unveiled rules for implementing "macro-prudential" policy with "counter-cyclical capital buffers."

The proposed rule makes for fun reading. The

countercyclical capital buffer (CCyB) ...is a macroprudential policy tool that the Board can increase during periods of rising vulnerabilities in the financial system and reduce when vulnerabilities recede.

 [CCyB? OMG, DC alphabet soup is now case-sensitive?]

The CCyB is designed to increase the resilience of large banking organizations when the Board sees an elevated risk of above-normal losses. ... Above-normal losses often follow periods of rapid asset price appreciation or credit growth that are not well supported by underlying economic fundamentals....the Board would most likely use the CCyB ... to address circumstances when potential systemic vulnerabilities are somewhat above normal. By requiring advanced approaches institutions to hold a larger capital buffer during periods of increased systemic risk and removing the buffer requirement when the vulnerabilities have diminished, the CCyB has the potential to moderate fluctuations in the supply of credit over time.

Decoded into English, this is what they're saying: Replay the end of the boom, 2005-2007. This time we really will see the crisis coming. This time we will force banks to issue more stock, hold back on paying dividends and bonuses to conserve capital during the boom when things are going great. This time we will directly tell banks to stop lending even though customers are lining up at the doors for cash-out no-doc refis. Replay the beginning of the bust,  2007-2008. This time we really will demand that banks get even more private capital, and stop paying dividends and bonuses, in the middle of a crisis, even though the same banks may be screaming of its impossibility.

(And... "to hold a larger capital buffer. This entire document uses the incorrect verb "hold" to describe capital, as if capital are reserves. One hopes the ideas are not as confused as the language.)

Hayek's famous criticism of central planning is that planners can't possibly have the information needed to properly supply toilet paper. Which they didn't. So as you read this gobbledy-gook, you should ask just that question -- not whether the Fed is well intentioned or not (it is), but how will Fed officials "assess vulnerabilities,"  "potential systemic vulnerabilities" or tell whether "asset price appreciation or credit growth" are or are not "well supported by underlying economic fundamentals?"

The proposal lays out the answer:

.. by synthesizing information from a comprehensive set of financial-sector and macroeconomic indicators, supervisory information, surveys, and other interactions with market participants. In forming its view about the appropriate size of the U.S. CCyB, the Board will consider a number of financial-system vulnerabilities, including but not limited to, asset valuation pressures and risk appetite, ...

The decision will reflect the implications of the assessment of overall financial-system vulnerabilities as well as any concerns related to one or more classes of vulnerabilities. ...

"valuation pressures" and "risk appetite" are not measurable or even defined quantities. "Classes of vulnerabilities" even less so.

If this sounds pretty wooly, you might be a bit reassured by

The Board intends to monitor a wide range of financial and macroeconomic quantitative indicators including, but not limited to, measures of relative credit and liquidity expansion or contraction, a variety of asset prices, funding spreads, credit condition surveys, indices based on credit default swap spreads, options implied volatility, and measures of systemic risk. In addition, empirical models that translate a manageable set of quantitative indicators of financial and economic performance into potential settings for the CCyB, when used as part of a comprehensive judgmental assessment of all available information, can be a useful input to the Board's deliberations. Such models may include those that rely on small sets of indicators—such as the credit-to-GDP ratio, its growth rate, and combinations of the credit-to-GDP ratio with trends in the prices of residential and commercial real estate... Such models may also include those that consider larger sets of indicators...

Though they might as well say "we will look at every number that comes across the wires." It is painfully obvious though that nobody has any clue how to turn this mass of data into a useful real-time index of "vulnerabilities."

The key is to distinguish a "boom" from a "bubble."  In real time. When all the bankers in your "surveys" and "interactions with market participants" are telling you it's a boom. "We'll look at every vaguely plausible number that comes in" is hardly a reassuring tie to the mast.

But in case even this smorgasbord data-dump seems too limiting; in case some congressional committee member says "you looked at the price of barbecue in setting the first bank of Texas' capital buffer, and that violates the regulation,"

However, no single indictor or fixed set of indicators can adequately capture all the key vulnerabilities in the U.S. economy and financial system. Moreover, adjustments in the CCyB that were tightly linked to a specific model or set of models would be imprecise due to the relatively short period that some indicators are available, the limited number of past crises against which the models can be calibrated, and limited experience with the CCyB as a macroprudential tool. As a result, the types of indicators and models considered in assessments of the appropriate level of the CCyB are likely to change over time based on advances in research and the experience of the Board with this new macroprudential tool.

Translation to English: We will be shooting from the hip, but we will cover up the communique's with a lot of numbers and models and mumbo jumbo to give the illusion of technical competence.

To be clear, I'm all for capital. Lots and lots of capital. Capital issued or retained, not "held," please. I'm for so much capital that the precise amount doesn't really matter.

And that's the point. By pretending that the Fed will set capital ratios down to the second decimal point, and then pretending to be able to adjust that ratio up or down by a few percentage points in response to a Rube-Goldberg model, the Fed pretends there is a very important cost to demanding too much capital, that it knows exactly where the cost-benefit optimum is, not just on average, but with great precision vary it over time. All of this is not just false, it is completely pie-in-the sky.  How can anyone with a straight face claim such an absurd level of competence?

So my objection really is the effort to dress this up with the aura of technocratic competence, or pretend the Fed is putting in rules that it will follow. (The link is, after all, a rule-making proposal.) It would be far more honest to issue one line: "The Federal Reserve will adjust capital requirements as it sees fit." Period.

The result is easy to foresee. "Counter-cyclical capital" and "macro-prudential policy" will become one more completely discretionary and judgmental policy tool for the Fed to command the banks.  It will be subject to intense political forces. The Fed will get it wrong, and feed the flames.  The fallout for the Fed, for good monetary policy, and for the economy will not be good.

While we're on gobbledy-gook language and the revealed confusion by our aspiring technocrats, the  "real economy" language is sad. From WSJ, the ECB

 will cut the interest rate to as low as minus 0.4%—the ECB paying the banks—if the banks lend more to the real economy than a benchmark amount linked to their recent loans.

Here we are in 2016, and our central bankers are peddling the medieval distinction between "real" and "financial" investment. Yes, ordinary Joe can be excused from this fallacy. But people with economics PhDs are supposed to understand that every asset is also a liability. Individually we can "buy paper, not real things." Collectively, we cannot.

“The market would much rather companies take the ECB’s cheap money and use it to buy each other,” said Robert Buckland, an equity strategist at Citigroup Inc.

OK, so even private sector equity strategists can get it wrong. But central bankers are supposed to understand accounting identities. I hope these are journalistic misunderstandings and not an accurate reflection of thinking at the ECB.

Oh, and on negative rates:

German reinsurer Munich Re said it plans to store more than €10 million ($11.3 million) of physical bank notes in vaults to test the feasibility of avoiding negative rates.

The ECB may have to get going on Miles' Kimball's plan to devalue currency relative to bank reserves!

The Habit Habit

The Habit Habit. This is an essay expanding slightly on a talk I gave at the University of Melbourne's excellent "Finance Down Under" conference. The slides

(Note: This post uses mathjax for equations and has embedded graphs. Some places that pick up the post don't show these elements. If you can't see them or links come back to the original. Two shift-refreshes seem to cure Safari showing "math processing error".)

Habit past: I start with a quick review of the habit model. I highlight some successes as well as areas where the model needs improvement, that I think would be productive to address.

Habit present: I survey of many current parallel approaches including long run risks, idiosyncratic risks, heterogenous preferences, rare disasters, probability mistakes -- both behavioral and from ambiguity aversion -- and debt or institutional finance. I stress how all these approaches produce quite similar results and mechanisms. They all introduce a business-cycle state variable into the discount factor, so they all give rise to more risk aversion in bad times. The habit model, though less popular than some alternatives, is at least still a contender, and more parsimonious in many ways,

Habits future: I speculate with some simple models that time-varying risk premiums as captured by the habit model can produce a theory of risk-averse recessions, produced by varying risk aversion and precautionary saving, as an alternative to  Keynesian flow constraints or new Keynesian intertemporal substitution. People stopped consuming and investing in 2008 because they were scared to death, not because they wanted less consumption today in return for more consumption tomorrow.

Throughout, the essay focuses on challenges for future research, in many cases that seem like low hanging fruit. PhD students seeking advice on thesis topics: I'll tell you to read this. It also may be useful to colleagues as a teaching note on macro-asset pricing models. (Note, the parallel sections of my coursera class "Asset Pricing" cover some of the same material.)

I'll tempt you with one little exercise taken from late in the essay.


A representative consumer with a fixed habit \(x\) lives in a permanent income economy, with endowment \(e_0\) at time 0 and random endowment \(e_1\) at time 1. With a discount factor \(\beta=R^f=1\), the problem is

\[ \max\frac{(c_{0}-x)^{1-\gamma}}{1-\gamma}+E\left[ \frac {(c_{1}-x)^{1-\gamma}}{1-\gamma}\right] \] \[ c_{1} = e_{0}-c_{0} +e_{1} \] \[ e_{1} =\left\{ e_{h},e_{l}\right\} \; pr(e_{l})=\pi. \] The solution results from the first order condition \[ \left( c_{0}-x\right) ^{-\gamma}=E\left[ (c_{1}-x)^{-\gamma}\right] \] i.e., \[ \left( c_{0}-x\right) ^{-\gamma}=\pi(e_{0}-c_{0}+e_{l}-x)^{-\gamma}% +(1-\pi)(e_{0}-c_{0}+e_{h}-x)^{-\gamma}% \] I solve this equation numerically for \(c_{0}\).

The first picture shows consumption \(c_0\) as a function of first period endowment \(e_0\) for \(e_{h}=2\), \(e_{l}=0.9\), \(x=1\), \(\gamma=2\) and \(\pi=1/100\).

The case that one state is a rare disaster is not special. In a general case, the consumer starts to focus more and more on the worst-possible state as risk aversion rises. Therefore, the model with any other distribution and the same worst-possible state looks much like this one.

Watch the blue \(c_0\) line first. Starting from the right, when first-period endowment \(e_{0}\) is abundant, the consumer follows standard permanent income advice. The slope of the line connecting initial endowment \(e_{0}\) to consumption \(c_{0}\) is about 1/2, as the consumer splits his large endowment \(e_{0}\) between period 0 and the single additional period 1.

As endowment \(e_{0}\) declines, however, this behavior changes. For very low endowments \(e_{0}\approx 1\) relative to the nearly certain better future \(e_{h}=2\), the permanent income consumer would borrow to finance consumption in period 0. The habit consumer reduces consumption instead. As endowment \(e_{0}\) declines towards \(x=1\), the marginal propensity to consume becomes nearly one. The consumer reduces consumption one for one with income.

The next graph presents marginal utility times probability, \(u^{\prime}(c_{0})=(c_{0}-x)^{-\gamma}\), and \(\pi_{i}u^{\prime}(c_{i})=\pi _{i}(c_{i}-x)^{-\gamma},i=h,l\). By the first order condition, the former is equal to the sum of the latter two. \ But which state of the world is the more important consideration? When consumption is abundant in both periods on the right side of the graph, marginal utility \(u^{\prime}(c_{0})\) is almost entirely equated to marginal utility in the 99 times more likely good state \((1-\pi)u^{\prime}(c_{h})\). So, the consumer basically ignores the bad state and acts like a perfect foresight or permanent-income intertemporal-substitution consumer, considering consumption today vs. consumption in the good state.

In bad times, however, on the left side of the graph, if the consumer thinks about leaving very little for the future, or even borrowing, consumption in the unlikely bad state approaches the habit. Now the marginal utility of the bad state starts to skyrocket compared to that of the good state. The consumer must leave some positive amount saved so that the bad state does not turn disastrous -- even though he has a 99% chance of doubling his income in the next period (\(e_{h}=2\), \(e_{0}=1\)). Marginal utility at time 0, \(u^{\prime }(c_{0})\) now tracks \(\pi_{l}u^{\prime}(c_{l})\) almost perfectly.

In these graphs, then, we see behavior that motivates and is captured by many different kinds of models:

1. Consumption moves more with income in bad times.

This behavior is familiar from buffer-stock models, in which agents wish to smooth intertemporally, but can't borrow when wealth is low....

2. In bad times, consumers start to pay inordinate attention to rare bad states of nature.

This behavior is similar to time-varying rare disaster probability models, behavioral models, or to minimax ambiguity aversion models. At low values of consumption, the consumer's entire behavior \(c_{0}\) is driven by the tradeoff between consumption today \(c_{0}\) and consumption in a state \(c_{l}\) that has a 1/100 probability of occurrence, ignoring the state with 99/100 probability.

This little habit model also gives a natural account of endogenous time-varying attention to rare events.

The point is not to argue that habit models persuasively dominate the others. The point is just that there seems to be a range of behavior that theorists intuit, and that many models capture.

When consumption falls close to habit, risk aversion rises, stock prices fall, so by Q theory investment falls. We nearly have a multiplier-accelerator, due to rising risk aversion in bad times: Consumption falls with mpc approaching one, and investment falls as well. The paper gives some hints about how that might work in a real model.

Tilting at Bubbles

Source: Wall Street Journal

The Wall Street Journal reports on the "Fed's Unsolved Puzzle: How to Deflate Bubbles" (That's the print version headline, much pithier than online.)

I thought I was reading The Onion. There it is, a graph marked "Asset Bubbles," measured, apparently, with interferometer precision.


I must have been asleep or something, since the last time I touched base with finance, mid-yesterday, we still didn't have an operational definition of "bubble," let alone a way of measuring one, beyond academics and Fed officials looking out their office windows and opining that prices seem awfully high (but not quite enough for them to put on a big short.) Let alone any scientific understanding of what policies might calm such bogeymen. How does the Fed know a "bubble" from a "boom," an "irrational valuation" from a rational willingness to take risk in a slow but steady real economy?

And, much more importantly, when did it become the Fed's job to diagnose and prick its perceptions of asset price "bubbles?"

Yet here we read

Six years after the financial crisis ended, the central bank remained ill-equipped to quell the kind of dangerous asset bubbles that destabilized the savings-and-loan industry during the late 1980s, tech stocks in the 1990s and housing in the mid-2000s.

...financial bubbles have been root causes of the past three recessions

 Iowa farmland prices rose 28% between the fourth quarter of 2010 and the fourth quarter of 2011, igniting fears of a dangerous bubble

Apparently "bubbles" have made their way from Monday-morning quarterbacking to established and measurable facts. (To clarify, this is a news story not an editorial, and the reporters, Jon Hilsenrath and David Harrison, are just passing on what they hear. )

Commercial real-estate prices are soaring and Fed officials face the conundrum of what, if anything, to do.

Fed officials said afterward they saw they lacked clear-cut tools or a proper road map of regulatory measures to help stem the simulated booms.

Even though many Fed officials favor using regulatory powers over interest rates to stop bubbles, the U.S. was a “long way” from establishing a regulatory system that could achieve that, Mr. Dudley said in September. 

Your darn tootin' they face that conundrum. Because diagnosing the sources of, and controlling, asset and real estate prices is not, and never has been, part of the Fed's job. 

The Fed has great power and independence. The price of that power and independence is limited sphere of action. It's also wise. Once the Fed becomes the central planner of real estate prices, and allocator of credit to control prices, it will neatly be sandwiched into a political role. Sellers and developers want more, and chant "prices are depressed, stimulate." Buyers want less and chant "pop this bubble" (but give me credit to buy.) The only possible answer is, real estate prices are just not our business.

Central banks have always been severely limited by statute and tradition to what they can try to control, and what tools they can use, in return for their independence. Traditionally, the central bank bought only short-term treasuries, and controlled only short-term interest rates, and its targets were limited to inflation and employment.  Intervening in mortgage backed security and long term treasury markets is already a stretch. Using interest rates to target asset prices is a stretch. Using regulatory power, to allocate credit, to control real estate prices, is way, way beyond the Fed's mandate.

Memo to Fed:  There is already a chorus angry at how much you exceed your sphere now. You may regard them as ill-informed peasants with pitchforks, but they happen to occupy seats in Congress and they're writing bills. If you decide to judge whether the price of farmland in Iowa is a "bubble," and to use your regulatory powers to stifle credit to Iowa farmers with the goal of determining the just price of farmland, those peasants with pitchforks aren't going to take it quietly.

The Fed has neither authority, mandate, road map, nor regulatory measures, because controlling real estate prices is no more its job than controlling carbon emissions. Congress could change that, and give the Fed broad authority. But it has not done so.

To be fair, perhaps this is a natural extension. The Fed took on the job of propping up house, bond, and arguably stock prices in the recession, and there is not a huge outburst of complaint. Perhaps therefore it is entitled to tamp down house, bond, and stock prices in a boom, if it so desires. Oh wait, there is a huge outburst of complaint.

Mr. Rosengren [president of the Boston Fed] had noticed more building cranes in Boston.

“Given our low interest rates, given that it is an interest-sensitive sector, it is probably worthwhile to start thinking about at what point do we become concerned that is growing too rapidly,” he said.

The Fed’s low interest-rate policies have helped drive investors into such assets as commercial real estate as they search for higher returns.

Fed officials said afterward they saw they lacked clear-cut tools or a proper road map of regulatory measures to help stem the simulated booms. (Repeated, with emphasis) 

The vague rationale for intervention is that there is a difference between "boom" and "bubble," between asset prices that are high because of "real" valuations vs. "irrational" ones, between something like "supply" and "demand" and somehow the Fed can tell in real time, offset the bad and allow the good. But that all disappeared in the above paragraphs. Boom and bubble are now the same. And we're not even talking about national or "systemic" "bubbles" anymore. Now the Fed is supposed to worry about the price of farmland in Iowa

This is how it's supposed to work. The Fed lowered interest rates, that raises asset values, higher asset values induce people to invest, which is "stimulative." Q theory 101. How do we know it's "too much?"

Despite the action in commercial real estate, debt levels across the broader financial system are still modest. Overall U.S. financial sector debt— $15.2 trillion in the second quarter—was down 16% from the third quarter of 2008. Financial sector debt has fallen to 84% of economic output from 125%, a sign the economy is less prone to a financial crisis on the scale of 2008.

“Our quantitative measures indicate a subdued level of overall vulnerability in the U.S. financial system,” Fed economists said in an August research paper that sought to assess risks of banks and markets overheating.

Now we're getting somewhere. How are asset price gyrations a "risk" anyway? Answer: if and only if they make their way through debt to default and runs. The right answer to such worries is to make sure there isn't a lot of debt in the way, and let asset prices do whatever they want to do. Keep people from storing gas in the basement; don't try to stop them from ever lighting a candle. The project that the Fed will micro manage prices so nobody ever loses money again is hopeless.

And the bottom graph looks pretty darn good. So what is the worry? If there is no debt in the way, why must the Fed try to control prices?

Some of them, including Ms. George [president of the Federal Reserve Bank of Kansas City] said rates weren’t the right instrument to use against bubbles. She favored demanding banks hold more capital.

Excellent! (I presume she was misquoted, as banks issue capital, they don't hold it, but a minor quibble.)

The graph: I looked up the original here, in a nice paper titled "Mapping Heat in the U.S. Financial System." The paper does not pretend to define or measure "bubbles." It's a nice index number/visualization/forecasting exercise with many more pretty graphs.

Fixed-income comments

A month ago,  I attended the SF Fed/Bank of Canada conference on fixed income. I had the chance to comment on Michael Bauer and Jim Hamilton's "Robust Bond Risk Premia.” My comments here.

As usual when faced with a really nice paper, I used most of my discussion time to survey the field and give my views on current facts and challenges, which is why my comments might be interesting to blog readers.

Some highlights: I reran regressions of bond returns in the style of Joslin, Priebsch, and Singleton, forecasting returns with the first  three principal components of yields, and growth and inflation. Here are the results:

First row: the slope factor forecasts returns with the usual 18% R2. Second row: Inflation and growth do not forecast returns at all. Third row: in combination with the first three principal components, the R2 rises to 0.26 by adding growth and inflation. Inflation now becomes a significant predictor, and its presence raises the coefficient and t statistic on the level and slope factors. This is an interesting OLS puzzle.

If you plot inflation, you see it is mostly a downward trend in this sample period. So, it occurred to me, what if I used a trend instead? The last two rows of the table add a trend. Indeed, with the trend, growth and inflation disappear. In fact, we can drop growth, inflation, and the third principal component, forecast returns with amazing t statistics and an R2 of 0.62, which must be an all time high.

What's going on here? Is the trend just picking up a trend in returns? Here is a plot of expected returns (a + b x_t) and actual returns (r_t+1) for four of the models in Table 1.

The point: the trend is not just picking up a trend in returns. And the 62% R2 is not a pathology of one big outlier, a trend, or something else.  Instead, the trend serves to filter the level factor, and to a lesser extent the slope factor. The message is not "a trend seems to forecast a trend in returns" but "the cyclical variations picked up by detrended level and slope factors seem to forecast returns."

So what does this all mean? Is this proof growth and inflation don't work because they are driven out by trends? No, the trend is after all a proxy for something economic.  (This is roughly Cieslak and Povala's point, who get over 50% R2 in a longer sample with smoothed inflation.) Is this all a big econometric goof, because serially correlated right hand variables are a mistake? No, and my comments go into this at length. Bauer and Hamilton's point is this econometric problem, but they don't get close to t statistics of 10. OLS cares about serial correlation of the residuals, but not of the right hand variables.  In the end, it's a interpretation issue, not an econometric one.

The biggest point of my comments: It's time to get past forecasting returns one at a time. Classic finance got past "is AT&T a good investment?" in the 1960s, after all, and moved on to portfolios and covariances. Here, the more interesting outstanding question is the factor structure of expected returns  -- do expected returns on all bonds move together over time? -- and the risk premium question -- what are the factors, covariance with which drives that variation in expected returns?

To this question, perhaps we should take a lesson from the VAR literature of the 1980s, and stop worrying tremendously about equation by equation parsimony in forecasting. Instead, accept that forecasting regressions will be a somewhat overfit, but put our attention in the cross-equation structure of forecasts.

To be specific, the next graph shows the expected returns of bonds with maturity 1-10 years -- the fitted value of each bond's return-forecasting regression. The graph is clear: these are not 10 different series. The expected returns on all bonds move in lockstep. There is a strong one-factor structure in expected returns.

Finance 101: Expected return = covariance of return with something, times risk premium. What's that something? In this context, the bonds whose expected return moves most over time should have returns that covary proportionally more with some factor. What is it? The next picture plots how much each bond moves with the common factor shown in Figure 11 against the covariance of the 10 bond returns with innovations in the bond principal components, growth, and inflation.

Again, the pattern is pretty clear: time-varying expected return corresponds completely with covariances with the level factor. Covariances with the other factors are all about zero, and do not vary in the same way as expected returns.

In sum, this simple exploration shows a pretty strong pattern: 1) There is a strong one-factor model of expected returns -- expected returns on bonds of all maturity move together over time. 2) There is a strong one-factor model of risk: the single time-varying risk premium in all bonds corresponds to covariance with a single factor, innovations to the level of interest rates.

This is all very simplified of course. The point: This kind of characterization of the joint behavior of bonds of various maturities -- and later of bonds, stocks, and foreign exchange -- seems like a more interesting unanswered question than the precise identity of forecasting variables for each security, taken in isolation.

These points are a bit of a rehash of older papers, Decomposing the yield curve and more generally  Discount Rates. But they are also an extension --- the "Decomposing the yield curve" point holds using the JPS forecasters and factors, and updated data.  This kind of inquiry needs a lot more work.

Hounded out of business II

Nathaniel Popper at the New York Times Dealbook, writes "Dream of New Kind of Credit Union Is Extinguished by Bureaucracy" It's a worthy addition to the series of anecdotes on how regulation, especially discretionary actions of regulators, are killing investment and businesses.

Again, we collect anecdotes as a challenge to measurement. There is no data series on numbers of businesses driven away by regulation. Yet.

This is a good anecdote, as it illustrates a too little reported underbelly of financial regulation.

Mr. Kahle saw how hard it was for the employees at his firm to obtain loans, and more broadly, how the existing financial system had helped contribute to the financial crisis. He thought he could do things differently, and he aimed to prove it when he began applying to open a credit union in early 2011.

Since then, the credit union has faced a barrage of regulatory audits and limitations on its operations, ...Now, Mr. Kahle is giving up on his dream of creating a new kind of bank, ...

...the troubles faced by his Internet Archive Federal Credit Union point to how difficult it can be to try out anything new in the heavily regulated industry.
After an 18-month application process, regulators let the Internet Archive Federal Credit Union open in 2012, but with restrictions that did not allow it to offer basic banking products, such as debit cards and online banking.

Mr. Modell said that during the 18-month application process, he and Mr. Kahle made 4,756 changes to their application and made it through only because of Mr. Kahle’s wealth.  “I could afford to say yes at every turn — every time they made some weird demand,” Mr. Kahle said. 

When they did get their charter from the N.C.U.A. in August 2012 — the first new credit union chartered that year — the Internet Archive Federal Credit Union was limited by the regulators to loans of $5,000 or less, and it could generally serve only people in a small area around New Brunswick, N.J., where the credit union was located.

It's a wonder that the US is still only in the mid 40s on the world bank's list of how hard it is to start a new business.  But just getting going, with restrictions that make profitability essentially impossible, is only the beginning.

it [the credit union] has faced a steady stream of official exams since: 11 in 14 months. In August, the credit union, by its own count, spent 187 hours dealing with regulators and only 61 hours dealing with customers.

The credit union’s other ideas for expansion were also shot down. In 2014, the Internet Archive Federal Credit Union tried to team up with an organization for migrant workers, the Farmworker Support Committee, to offer bank accounts and cheaper money transfers, but the idea was eventually rejected by an N.C.U.A. examiner.

And when the regulators turn against you, they know how to turn the screws:

Mr. Modell and Mr. Kahle said the red flags raised by the N.C.U.A. examiners had been over small discrepancies and record-keeping issues — and often turned out to be factually wrong.

“None of the compliance issues listed in the report were correct,” the credit union wrote in an appeal sent to the N.C.U.A. in May, after the agency lowered the credit union’s regulatory rating.

The N.C.U.A. sent its examiners on an increasingly frequent basis and requested more and more monthly reports from Mr. Modell... By mid-2014, the credit union had made less than $50,000 in loans and Mr. Kahle suggested to Mr. Modell that it was time to give up

And this business seems pretty much a poster child of benevolent capitalism:

“The original vision of this thing — of helping nonprofit workers, or helping the poor — they will not allow it,” Mr. Kahle said.

Given the bad press payday lenders get, this is doubly sad. The quantifiable result:

the number of credit unions in the United States has been shrinking each year since the crisis. There are around 6,300 credit unions, down from 7,000 in 2012 and 8,400 in 2007.

The larger backdrop would be amusing if it were not tragic. While the monetary policy part of the Fed has wanted stimulus and more lending, the regulatory apparatus has apparently been busy making sure banks don't lend, at least to anyone who needs the money, new banks don't start, and financial innovations don't emerge.

Update: LabMD CEO Michael J. Dougherty has a blog and a book.

The 13 Trillion Dollar Question

On Tuesday Nov 10 there will be a conference in Chicago on "The $13 Trillion Question: Managing the U.S. Government’s Debt" hosted by the Initiative on Global Markets at Chicago Booth, and the Hutchins Center on Fiscal and Monetary Policy at Brookings. (The Brookings announcement here.)

Robin Greenwood will present "The Optimal Maturity of Government Debt and Debt Management Conflicts between the U.S. Treasury and the Federal Reserve" arguing that the Fed and Treasury are working to cross-purposes -- the Fed buys what the Treasury sells -- and that the government  should go after low rates on long term bonds rather than the budget insurance of issuing long term bonds.

(The government faces the same decision a homeowner does: borrow at near-zero floating rates,  but maybe rates shoot up and so do your payments, or borrow long at 2% rates, and pay more if rates don't go up. Robin and Larry favor the former. I'm more risk averse. Maybe living in California has sensitized me  that just because you haven't seen an earthquake recently doesn't mean you shouldn't buy earthquake insurance. But it's a good argument to have qualitatively -- what's the risk, and what's the reward.)

I will present "A new structure for Federal Debt," arguing for an overhaul of which instruments the Treasury issues, to make them more useful for financial markets and financial stability as well as for government borrowing and risk management. (Earlier blog post about this paper here.)

There will be extensive discussion and broader issues, and (the big draw) a panel of Seth  Carpenter, Charles Evans, and Sara Sprung, moderated by David Wessel.

The conference is by invitation, but you can still sign up here until they run out of room, or email Jennifer (dot) Williams at chicagobooth (dot) edu. It will also be viewable by live webcast, link here, starting 1:30 central.

Update: Video of the event here.



Program

Session I - The Optimal Maturity of Government Debt and Debt Management Conflicts between the U.S. Treasury and the Federal Reserve

Speakers

Robin Greenwood, George Gund Professor of Finance and Banking, Harvard Business School
Samuel G. Hanson, Assistant Professor of Business Administration, Harvard Business School

Discussant

Guido Lorenzoni, Breen Family Professor, Northwestern University

Moderator

Austan Goolsbee, Robert P. Gwinn Professor of Economics, University of Chicago Booth School of Business

Session II - A New Structure for U.S. Federal Debt

Speaker

John H. Cochrane, Senior Fellow, Hoover Institution and Distinguished Senior Fellow, University of Chicago Booth School of Business

Discussant

James J. McAndrews, Executive Vice President, Federal Reserve Bank of New York

Moderator

Anil K Kashyap, Edward Eagle Brown Professor of Economics and Finance, University of Chicago Booth School of Business

Session III - Panel Discussion

Panelists

Seth B. Carpenter, Assistant Secretary for Financial Markets, Department of the Treasury
Charles Evans, President and Chief Executive Officer, Federal Reserve Bank of Chicago
Sara Sprung, Managing Director, Neuberger Berman

Moderator

David Wessel, Director, The Hutchins Center on Fiscal and Monetary Policy, Brookings Institution

An essay. It's an overview of what a growth-oriented policy program might look like. Regulation, finance, health, energy and environment, taxes, debt social security and medicare, social programs, labor law, immigration, education, and more. There is a more permanent version here and pdf version here. This version shows on blogger, but if your reader mangles it, the version on my blog or one of the above will work better.

I wrote it the Focusing the presidential debates initiative. The freedom of authors in that initiative to disagree is clear.

Economic Growth

Growth is central

Sclerotic growth is the overriding economic issue of our time. From 1950 to 2000 the US economy grew at an average rate of 3.5% per year. Since 2000, it has grown at half that rate, 1.7%. From the bottom of the great recession in 2009, usually a time of super-fast catch-up growth, it has only grown at two percent per year.² Two percent, or less, is starting to look like the new normal.

Small percentages hide a large reality. The average American is more than three times better off than his or her counterpart in 1950. Real GDP per person has risen from $16,000 in 1952 to over $50,000 today, both measured in 2009 dollars. Many pundits seem to remember the 1950s fondly, but $16,000 per person is a lot less than $50,000!

If the US economy had grown at 2% rather than 3.5% since 1950, income per person by 2000 would have been $23,000 not $50,000. That’s a huge difference. Nowhere in economic policy are we even talking about events that will double, or halve, the average American’s living standards in the next generation.

Even these large numbers understate reality.

GDP per capita does not capture the increase in lifespan — nearly 10 years — in health, in environmental quality, security and quality of life that we have experienced. The average American today lives far better than a 1950s American would if he or she had three rather than one 1950s cars, TVs, telephones, encyclopedias (in place of internet), or three annual visits to a 1950s doctor.

But even these less quantified benefits flow from economic growth. Only wealthy countries can afford environmental protection and advanced health care. We can afford to worry about global warming. India worries about 600 people per toilet, emphysema from burning cow patties, and easily treatable parasitic infections. Our ability to defend freedom around the world — even if we are wise enough to do it sensibly — depends on robust economic growth. If GDP had grown at 2%, not 3.5%, we would only be able to afford half the military we have today. The immense improvements in the quality of goods and many services we have today are part of the engine of economic growth.

Looking forward, solving almost all our problems hinges on reestablishing robust economic growth. Tax revenue equals tax rate times income, and growth determines how much income there will be. The amount of tax revenue our government has available to pay off debt and to pay the ballooning social security and health care expenses depends almost entirely on economic growth. Larger tax rates can’t come close to raising that much money.

For example, the Congressional Budget Office, making its regular gloomy analysis of the US long-run budget outlook, assumes 2.2% growth from now until 2040.³ But if GDP grew by 3.5% instead, even with no structural reforms at all, GDP in 2040 would be 38% higher, tax revenues would be 38% higher, and a lot of the problem would go away on its own. A 38% increase in Federal Revenue by higher tax rates or a 38% cut in spending are unlikely. Conversely, if GDP only grows 1%, GDP and tax revenues will be 26% lower than the CBO forecasts, which will force a fiscal crisis.

38% more income — or 26% less income — drives just about any agenda one could wish for, from strong defense, to environmental protection, to the affordability of social programs, to the welfare of any segment of the population, to public investments, health, and fundamental research.

And 3.5% is only a return to the post-WWII norm. Pre-2000 economic policies were not ideal. If we achieve 4% or more growth, even greater benefits occur.

The source of growth

Over long periods of time, economic growth comes from one source: productivity, the value of goods and services each worker can produce in a unit of time.

In turn, productivity comes from new ways of doing things. New ideas, at heart; new inventions, new products, new processes, new technology; new ways of organizing companies; new and better skills among workers. Southwest Airlines figuring out how to turn a plane around in 20 minutes, and Walmart mastering supply logistics, are as much productivity growth as installing scanners or ATMs. Workers who know how to use computers rather than shovels produce a lot more per hour.

Higher productivity typically comes from new companies, which displace old companies — and displace the profits of their owners, and the healthy pay and settled lives of their managers and workers. Southwest enters and either displaces the legacy carriers — Pan Am and TWA — or forces wrenching changes for survivors such as American and United. A&P displaced mom and pop stores. Walmart displaced A&P. Amazon may displace Walmart. Nobody likes the process. Everyone needs the results.

Nothing other than productivity matters in the long run. A factor of three increase in income in 50 years, and the much larger rise in income and health since the dawn of the industrial age, dwarfs what unions bargaining for better wages, progressive taxes or redistribution, monetary, fiscal or other stimulus programs, minimum wage laws or other Federal regulation of labor markets, price caps and supports, subsidies, or much of anything else the government can do.

More people working, and working longer hours, can improve income a bit, but soon runs in to an upper limit. Our grandparents worked long hours, but were much worse off than we are.

Saving, investment and capital formation can improve income a bit, but its benefit is limited as well. A 1950 worker working with twice as many 1950 machines produces much less than a modern worker using current technology. Only new ideas, new products, new technologies, new organizations, and new skills produce such huge increases in prosperity.

In this context, the decline of US GDP growth coincides with more worrying changes. Productivity growth is declining. New business formation is sharply down. Mobility of people from job to job has declined.

Restoring growth: a general strategy

A debate rages among economists why America’s growth has slowed. Most commentators advocate one side of that debate, and advocate strong policies according to their favorite theory. Lots of new ideas and grand policy programs are being dreamed up. Someone putting together a policy program might feel they have to choose a side in that debate, or they might wish to let that debate settle, to identify the most important policies.

Either approach is, I think, a mistake, given the urgency and magnitude of the problem, and given the likelihood that such a highly politicized economic debate will come to useful resolution anytime soon.

Let us instead work on the simple, common-sense things that everyone knows are broken, everyone understands are retarding growth, and that when fixed can increase growth. As opposed to looking for big magic bullets, new and clever theories, and ignoring the simple problems staring us in the face.

Will this approach restore 3.5% growth? Will it bring us to 4% or more growth? Well, really, it doesn't matter. When we have a big problem, and we know simple steps will help that problem, we should take those steps. We should do so, especially, because most of these simple steps can be taken at no fundamental economic or other cost.

Our economy is like a garden, but the garden is choked with weeds. Rather than look for some great new fertilizer to throw on it, why don’t we get down on our knees and pull up the weeds? At least we know weeding works! For another metaphor, our economy has become like a hoarder’s house. For a while he could get through the passages and keep life going, but now the junk is closing in. Well, rather than read the architectural magazines about just what the perfect house will look like, let’s get to work cleaning up the mess.

Politics

Alas, such a common-sense, weed-the-garden program has little attraction to many ambitious politicians. Many politicians want a big new program, big new laws and initiatives — a New Deal, a Fair Deal, a Great Society. They don’t see cleaning up the mess left behind by their predecessors as the way to getting one’s face carved on Mt. Rushmore, let alone to win an election. Economists like big new ideas and programs too. Nobody got a Nobel prize for saying, let’s take Adam Smith’s 250 year old classics to heart.

But it is a big idea, a big program, and one that needs and will reward the courageous leadership of great politicians. Everybody has to give up their little deal, protection, tax break and subsidy; everyone has to allow their businesses or profession to be open to competition. Each person must understand that the small loss that he or she will experience directly will be more than made up by everyone else giving up theirs. Politically, rather than fall back on “I’ll support your little deal, you support mine,” everyone has to become part of the coalition that supports reform — “no, I’m not getting mine, so I’m not going to support you getting yours.”

Forming such a coalition and keeping it together is hard. It is the essence of what great politicians can achieve.

Cleaning out the weeds also needs a large effort of simple governance. The President has to revisit and rewrite the mass of executive orders and memos. The Congress has to get serious and pass laws that are actually laws, not thousand page instructions for agencies to figure things out. It has to get around to repealing laws everyone understands are bad — the Jones act restricting shipping, the ban on oil exports, and so on — and reforming laws that everyone understands need to be reformed. It needs to actually follow its own budget law. The heads of agencies will have to renew the staff and reorient them to growth-oriented policy, and undertake a sweeping house-cleaning of regulations and procedures. They will have to implement managerial techniques such as pervasive cost-benefit analysis, regular retrospective review, and sunsets.

All of this is hard too. But it is the basic work of competent, growth-oriented government.

It is tempting to cast the question before us as growth vs. redistribution, or growth vs. inequality, as the rhetoric of redistribution and inequality pervades the arguments from those who want to continue the policies that are strangling growth.

But giving in to that rhetoric is a mistake. The US, in fact, has one of the most progressive tax systems in the world. And the relatively minor costs of government assistance to truly poor, needy, mentally ill or disabled people are not major impediments to growth. The weeds choking the economy represent cronyist redistribution to wealthy people, well-connected industries, and other powerful groups such as public employee unions, and large transfers among middle income people (social security and medicare). They are not, by and large, the result of genuine and effective redistribution from rich to needy poor.

When the average person (voter) expresses concern over inequality, what they really mean is that they are concerned that average people are not getting ahead economically. If the average person were getting ahead, whether some big shot CEOs fly on private jets or not would make little difference. Conversely, the average voter, if not the average left-wing pundit, does not support equality of misery. If the average person continues to do poorly, it would bring them little solace for the government to tax away the lifestyles of the rich and famous.

Long-term robust economic growth is the only way to deliver sustained improvements in the lot of average Americans, and the less fortunate in particular. Redistributing Marie-Antoinette’s jewelry did little for the average French farmer.

The golden rule of economic policy is: Do not transfer incomes by distorting prices or slowing competition and innovation. The golden rule of political economics seems to be: Transfer incomes by distorting prices and regulating away competition. Doing so attracts a lot less attention than on-budget transfers or subsidies. It takes great political leadership to force the political process to obey the economic rule.

Regulation

The vast expansion in regulation is the most obvious change in public policy accompanying America’s growth slowdown. Most recently, under the Dodd-Frank act and the ACA or Obamacare, these two large segments of the economy have seen radical increases in regulatory intervention. But environmental, labor, product, and energy regulation have all increased dramatically as well.⁴

Sometimes, regulation slows growth in return for public benefits, such as environmental protection or transportation safety. One can argue whether it does so efficiently, but there is a purpose.

Most economic regulation, however, is specifically designed to slow growth. The purpose of most economic regulation is to transfer money to a specific group of people, companies, or industry. It does so by slowing down new entrants, impeding competition, mandating uneconomic actions or cross-subsidies, slowing innovation, turning off price signals, distorting incentives, and encouraging waste. These are the tools of economic regulation, and they all impede economic growth.

People often complain that there are too many rules and regulations, or that the cost of filling out forms is too high, that there is too much red tape, that there are too many lobbyists, or that the direct measurable costs on industry are too large. The economic impact of regulation goes far beyond these standard complaints. The overwhelming cost of regulation is the economic dislocation: companies not started, products not produced, innovations not innovated, people not hired, costs not slashed, prices too high. And growth too slow. Just because it’s harder to measure these costs does not mean that these are not the overwhelmingly more important costs, and the costs that we need to address.

Economic regulation has left behind the rule-of-law framework that many Americans suppose governs their affairs. In the popular imagination, regulation is about rules, and there are just too many of them. In many areas, however, the regulations are so vast, so complex, self-contradictory and so vague, that they basically give the regulators free rein to do what they want. In many cases, there is not a set of rules that you can read and comply with. You need to ask for preemptive permission from a regulator, who determines if your project can go ahead. Delay in getting needed approval is as good as denial in many cases. Projects that cost millions cannot bear years or often decades of delay in getting approvals.

In other cases, vague and expansive laws and regulations give regulators ammunition to pursue a few selected victims, to extort big settlements or send a few examples to jail. And by doing so to frighten the others into following the regulators’ commandments. In many areas just about everyone is in technical violation of some law or regulation.

We are used to the right to see evidence against us, challenge witness testimony, and appeal decisions to an independent and higher court. These rights often do not apply to regulations, where the agency is prosecutor, police, judge, jury, and executioner all wrapped in one. The methods for determining an “abusive” practice or “discriminatory” outcome are not revealed ahead of time so that people could structure their actions in accordance with the rules.

Much of this state of affairs is Congress’ fault, for writing long vague bills which devolve legal power to the agencies. But in an increasing trend, regulatory agencies are going far beyond even the clear limits of their statutory authority and writing rules or commanding outcomes clearly far beyond the plain language of the law. The EPAs expansion of carbon regulation and the definition of wetland are good cases in point.

The popular debate is about “more” vs. “less” regulation. Regulation is not more or less, regulation is effective or ineffective, smarter or dumber, full of unintended consequences or well-designed, captured by industry or effective, based on rules or based on regulator whim, accountable or arbitrary, evaluated by rigorous cost benefit standards or by political winds, distorting economic activity or supporting it, and so forth.

So “de-regulation” is also an inappropriate slogan. “Smart regulation,” or “growth-oriented regulation” are much better descriptors of what needs to be done.

Finance

Financial regulation, even more transparently than other regulation, is just about who gives money and who gets money.

Under the Dodd-Frank act, a highly regulated industry has become suffocatingly regulated. The Federal Reserve embeds hundreds of employees at each major bank, who pass judgment on every decision. The justice department and SEC routinely pursue banks and other financial institutions for multibillion dollar settlements, and now will pursue individuals with criminal charges. The fixed costs of running a compliance department are so high that it is nearly impossible to start a new financial company in the US. Just one new bank has been chartered since the passage of Dodd-Frank.

The parts of the financial system that failed and were bailed out in 2008 — Fannie and Freddie, commercial banks — were already among the most highly regulated businesses in America. Regulation did not fail for being absent. Regulation failed for being ineffective.

Alas, the basic structure of the Dodd-Frank act simply doubles down on the same basic design that has failed again and again: The government guarantees a wide swath of debt, by promise (deposit insurance) and by ex-post bailout. An army of regulators tries to keep banks and other financial institutions from exploiting the guarantee and taking too much risk, and clairvoyantly to forecast panics and take action to stop them. That’s like sending your brother in law to Las Vegas with your credit card, but asking his kids to keep an eye on him.

Like much else in America, our government works to cross purposes. It subsidizes debt with tax deductibility, deposit insurance, too big to fail guarantees, regulatory preference for holding short-term assets, liquidity rules, credit guarantees, Fannie and Freddie, the home mortgage interest deduction, community reinvestment act, student loan programs and so forth. And then it tries to regulate against using debt with bank asset regulation, stress tests, consumer financial protection, macro-prudential policy, and so on.

The alternative is clearly laid out in many sources: Risky investments must be largely financed by issuing equity, not by borrowing very short term money. When that happens, the mass of regulation is simply not needed in order to stop financial crises. Then we will “only” face the task of removing needless regulations whose main purpose is to create subsidies and protections for various clienteles.

Health

The ACA, thousands of pages of law, tens of thousands of pages of regulations, and even more decision-making power by newly empowered regulators, such as the thousands of waivers given to individual companies, represents an enormous increase in Federal intervention in the market for health care and health insurance. Like finance, health was already highly regulated. And like finance, most of the ACA simply doubled down on the same basic regulatory structure that had caused so many pathologies before.

The central problem of preexisting conditions was an artifact of regulation. In the ideal form of health insurance, you buy cheap catastrophic insurance when young, but the insurance policy can follow you as you age, change jobs, and move from state to state, and does not radically increase premiums if you get sick.

Why don’t we have that ideal insurance? Because previous rounds of regulation outlawed it. In the 1940s the US government allowed tax deductions for employer-provided group insurance, but not employer contributions to individual insurance or individuals’ contributions to such insurance. By laws, insurance is not portable across state lines. Thus, there is no reason for anyone who might get a job or move to buy long-term individual insurance that protects against the emergence of pre-existing conditions. In response to the preexisting conditions problem, the ACA forces community rating — everyone pays the same price—tries to mandate healthy people to buy insurance, and steps up pressure on employer provided group plans, which are the source of the problem.

Similarly, once insurance was tax deductible, there was an incentive to salt it up. You would not buy car insurance that “paid for” oil changes — especially if you had to deal with insurance paperwork each time. But with a tax deduction it’s worth buying health insurance that “pays for” routine small expenses. Then the government (state and local too) instituted mandates that insurance must “pay for” — and, of course, charge premiums to cover — all sorts of additional procedures, which makes insurance too expensive.

We need to allow simple, portable, largely catastrophic, lifelong, guaranteed-renewable health insurance to emerge. Right now it’s illegal. To the extent that the government wishes to subsidize health insurance — and it should — then it should give straightforward vouchers, which people can use to buy insurance, or to fund health savings accounts. Such vouchers should take the place of Obamacare, Medicaid, and Medicare.

Health care and insurance is not just distorted from the demand side — too many people paying with someone else’s money. The supply side is ossifyingly restricted as well. New hospitals, new clinics that specialize in cheaply providing one service well, new doctors, new nurses, new insurance companies, all find a wall of laws, regulations, and officials blocking their path. For a reason: To maintain the profits of and cross-subsidies provided by the existing incumbents. Non-profit status itself blocks efficiency: you can’t take over an inefficient non-profit, and non-profits can’t issue equity to make important investments. In reducing the cost and improving the quality of health care, efficiency is far more important than trying to avoid a competitive rate of return to owners.

Energy and Environment

There are few places in the American government where one can witness inefficiency and growth-sapping regulatory bungling on the scale seen in our energy and much (not all) environmental regulation.

Like much else in America, our government pursues conflicting aims. It tries to subsidize and drive down the price of energy. And then it tries simultaneously to regulate against our using energy in a hundred different ham-handed ways, from mileage standards for cars, energy efficiency standards for windows and appliances, special parking places for electric vehicles,

$7,500 tax credits to subsidize $100,000 Tesla cars bought by silicon valley zillionaires, hundreds of annually extended tax credits for various energy boondoggles, and so forth.

The poster child for inefficiency may well be the mandate for gasoline producers to use ethanol. Corn ethanol, it turns out, does nothing to help the environment: It takes nearly as much petroleum energy to produce it as it contains, in the form of fertilizer, transport fuel and so on; it uses up valuable land, which directly emits greenhouse gases, and contributes to erosion and runoff; it drives up the price of food. The only thing sillier was the mandate to include cellulosic ethanol, because the government mandated a technology that simply did not work.

If you were wondering why we do this, it should come as no surprise that corn is produced by big companies in Iowa. If you need more evidence, note that the US also has heavy restrictions on the importation of sugar cane ethanol — as we restrict all sugar cane imports — which actually might be of some environmental benefit. The planet, of course, does not care whether corn is grown in Iowa or sugar cane in Brazil. Corn growers and sugar producers do care.

A litmus test for a presidential candidate ought to be the willingness to stand up in Iowa and say, “Ladies and Gentlemen, a huge government subsidy for corn ethanol is a rotten idea.”

Similarly, if you thought that subsidized production of photovoltaics and the various subsidies to putting solar cells on your roof, including the requirement that your fellow citizens buy electricity back from you at retail prices, are about the environment, you will be puzzled by our government’s heavy import restrictions on cheap Chinese made solar cells. Obviously, mother nature cares not where the cells are produced. Mother politics does.

Energy and transportation policy seem to indulge flights of magical thinking. California, facing a drought, and not having built water projects in decades, is going to spend well over $60 billion dollars on a high-speed rail line. This is advanced in the cause of carbon emission reduction. And quite literally, the case has been made that by building the rail line, we will lower global temperatures, and increase rainfall. If on a dollars per ton of carbon saved the rail line fails elementary cost-benefit analysis, on dollars per drop of water created, it fails the magic vs. reality test.

As this example makes clear, the Federal government is not alone. State and even local regulation is partly to blame as well.

Strong zoning laws forbid people from building houses near where they work, and forbid them from building workplaces near where people live, and from building shops near either. An electric car driving 60 miles is much less energy efficient than living in a high-rise apartment, in a mixed residential/commercial neighborhood, and walking!

A growth-oriented, and anti-cronyist energy policy is pretty simple. To the extent that the government wishes to reduce carbon emissions, impose a simple and straightforward carbon tax. In return, eliminate all the detailed mandates, subsidies, quantity regulations, and boondoggle unprofitable projects. If energy costs more, people will quickly figure out on their own what makes sense.

Energy is an economic paradox, as it is so highly regulated, with so much government picking of technologies, but simultaneously has such a flat long-run supply curve and there are so many technological alternatives. A large price of polluting energy is the most efficient way to induce clean energy innovation; far more efficient than massive amounts of federally subsidized research and development to financially unprofitable businesses and bureaucrats picking technologies. And price-induced behavior changes can reduce usage much more easily than mandating fancier technologies. Paying some attention to turning off the lights when you leave the room is more efficient than mandating LED bulbs and leaving the lights on.

If you are serious about carbon, let the words “nuclear power” pass your lips. We have sitting before us a technology that can easily supply our electricity and many transport needs, with zero carbon or methane emissions. New designs, if only they could pass the immense regulatory hurdle, would be much safer than the 1950s Soviet technology that failed at Chernobyl or the 1960s technology that failed at Fukushima. We are now operating antiques. And even with this rate of accident, nuclear power has caused orders of magnitude less human or environmental suffering than any other fuel.

Similarly, the most environmentally friendly way for people to live is in tightly packed cities, fed by genetically modified foods which yield more per acre of farmland and require fewer fertilizers and pesticides, from laser-leveled fields run efficiently by large corporations in the highest productivity locations. Federal policies to the contrary are not just anti-growth, they’re anti-environment too. When Federal policy can say these things in public, it will have a bit more standing to invoke the name of “science.”

Environmental policy at a minimum needs a far more frequent application of cost-benefit analysis!

As important as carbon may be, our environmental policy has become obsessed with this one danger. But slow warming and sea level rise in 100 years are not the only, or possibly the main, environmental danger we face.

Most of the large species going extinct — elephants, rhinos, lions, and so forth, to say nothing of the more numerous and less photogenic — will go extinct from human predation, poaching, and loss of habitat long before climate has any effect on them. Most of the world faces environmental problems far more pressing than climate. And by focusing on climate, our government is spending far too little time, research and money on small but catastrophic dangers such as global pandemics, crop failures, animal diseases, and so on. As in finance, the unexpected and swift dangers are more likely to cause a crisis than the slow moving widely anticipated ones.

Taxes

Perhaps one economic issue just about every corner of the political spectrum can agree on is that our tax code is a massively complex and broken mess, needing reform.

Practically everyone agrees on the basic structure of a growth-oriented tax reform: Lower marginal rates — the extra amount of taxes you pay on an extra dollar of income determines the disincentive to earning that income. To raise revenue at lower marginal rates, broaden the base, i.e. remove exemptions and loopholes. And massively simplify the code.

Admittedly, not everyone agrees that tax reform should be oriented to growth. The voices for higher taxes argue for redistribution or decapitation — removal of high incomes, even without benefit to lower-income people — freely admitting the growth consequences of high taxes are at least not positive. They just view distributional goals as more important than growth.

Often, however, tax reform proposals sacrifice too quickly the principles of what a good tax system should be with perceived political accommodations to powerful interest groups. Economists should not play politician. We should always start with “in a perfect world, here is what the tax code should look like,” and accommodate political constraints only when asked to. Political constraints change quickly. Economic fundamentals do not.

Herewith, then, a brief reminder of basic principles:

The right corporate tax rate is zero. Corporations never pay taxes. Every dollar of taxes that a corporation pays comes from higher prices of their products, lower wages to their workers, or lower returns to their owners.

Which one, depends on who can get out of the way. While it is politically tempting to suppose that wealthy stockholders bear the burden of corporate taxation, they are in fact the most likely to be able to avoid taxation. While imposing a corporate tax may hurts existing stockholders, by lowering the value of the stock, there is no reason new investors will give the corporation money unless they can get the same after-tax return they can get elsewhere, and in particular abroad. Thus, new investment dries up until the company can pay the same after-tax return to its investors — by raising prices, lowering wages, or reducing scale to generate greater before-tax profits. In addition, these days the owners and investors of corporations are as much your and my pension fund as they are rich individuals.

For all these reasons, eliminating the corporate tax is as likely to be more rather than less progressive. The higher prices a corporation charges hurt everyone. The lower wages corporations pay hurt workers. The income it passes along to its owners is subject to our highly progressive tax system.

A growth-oriented tax system taxes consumption, not income. When we tax income that is saved, or the investment income that results from past saving, we reduce the incentive to save, invest, start companies and build them, vs. enjoy consumption immediately. One of the first theorems you learn in an economics class on taxation is that the right tax on rates of return is zero.

A person-based consumption tax can be progressive. It is useful to collect the basic tax as a VAT. Then people in higher brackets can declare income and receive credit for investments.

The estate tax is a particularly distorting tax on saving and investment. One may sympathize with the the moral judgment that rich kids don’t “deserve” inherited wealth. But the point is on the incentives of the giver. The tax code should not give strong incentives to middle-age people to stop building their businesses, investing their money, spend their money on round the world cruises and their time with tax lawyers. Nor should it force the breakup of privately held businesses to pay taxes. Maybe the kids don’t deserve it, but if people cannot provide better lives for their children, we remove one of the strongest and oldest human incentives for economic activity.

Taxing corporations rather than people and taxing income rather than consumption is behind many complexities of the tax code. For example, right now the corporate and individual tax rates must be at roughly the same level. If we tax corporate income less, then people rush to incorporate themselves. If we tax personal income less, the opposite. But if we tax consumption and not income, then there is no tax benefit to incorporating yourself. As another example, we only need special health savings accounts and college savings accounts because we tax income. If we taxed consumption we would just save for health, college, and retirement as we do everything else.

In partial recognition of the distortions caused by taxing rates of return, our tax code includes an absurdly complex web of ways of getting around capital income taxes, from IRAs, Roth IRAs, 527(b), 401(k), special tax treatment of pension funds and life insurance, lower rates for long-term capital gains, and the various trust shenanigans of the estate tax. Removing the attempt to tax investment income would make all of these complex structures irrelevant. Then they can be removed, greatly simplifying the code.

The economic distortions of the tax system result from the overall marginal tax rate, not each tax alone. The economic distortion due to taxation does not care that there are separate federal, state and local taxes. The economic distortion is the sum of all these. Start by producing one dollar more of value for your employer. Now subtract the corporate income tax, the payroll tax (social security, medicare, etc.), your federal, state, and local income taxes; the investment taxes, capital gains taxes or estate taxes paid between earning and consuming, and the sales taxes, excise taxes, property taxes, gas taxes and so forth that you pay when you buy something, to see how much of value you actually get in return for the dollar of value you provided to your employer. That’s the overall marginal tax rate.

Far too much tax discussion considers federal income taxes alone as if the others did not exist. They do exist. I only half-jokingly suggested an alternative maximum tax.⁵ Add up all the taxes you pay, including all the taxes companies whose stock you own pay, to any level of government. If it’s above some high number — say, 70% — you’re done and have to pay no more.

When we say broaden the base by removing deductions and credits, we should be serious about that. Thus, even the holy trinity of mortgage interest deduction, charitable donation deduction, and employer provided health insurance deduction should be scrapped. The extra revenue could finance a large reduction in marginal rates.

Why? Consider the mortgage interest deduction. Imagine that in the absence of the deduction, Congress proposes to send a check to each homeowner, in proportion to the interest he or she pays on money borrowed against the value of the house. Furthermore, rich people, people who buy more expensive houses, people who borrow lots of money, and people who refinance often to take cash out get bigger checks than poor people, people who buy smaller houses, people who save up and pay cash, or people who pay down their mortgages. A rich person buying a huge house in Palo Alto, who pays 40% marginal income tax rate, gets a check for 40% of his huge mortgage. A poor person buying a small house in Fresno, who pays a 10% income tax, gets a check for 10% of his much smaller mortgage. There would be riots in the streets before this bill would pass. Yet this is exactly what the mortgage interest deduction accomplishes.

Charitable donations follow the same logic. Suppose Congress proposed to match private charitable donations with federal dollars. Rich people get 40% match, but poor people only get 10%. Not only would that cause riots, but then there would be a much closer eye on just what “charities” mean in today’s America if they received direct checks from the Treasury. We may moan at the complexities of federal expenditures, but there is at least some oversight. Charities spend tax money largely in the dark. The shenanigans of the Clinton foundation are only the most recent visible example of how “nonprofits” are often the latest scam in the American legal system. Notice how every sports star or celebrity has a charitable foundation? They are great ways to escape estate taxes and investment taxes as well as campaign finance laws. Your kids can serve as the executives of the foundation.

Yes, universities (such as my employer) may suffer. Well, I started this essay with the idea that everyone must give up their little subsidy so that the rest will give up theirs. So too must academics.

Americans remain generous. Even without a tax incentive, Americans will give to worthy causes, as they give now to political campaigns. Worthy charities, such as my employer, may even gain by substitution away from tax and political scams.

In sum, the ideal tax system taxes people, it taxes consumption not investment income, and it taxes at a very low rate with a very large base.

The political debate on taxes

Why is this so hard? Because our political debate mixes different goals.

The central goal of a growth-oriented tax system is to raise the revenue needed to fund necessary government spending at minimal distortion to the economy, and in particular minimizing the sorts of distortions that impede the growth process.

A first objection comes from those who want to pair reform of the code with substantial rises in overall revenue. This has been the main stumbling block to tax reform under the Obama Administration.

Second, our tax code mixes raising revenue with a host of special provisions designed to encourage specific activities and transfer income to specific groups or businesses. Objections come from those who what to preserve one or another subsidy, deduction, or exemption.

Third, our tax code mixes raising revenue with efforts to redistribute resources across income and various demographic classes.

The result is paralysis. The answer lies in separating the arguments. One could go so far as to separate the actual legislation.

First, we should discuss the structure of the tax code separately from the proper level of revenues. Let us agree that we will eliminate deductions and exemptions and have three brackets. Start with a revenue-neutral code. But agree that we can separately and much more frequently adjust the rates, which adjust the overall level of revenues.

Second, we should separate the tax code from the subsidy and redistribution code. Let us agree, the tax code serves to raise revenue at minimal distortion. All other economic policy goes into the subsidy code. And subsidies should be on-budget and explicit. So, you want a subsidy for home mortgage interest payments? Sure, let’s talk about it. But it will be an on-budget expense — we will send checks to home buyers if we do it. You want to give $7,500 to each purchaser of electric cars? Sure, let’s talk about it. But it will be an on-budget expense. We will send $7,500 checks electric car purchasers if we do it.

Yes, advocates will object. Congress is not at all likely to appropriate money in this way! Tax credits and deductions are very useful for hiding things like this. But again, honest political leadership should say, if we have to hide what we’re doing from the American people, then we shouldn’t be doing it. Or, we should structure it in a way that is acceptable.

This discussion reflects another reality: The size of the US government is vastly greater than we think. It looks like Federal spending is only about 20% of GDP. But each deduction and mandate is the same thing as a tax and a subsidy. By bringing each deduction and tax credit on budget, we can correctly see exactly the size of our government, and more wisely vote on that size.

Even if my dream of putting all subsidies on budget fails, they should at least be conceptually separate parts of the tax code, and debated separately. The key is to keep the basic tax code focused on raising revenue at smallest possible economic distortion, and to argue separately about subsidies.

The art of politics is, of course, bundling things in a way to get deals done. But it is clear that the current bundling is producing paralysis. Those on the left that wish to raise revenue suspect that those who wish to reform the tax code will not later allow a discussion on revenue, so they must hold reform hostage. Likewise with those who want subsidies. Rather than produce another bundled mess, a great politician should be able to promise an honest hearing on revenue and unpalatable subsidies to get a clean growth-oriented reform.

Redistribution by our federal government fails because of its similarly chaotic approach. Discussions of progressivity consider redistribution through the federal income tax code forgetting about the smorgasbord of social programs and other taxes. Social security, medicaid, food stamps, unemployment insurance, and so on and so on all overlap to an incoherent mess. These should be condensed into one coherent approach to helping lower-income Americans. You can redistribute, if desired, by checks as well as by differing tax rates.

The central problem is again the tension between economics and politics. When a growth-oriented economist writes about taxes, the most important question is the distortion. What economic decision is distorted by taxes? If you produce $2 for your employer but only receive $1 in value, does that distort your decision to work, to take a job, or to invest in the skills needed for the job? Who gets how much money is really not that important to growth.

When the political system discusses taxes, the only question is who gets how much money, subdivided into minute income, geographic, racial and industry categories. Nobody pays attention to the distortions. But the distortions lower growth, and it is the job of wise political leadership to move the public discussion in that direction.

The current tax discussion understates, I think, the importance of simplicity in the tax code. A simple code makes its incentives transparent. A simple code vastly reduces compliance costs. And most of all, a simple code is much more clearly fair. Americans now look at the tax code and suspect — often rightly — that rich smart people with clever lawyers are getting away with things. Our voluntary tax code depends vitally on removing this suspicion. The Greek equilibrium in which each person cheats because he knows everyone else is cheating, corrosive far beyond its effect on revenue, can break out here too.

Tax lawyers and economists often come up with complex schemes to achieve parts of the principles I advocate, without doing much violence to the current code. I think this is a mistake. People who look forward to late March and early April each year as a time to show their hard-won expertise should remember how much the rest of the country hates the experience.

For example, rather than eliminate the corporate tax, some economists advocate having corporations notify each stockholder how much tax is paid on his or her behalf, and then the stockholder can deduct the corporate tax payments from his or her individual taxes. That achieves the same economic result, if the costs of filling out forms are zero.

But that setup is disastrous for commitment and simplicity. The corporate tax remains, and arguments about just what corporations can and can’t deduct, which income where they pay taxes on remain firmly in place. With the corporate tax system still in place, we are a sneeze away from limiting or removing the pass-through. And one cannot ask for a way that smacks more of a handout to “the rich,” hiding its effect of lowering product prices or raising wages. The code is only simplified if the corporate tax is eliminated. (And, if the government wants to subsidize R&D, energy investments, or other activities, do so with on-budget subsidies, just like for people.)

As another example, it seems politically easier to leave in place cherished deductions like health insurance, home mortgage interest, and charity, but limit the total amount of deductions any one person can take. That achieves the economic purpose.

But this setup leaves intact a perpetual argument. Next year, let’s renegotiate a higher limit. Or let’s exempt my favorite deduction from the limit. As long as each deduction remains in place, so does the constituency in its favor, and so do all the thousands of pages of tax code each entails.

Zero is zero. If you don’t kill a tax completely, it keeps coming back like zombies in a science fiction movie. If you don’t kill a tax completely, you do nothing to simplification of the tax code.

Eliminating whole sections of the tax code, rather than nullifying them with clever schemes, has another important advantage. A growth-oriented tax code operates by incentives, but people have to understand the incentives. Tax economists tend to be ultra-rational, and figure that people will react to the actual financial incentive even if it is quite hidden. Of course, the point of hiding it — of offering corporate tax rebates, say, rather than eliminating the corporate tax, or sharply limiting deductions rather than eliminating them — is precisely to fool people politically into thinking the provisions are still there. Well, people so fooled may not see the economic incentive either. Behavioral economists who argue that only very clear, simple, provisions have the appropriate incentives have a point. And their point argues for a simple code full of zeros rather than a complex code that has the same set of economic incentives once an expert combs through it.

Debt and deficits; social security and medicare

Debt and deficits are a looming threat to growth. Read any one of the nonpartisan Congressional Budget Offices’ long-term budget outlooks.

Our central problem is straightforward: promises to pay social security benefits, medicare and other health care will soon overwhelm the US budget. Hidden mountains of unfunded pension liabilities, state debts, student loan debts, and debts the US will incur if another financial crisis, recession, or war face us, add to the risks.

Growth-oriented policy will do a lot to solve the debt and budget problem. Economic growth raises tax revenues without raising tax rates. Stagnant growth will make all these problems much worse.

Conversely, a looming debt crisis or the extreme taxes that would be needed to pay for an unreformed system will be strong drags on economic growth. So, setting long-run spending in order now is both necessary, and much easier than doing it later.

Indexing social security to price inflation rather than wage inflation takes care of much of the social security problem. Indexing it to the prices of things that old people actually buy helps even more. Changing the nature of health care support to vouchers, and enacting the other health care reforms mentioned above will give both better help to people in need and solve that budget problem. Both of these steps are much easier the sooner they are taken, so that nobody has to receive an actual cut in benefits.

An economist should emphasize the distortions to economic decisions embodied by these programs, not the cost per se. Programs are bad when they require taxes so large that the taxes kill growth, or when the incentives of the programs sap people’s incentive to work, save, and invest. Social security should be converted to private accounts, not so much to save the government money as to ensure that each person knows that an extra hour of work, or extra effort made to learn a new skill or start a company, results eventually in greater resources for him or her, not just greater taxes.

Social programs

From a growth perspective, the most important characteristic of social programs is also not so much their cost, as it is their disincentives and their ineffectiveness.

Most of our social programs phase out as income rises, often with hard steps at which if you earn one extra dollar you lose a large benefit. If you earn an extra dollar, you can lose health care subsidies, food stamps, social security, medicare, disability payments, and a host of smaller subsidies from home heating oil subsidies, child care subsidies, transportation subsidies and even (in my home town) parking permit subsidies.

As usual in our weed-pulling exercise, there are so many programs and they interact in so many ways, that adding them all up is hard. The broad picture though is that for many Americans there is close to a one for one tax rate from zero up to $60,000 per year in the form of reduced benefits.

The answer is not necessarily to be stingier. The answer, as elsewhere, is to design programs with more attention paid to marginal disincentives, and to design programs that fit together rather than assume each one acts in isolation.

One good way to eliminate marginal disincentives is more frequently to condition support on time rather than income. Unemployment benefits work to some extent this way. Yes, you lose unemployment benefits if you get a job, which provides a disincentive. But you can only earn unemployment benefits for a certain period of time.

It is surprising, in fact, that a society as fluid as ours conditions so much of its government activity on income, as if income were a permanent and innate characteristic. Income changes rapidly through time and over the life cycle.

Social programs are so expensive because most of them are middle class subsidies, not help for the truly poor and desperate. We need to spend more is on the truly unfortunate. Schizophrenics in the streets are unbecoming of a great nation, and helping them costs relatively little. They don’t vote.

Labor law and regulation

Our government and politicians keep repeating how much they want to “create jobs” and help Americans to work.

A martian, parachuting down and studying our economy would come to the opposite conclusion. There are few economic activities in which the government throws more obstacles than that of hiring someone.

Start, of course, with taxes: income taxes and payroll taxes are primarily taxes on employment. But the regulatory burdens of employment are larger still, as anyone who has tried to get a nanny legal will attest.

Minimum wages, occupational licensing, anti-discrimination laws, laws regulating hours people can work, benefits they must receive, leave they must be given, fear of lawsuits if you fire someone, and so forth all impede the labor market.

We are swiftly becoming a nation divided, as Europe is, between “haves” with expensive, highly regulated, full time jobs — that are inflexible for people who wish part time work — and often illegal, under the table, part time “gig” work.

Companies have innovated around many of these distortions with contract workers, but the current fight whether contract workers, independent contractors (Uber drivers) and franchisees must be considered employees of the parent company threatens to undo all of that, placing another huge wedge in the labor market and segregation between well paid, hard to get, full time jobs and a larger pool of unemployed.

America needs a vast deregulation of its labor market. I want to work for you, you want to pay me? Good enough.

The usual argument is that workers need protection of all these laws. Well, the supposed protections do cost economic growth, and they do reduce employment. How much do they actually protect workers? The strongest force for worker protection is a vibrant labor market — if you don’t like this job, go take another. The tightly regulated labor market makes it much harder to get a new job, and thus, paradoxically, lowers your bargaining power in the old one. At a minimum let’s revisit just how much protection is actually being given, and just what the cost in growth is, and whether it’s worth it.

Immigration

“Give me your tired, your poor, Your huddled masses yearning to breathe free, ..”
- Emma Lazarus.

“He has endeavoured to prevent the population of these States; for that purpose obstructing the Laws for Naturalization of Foreigners; refusing to pass others to encourage their migrations hither,..”
- Declaration of Independence.

Not any more.

We can end illegal immigration overnight: Make it legal. The question is, on what terms should we allow legal immigration.

The immigration debate has nothing to do with who is allowed to come to this country. That’s the tourist visa debate. The immigration debate is about who is allowed to work in this country, and, later, who is allowed to become a citizen. Our Federal government has a massive program in place to stop people from working. That is immigration law.

Immigrants contribute to economic growth. Even if income per capita is unchanged, imagine how much better off our social security system, our medicare system, our unfunded pension promises, and our looming deficits and debt would be, if America could attract a steady flow of young, hard-working people who want to come and pay taxes. Aha, we can attract them! They’re beating the doors down to come. But then we keep them out.

Allowing free migration is, by many estimates the single policy change that would raise world GDP the most. If you believe in free trade in goods, and free investment, then you have to believe that free movement of people has the same benefits.

The most common objection is that immigrants steal American jobs. No, they create American jobs, just as a higher birthrate of Americans would do. Every immigrant is as much a consumer of things we produce, a buyer of houses and cars, a starter of new businesses, as he or she is a worker. Immigrants come to do jobs that are available, not jobs that Americans don’t have. They do work that complements those of Americans, and thus make Americans more productive and better off.

There is very little economic argument for keeping immigrants out of California from old Mexico that would not also apply to keeping immigrants to California out of new Mexico. (Or, as Oregonians, Coloradans, and Texans might wish, keeping Californians out of their states!)

We worry about immigrants using social programs. Fine, but why then is immigration skewed to family members, likely to use social programs, and excludes workers, least likely to use them? If the worry is that they’ll go on welfare, why on earth do we forbid them from earning a living? If social program overuse is a worry, charge a $5,000 bond at the border, require proof of $10,000 of assets and health insurance, and anyone who is convicted of a felony goes home. This fear does not excuse our immigration system.

The status of the 11 million already here is a national embarrassment. 11 million people live in this country, work, pay taxes, buy food and cars and houses, and yet are deprived of legal protection, easily exploited by employers, afraid to even take airplanes, let alone not allowed to vote. If this were a racial minority, we would be scandalized.

But immigration law is so dysfunctional that we need not discuss radical programs. Let’s fix the basic growth-killing pathologies that we all recognize need to be fixed.

Start by letting in people who obviously contribute to the American economy and society. Ambitious young people come to the US to get degrees in medicine, engineering, and business.They want to stay, work, buy things from our businesses and pay taxes. They want to start businesses and hire people. We kick them out. The H1B visa lottery should simply be abandoned. Any high-skill immigrant should be able to stay. Any high-wealth immigrant should be able to stay. Immigrants often start small businesses that serve poor areas. Anyone who starts a business should be able to stay. People who came at a young age, have been through American schools, served in the US military, and know no other country should be able to stay.

The immigration discussion is full of more nonsense than any other policy question facing the country. No, immigrants are in fact much less likely to commit crimes than Americans. No, terrorists come on tourist visas. They do not swim the Rio Grande and stop to pick vegetables for a few years before blowing things up. And we already spend more than twice — $13 billion dollars — on the border patrol than we do — $ 6 billion — on the entire FBI. They are “illegal” some say. Well, that’s easy to fix. Change the law, and they will no longer be illegal! Constructing a great Ice Wall on the border with Mexico is a canard. Immigrants come on airplanes and overstay tourist visas.

As with taxation, the immigration debate needs to separate completely separate questions: Who is allowed to enter the country? Who is allowed to work here? These are completely separate issues. Restrictions on work do nothing to address security.

Immigration and growth feed each other. Immigrants help economic growth. But conversely, the lack of economic growth is feeding a misguided but understandable resentment towards immigrants.

Education

How often must commenters on all sides of the political spectrum complain that America’s public schools are awful?

They are particularly awful for people of lower income, minorities and new immigrants. The problem is not money. Study after study shows that America spends as much or more money on eduction than other countries, and experiment after experiment has shown almost no effect of showering money on bad schools.

The culprit is easy to find: awful public schools run by and for the benefit of politically powerful teachers’ and administrators’ unions. (Don’t forget the latter! Teachers account for only half of typical public school expenses.) Education poses a particularly large tradeoff between profits to incumbents and economic growth, since education lies at the foundation of higher productivity. In addition, the costs of awful schools fall primarily on lower-income people who cannot afford to get out of the system. It is one of the major contributors to inequality.

The solution is simple as well: widespread financing by vouchers and charter schools. As with health care, a vibrant market demands that people control their spending, and can move it to where they get better results. As with health care, the government does not have to directly provide a service in order to help people to pay for that service. But as with health care, a healthy market also demands supply competition, that new schools be allowed to start and compete for students.

Higher education has been relatively healthy in the US, but Federal policy is busy making a mess of it. The correlation between more and more subsidy to higher education, the astronomical rise in tuition, and the leftward drift of campus politics towards support of a larger government is hard to miss. The Federal government took over the student loan market, and is busy creating a new debt bomb that will likely end in another mass bailout. Immigration restrictions are making it harder for students to access this, one of our great export successes.

There is a strong correlation between college education and later income. That does not mean that more college education will automatically generate more individual income or more economic growth. To some extent, smart people who will earn more money anyway go to college, and smart people who know they will benefit from a college education go to college. To a greater extent, people who choose science, engineering, math, computer, or business majors go on to earn greater incomes. Those who study other subjects may profit personally from the experience, but generally do not go on to contribute as much to economic growth.

Loans that are forgiven if one does not earn a higher income, or forgiven for students who go in to non-profit, social work, government or other low-paying work, or who do not work at all, are particularly troublesome from a growth perspective.

Sweat the little stuff

Our growth needs to be revived by pulling a thousand little weeds. A selected few reminders and examples follow.

We still have agricultural price supports, tariffs and quotas such as sugar and oranges.

Trade is relatively free, but could be freer. And keeping trade open requires endless effort against the forces of protection.

The opponents of free trade, and immigration, adduce long-standing fallacies, that one must constantly fight. When, say, China, sends us cheap manufactured goods, they take dollars in return. Every one of those dollars ends up buying an American export, or invested in America. Trade is not a “competition,” and our trading partners are not “competitors.” We win in trade when American consumers get to buy things more cheaply. The point of trade is not to increase exports. When Germany sent Greece Porsches in return for worthless pieces of paper, it was Greece that came out ahead in the deal, not Germany.

That much of the nation’s infrastructure is crumbling is a common observation. And infrastructure supports growth. Low interest rates are a particularly propitious time to build infrastructure.

So why is there less consensus for a large program to repair and build public infrastructure, including roads and bridges, but also bicycle paths, parks, airports, ports, and so forth? In large, part, I think, our government has squandered its people’s trust in its ability to carry out infrastructure projects in a cost-effective, well-planned, and timely fashion. Instead, voters are used to reading about bridges to nowhere, high speed trains from nowhere to nowhere, billion dollar cost over runs, decade plus waits for permits, massive consulting fees, and other pathology.

The process of infrastructure investment needs a complete overhaul. To mention just a few, it is no surprise that costs spiral when projects must pay “prevailing wages” and obey set-asides for specific contractors, or when environmental review takes years. It is no surprise that projects are not repaired when federal funds pay for new construction but not repair. Federal funding diverts resources to rail, a charming but very inefficient mode of transport, over freeways, airports, buses, bus lanes or bus rapid transit, or other needed modes. Real time tolling, private toll roads, and congestion pricing are easy ideas, used successfully in other countries, but almost never here.

So, yes, we need a growth-supporting infrastructure program. But our political leadership needs to show us it can construct infrastructure in a more competent, less politicized, way, focused on delivering the needed infrastructure at least cost to the taxpayer.

There is good spending

I close this essay with two areas in which I think our Government could spend some more money, in ways that would enhance economic growth.

Our legal and criminal justice system is clearly becoming dysfunctional. This system is trapping many people already struggling with poor schools and job prospects. That we spend tens of thousands of dollars to house prisoners and next to nothing to train them to succeed when they exit guarantees their return. Even doubling resources, so that crimes in poor neighborhoods are routinely solved, so that people accused of crimes have speedy trials and reasonable representation, not life-destroying years waiting for cases to be heard, so that people who are imprisoned receive some basic help in dealing with the outside world, would cost little compared to the trillions we spend on middle-class social programs.

The war on drugs is a massive failure. Not only is it leading to mayhem in poorer areas of the US, it is causing narco-states, corruption, violence, and poverty in our neighbors, and driving much immigration pressure. Al-Quaeda, the Taliban, and ISIS earn lots of money from drug trafficking. Legalization would drive them out of business far more effectively than war.

The federal government has a role in financing basic research. Yes, 95% of funded research is silly. Yes, the government allocates money inefficiently. Yes, research should also attract private donations. But the 5% that is not silly is often vital, and can produce big breakthroughs. Like the military, there are a few things the federal government must do. We are falling behind on basic research investments.

More

And FDA approvals take forever. And patent law is a mess leading companies to spend too much time on lawsuits. And anti-trust law is completely outdated, just throwing sand in the gears. And the NLRB and EEOC are making a mess of labor markets. And the FCC is going to turn the internet into the 1965 French telephone company. And... well, this could go on pretty much forever.

There are a lot of weeds. Just turn to the Hoover research website, especially Economic Policy, Education, Energy Science & Technology and Health care tabs. Turn to Cato’s website and browse down the “Research Areas” tabs, especially the Education, Energy and Environment, Finance, Health Care, Regulatory studies, Tax and budget, and Trade and Immigration tabs. I have kept this essay deliberately free of a forest of numbers and citations for easy reading, but the numbers and citations are easy to find.

This essay summarizes some of my own earlier writings on many of these issues, all available on my webpage. For more on regulation, see “The Rule of Law in the Regulatory State.” For more on health care and insurance see “After the ACA: Freeing the Market for Health Care” and “Health Status Insurance.” On financial reform (alternatives to Dodd-Frank) see “Towards a Run-Free Financial System.”

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¹ John H. Cochrane is a Senior Fellow of the Hoover Institution, Stanford University. This essay is copyright © John H. Cochrane.

This essay was prepared as a contribution to “Focusing the Presidential Debates.” Other essays and information can be found at  FocusingThePresidentialDebates.com

This essay may evolve over time, so please post or pass on links to the original pdf file or this webpage rather than pass on copies of the file.

²The numbers are based on real gross domestic product, series GDPCA, and total population, series POP, from the St. Louis Fed FRED database. Growth rates are continuously compounded, i.e. log.

³ Congressional Budget Office, June 2015 Long-Run Budget Outlook, Table A-1 p. 112

⁴Technically, “regulation” means rules written by independent administrative agencies, such as the Environmental Protection Agency, the Federal Aviation Administration or the Federal Reserve. Congress delegates authority to these agencies to write the actual rules. These rules have the force of law, and can carry criminal penalties including jail time, even when no intent to violate rules is alleged. Most economic regulation takes this legal form, but a great deal remains actual laws. I will use “regulation” a bit loosely to refer to both legal forms of government intervention in the economy.

⁵ Wall Street Journal, April 14 2013, http://faculty.chicagobooth.edu/john.cochrane/research/papers/Alternative_maximum_tax_WSJ.pdf