IOR caused the recession!

Apparently saying something nice about the Fed last week stepped over some bright line somewhere.
Lois Woodhill, writing at Forbes.com, wrote one of the most unintentionally hilarious rebukes here.

Source: Louis Woodhill at Forbes.com

The above chart

...shows what happened the last time the Fed raised the IOR rate [to 0.25%] (remember, it was zero for 95 years). 

The plunge in velocity overwhelmed the Fed’s frantic money creation during the period immediately after it started paying IOR.  NGDP tanked, taking RGDP and employment with it. 

Look, something caused the economic collapse of 2008-2009.  Given the evidence, IOR looks a lot like a man caught at a murder scene with a smoking gun in his hand.

Interesting.  Interest on reserves caused the recession!


Well, well. For 6 years now, we've been debating the cause of the recession and financial crisis. Was it "global imbalances," "savings gluts," Fannie and Freddie and the CRA, "deregulated" finance, "Wall Street greed," too big to fail guarantees, predictable engineering around bad regulation, housing bubbles, and on and on. Was the recession going to happen anyway, caused by credit supply disruptions, caused by a flight to quality in a systemic run, a technology shock or what... Thank you Mr. Woodhill, we've finally found the smoking gun -- 25 bp of interest on reserves!

No, this does not appear to be a joke.  It certainly gets the correlation vs. causation gold star for the week.

I'm still in "say something nice'' mode, so there are quite a few sensible things in Woodhill's column:

Given that the Fed stands ready to serve as the “lender of last resort,” it is capital, not reserves, that determines a bank’s ability to weather a financial crisis.

JC: Yes, and I think I'm pretty vocal on the extreme end of the narrow deposit-taking, 100% capital investment banking fringe. (I've plugged my papers enough on the blog already, so won't do so again.)

The Fed’s most important job—and one that only it can do—is to provide the U.S. economy (and the world) with a stable dollar.  

JC: Indeed on the former, and not so sure on the "can do" part even there.

I think our confusion stems from the fact that I stuffed an entire narrow deposit-backing / equity financed banking proposal into one sentence: "Banks holding lots of reserves don’t go under." Oh well, opeds are short.

And to be sure, there are plenty of thoughtful reasons to disagree with my analysis. And there are plenty of other areas to remain critical about Fed policy. I remain dubious of "macroprudential" policy and whether monetary policy can do anything at all about long-term labor-force participation -- people who aren't working and aren't even looking for work.

Musgrave on 100% reserves

In a comment on an earlier post, Ralph Musgrave pointed to his interesting new paper on 100% reserve banking.

I haven't read the paper yet, but I love the Table of contents, reproduced partially below.

The name "narrow Banking" or "full reserve banking" needs improvement. It's really very wide banking -- so long as the banking is funded by equity or long-term debt. To say "narrow" is almost a fallacy in itself, and perpetuates the fallacy that bank lending will dry up. Maybe "Equity financed banking" or "full reserve deposit taking" would be better. Can anyone think of a name that is both sexy and accurate?

Musgrave's Fourty-four fallacies regarding full reserves:

Section 2: Flawed arguments against FR. .............................. 36
1. FR limits the availability of credit? ................................................................. 36
2. Central bank money is not debt free?............................................................ 38
3. Bank capital is expensive for tax reasons?.................................................... 38
4. FR means the end of banks?......................................................................... 39
5. Central banks will still have to lend to commercial banks? ............................ 39
6. FR stops banks producing money from thin air which can fund investments?... 41
7. Investments under FR might not be viable? .................................................. 41
8. FR will not reduce pleas by failing industries to be rescued by government? 42
9. The cost of converting to FR will be high?..................................................... 42
10. Central bank committees won’t be politically neutral? ................................... 42
11. Administration costs of FR would be high?.................................................... 44
12. The cost of current accounts will rise under FR?........................................... 44
13. FR is dependent on demand injections? ....................................................... 45
14. The effect of FR on inflation and unemployment is unclear?......................... 45
15. FR would drive business to the unregulated sector?..................................... 46
16. The state cannot be trusted with peoples’ money?........................................ 46
17. Vested interests would oppose FR?.............................................................. 47
18. FR will reduce innovation by banks? ............................................................. 48
19. Deposit insurance and lender of last resort solves banking problems?......... 48
20. Lenders will try to turn their liabilities into “near-monies”? ............................. 49
21. Anyone can create money, thus trying to limit money creation is futile?........ 50
22. Advocates of FR are concerned just with retail banking? .............................. 51
23. Central banks will still have to lend to commercial banks? ............................ 39
24. It wasn’t just banks that failed in 2008: also households became overindebted?...........................................................................................................52
25. Creation of liquidity / money is prevented?.................................................... 53
26. Funding via commercial paper would be more difficult under FR? ................ 54
27. FR is nearly the same as monetarism? ......................................................... 54
28. There is no demand for safe or warehouse banks?....................................... 55
29. FR would cause a stampede to safe accounts? ............................................ 56
30. FR would raise the cost of funding banks?.................................................... 56
31. Fractional reserve is not fraudulent? ............................................................. 57
32. FR will not stop boom and bust? ................................................................... 58
33. Bank shareholders will demand a high return to reflect their uncertainty about
what a bank actually does? ................................................................................. 60
34. FR reduces commercial bank flexibility? ....................................................... 60
35. FR would not stop bank runs?....................................................................... 61
36. Vickers’s flawed criticisms of FR. .................................................................. 61
37. Regulating loans is better than FR? .............................................................. 68
38. FR doesn’t insure against liquidity shocks?................................................... 69
39. Government couldn’t produce enough money under FR? ............................. 70
40. FR prevents all lending?................................................................................ 70
41. Banks will try to circumvent FR rules?........................................................... 72
42. Converting to FR involves a huge bailout of existing banks? ........................ 72
43. The Money Creation Committee would not regulate demand accurately? .... 75
44. Interest rate gyrations would be larger under FR?......................................... 76

A Few Things the Fed Has Done Right

WSJ Oped, here.

As Federal Reserve officials lay the groundwork for raising interest rates, they are doing a few things right. They need a little cheering, and a bit more courage of their convictions  ...

I like the large balance sheet and market interest on reserves. I just want them to be permanent, not additional tools for Fed discretionary policy.

I'll post the whole thing in 30 days.

The Oped builds on a new paper, Monetary Policy with Interest on Reserves, and on Toward a Run-Free Financial System. In the latter, I advance the idea that the Fed and Treasury should first offer interest-paying money, and then stamp out private substitutes, just as the US first offered banknotes and then stamped out run-prone substitutes in the 19th century. Interest on reserves, a big balance sheet,  and opening reserves to all are a first step.


There are some big unknowns which I don't touch on in the oped. (That's what the cryptic last paragraph refers to.) Will the Fed really be able to control interest rates just by raising the rate on reserves? And while also controlling the size of the balance sheet? Will interest rates thus controlled have the expected effect on the economy? The first paper spends a lot of time on the latter question.

It's not so obvious the Fed can control interest rates and the balance sheet. If the Fed said, tomorrow, interest rates shall be 5%, and started paying 5% on reserves, would Treasurys, mortgages, credit cards, bank deposits, etc. all really rise 5 percentage points instantly? If you pay your nanny $50 per hour, will all nannies suddenly get $50 per hour?

If the Fed said "5%, come and get it, give us your Treasurys and we will give you 5% reserves'' it would be clearer. But then the Fed would lose control of the balance sheet, and would likely expand -- a lot -- a reversal of the usual sign for a tightening.

Now, there is an arbitrage argument that the Fed can raise rates while keeping the balance sheet unchanged: Banks try to steal each others' depositors by offering more interest on deposits. Then Treasury holders try to hold bank deposits. I read the reverse repo program as a lack of faith that banks are anywhere near that competitive any more. In the reverse repo program, if a non-bank financial institution gets reserves, bank-held reserves and bank deposits have to go down dollar for dollar, a little noticed consequence and incentive to competitive behavior.

But then the question goes to another level. If Treasury rates rise 5%, and expected inflation doesn't jump 5% in neo-Fisherian delight, capital would flow in from abroad.

To see it more clearly, suppose the Treasury said "ok, the Fed wants rates to be 5%. So rather than auction debt, we'll set the price. 5%, how much do you want?'' The answer would be "a lot!'' But the end result is no different.

It's easy to set a price if you let quantities adjust. It's a lot harder if you also want to control the quantity.

My bet: The Fed will seem fine to be in control of loudly-telegraphed 0.25% bp rises, as open-mouth operations rather than actual open market operations seemed to provoke previous rate hikes. They will never try 5% overnight and we find out if they really control interest rates.

Lazear on Labor

Ed Lazear has a very nice short column, Job Turnover Data Show Lots Of Churning, Little Job Creation on Investor's Business Daily.

Modern labor economists see employment and unemployment as a search and matching process with a lot of churn. The popular impression, echoed in most media discussion, is that there is a fixed number of jobs, and people just wait around for more jobs to be "created." That's what it may feel like to an individual, but that's not how the economy works. Lazear's column puts in one very short space some of the better ways to think about unemployment.

The central fact of labor markets is huge churn, not a fixed number of lifelong jobs:

During the typical month when jobs increase by about 100,000, 5.1 million workers are hired and five million separate from their jobs, resulting in a net change of +100,000 jobs. 

During the worst month of the most recent recession (June 2009), when net jobs decreased by almost half a million, there were still 3.6 million hires. 

The labor market is dynamic; even through sluggish periods, there is tremendous churn.

Recessions are not what you think:

One might expect that hires would fall and separations would rise in recessions.
Not so. There are lots of hires in booms but also a large number of separations; and in recessions there are lower levels of both hiring and separations... 

Workers quit to move to better jobs when the labor market is strong. 

...as was typical in this and previous recessions, separations declined along with hiring. Because hires are so large and variable, net job creation depends in large part on what happens to hires.

CON at it again.

An intriguing news item, University of Chicago's Plan to Add 43 Hospital Beds Quashed by the State by Sam Cholke about the University of Chicago's attempt to expand its hospital. And one more of today's costs-of-regulations anectodes.

In researching "After the ACA" about supply-side restrictions in medicine and health insurance, I became aware of CON ("certificate of need") laws. Yes, to expand or build a new hospital, in many states, you need state approval, and those proceedings are predictably hijacked politically. For once, they came up with an unintentionally appropriate acronym.

I was interested in this story that not just competing hospitals, but also local activists who want U of C to lose a bundle of money on a trauma center stopped the expansion.

Protesters who want trauma center services at the university testified at the hearing in Bolingbrook and claimed credit for the decision.

Also interesting,

According to the report, the proposed 40 private intensive care unit rooms were too large to comply with the state’s standards.

Each room was planned to have a shower and an alcove for nurses to fill out reports out of view of the patient, making the rooms 36 square feet larger than the maximum the state recommends.

Sounds nice. I didn't know the state of Illinois had a standard for the maximum permissible size of a hospital room.

The report also says the expansion of surgical beds is not necessary because the university isn’t using its existing beds.

The state requires the beds must be occupied a minimum of 88 percent of the time to meet efficiency standards and justify an expansion. In 2013, the university had patients in surgical beds 79 percent of the time,

Let's take this more generally. No restaurant should be allowed to refurbish and put in nicer tables it's at 88 percent of capacity now.

It sounds like the U of C wants to go after, as one doctor put it to me once, "Saudi Princes with interesting cancers." The model of all hospitals these days is to cross-subsidize care that doesn't pay for itself with patients like these. Except the golden-egg hunters want the egg before raising the goose.

As usual, the issue is not what should be done but who gets to decide. Should the U of C build bigger nicer hospital beds? Should it run a trauma center? Good questions -- but why is this anyone but the U of C's business?

Hilariously, this all started as a "cost control" measure, forgetting that in economics, costs go down when you let supply curves move to the right.

Immigration reading

Does Economics 101 Apply to Immigration? by Robert VerBruggen, a review of George Borjas' new book Immigration Economics.

The question is central to the immigration debate. If new people come in, do they depress the wages of competing workers here, and if so how much? "But it's 'suprisingly difficult' to demonstrate that this actually happens, according to the famed Harvard labor economist George Borjas. Very good review, need to read the book.

Of course, protectionism 101 still applies. If cheap Chinese sneakers come in, do they depress the profits of competing sneaker producers here? Yes. Does that mean we wall off trade? No, but neither ignore its distributional consequences.

FDA and the costs of regulation

The Wall Street Journal has had two recent articles on the FDA, "Why your phone isn't as smart as it could be" by Scott Gottlieb and Coleen Klasmeier on how FDA regulation is stopping health apps on your iphone, and Alex Tabarrok's review of "Innovation breakdown," the sad story of MelaFind, a device that takes pictures of your skin and a computer then flags potential cancers. The FAA's ban on commercial use of drones is another good current example.

One of our constant debates is how much regulation or the threat of regulation is slowing economic growth.  Over the weekend, for example, Paul Krugman, finding the New York Times itself too soft on libertarians,

Actually, the cost of bureaucracy is in general vastly overestimated. Compensation of workers accounts for only around 6 percent of non defense federal spending, and only a fraction of that compensation goes to people you could reasonably call bureaucrats. 

And what Konczal says about welfare is also true, although harder to quantify, for regulation. For sure there are wasteful and unnecessary government regulations — but not nearly as many as libertarians want to believe. When, for example, meddling bureaucrats tell you what you can and can’t have in your dishwashing detergent, it turns out that there’s a very good reason. America in 2014 is not India under the License Raj. 

Well, maybe, maybe not. Nothing in the FDA or FAA articles mentions the cost of the bureaucrats' salaries as the drag on growth, so that's a classic red herring.

The cost of regulations is the new businesses that don't get started -- or that fail as MelaFind nearly did, because the Raj would not grant a license -- the innovative products they would bring us, the employees they would hire, and so on.

The trouble is, these costs are awfully hard to measure. In the big demand vs. distortions debate (e.g. here) for our current stagnation, how do you put numbers to anecdotes such as these, and then add them up over the whole economy?  So far, it hasn't been done. Like the Laffer curve, we sort of know where the end point is -- even Krugman understands the stagnation of the License Raj, and Hernando De Soto is pretty convincing on regulatory-induced stagnation in other countries. But where are we on that spectrum? Krugman has no evidence that it's small. And I have no solid, quantifiable evidence that it's big. How do we do a "Potential GDP" that adds up these costs, as the CBO attempts to add up capital and people?

For the problem is not really in the cost of the regulation as written down. The problem is the cost of the regulatory system, the cost of the whimsical, political, and discretionary actions taken by regulators, as in this instance.

An important lesson in economics, and in science is, that which you can't measure you tend to ignore. So it's quite easy for us to go on, with economists such as myself reading these anecdotes and inferring we have a major problem, and others convinced that there's nothing here that a trillion dollars or so of "demand" wouldn't cure. Finding a way, even a conceptual framework, to add up these anecdotes would be a big breakthrough.

It matters for the big macro debate. It also matters as we think about financial regulation.

I can't resist a late snarky note on my dialog a few years ago with Glen Weyl and Eric Posner over their proposal that the government create an FDA-like agency to evaluate all financial products before the government allows companies to market them.  I wonder, after more and more stories like this come out if they still think it's such a great idea!

Prodded by Glen and Eric, I've been struggling with the idea of cost-benefit analysis for financial regulation. We need some sort of structure to evaluate all the clever proposals agencies are unleashing un us. But how do you add up these kinds of costs? And not end up, like Krugman, counting paperwork hours and bureaucrat salaries that are specks on the tip of the iceberg of the real costs?