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Caballero #1: Demand for Safe Assets in the Financial Crisis

The Minneapolis Fed publishes a magazine called the Region that has consistently excellent interviews with leading economists. The June 2011 issue has an interview with Ricardo Caballero, who is chairman of the MIT economics department. To avoid making this post of encyclopedic length, I\’m going to break it into three parts: Caballero on the demand for safe assets in the financial crisis, on moral hazard concerns during a financial crisis, and on how to do macroeconomics these days. But the excerpts in these three posts just scratch the surface of the interview, and the whole thing is worth reading.

Here\’s Caballero on what he sees as the underlying root of the financial crisis: a global shortage of financial assets, and especially highly-rated fixed income assets. In describing the financial crises, he says:

\”It’s a story in two steps. The first, present at least since the Asian crisis, is that the world has experienced a shortage of assets to store value. Emerging and commodity-producing economies have added an enormous demand for assets that is not being met by their limited ability to produce these assets. I believe this global asset shortage is one of the main forces behind the so-called global imbalances, the low equilibrium real interest rates that preceded the crisis, and the recurrent emergence of bubbles. Contrary to the conventional wisdom, I think these phenomena are not the result of loose monetary policy, but rather the other way around: Monetary policy is loose because an asset shortage environment would otherwise trigger strong deflationary forces. …

\”This is the second step, which began in earnest after the Nasdaq crash, when foreign demand for U.S. assets went back to its historical pattern of being heavily concentrated on fixed income … and especially on highly rated instruments. …The enormous demand for U.S. assets, with a heavy bias toward “AAA” instruments, could not be satisfied by U.S. Treasuries and single-name corporate bonds, and that imbalance generated huge incentives for the U.S. financial system to produce more “AAA” assets. As a result, we saw both the good and the bad sides of the most dynamic financial system in the world, in full force. Subprime loans became inputs into financial vehicles, which by the law of large numbers and by the principles of tranching were able to create \”AAA\” instruments from those that were not. …

\”Unfortunately, by construction, AAA tranches generated from lower-quality assets are fragile with respect to macroeconomic and systemic shocks, when the law of large numbers doesn’t work. That is, this way of creating safe assets may be able to create micro-AAA assets but not macro-AAA assets. In other words, these assets were not very resilient to macroeconomic shocks, even though they might have technically met AAA risk standards. …

\”In principle, this was not a big issue, but it became a huge one when highly leveraged systemically important institutions began to keep these macro-fragile instruments in their balance sheets (directly, or indirectly through special-purpose vehicles, or SPVs This was an accident waiting to happen; AIG and the investment banks should have known better, but the low capital charges were too hard to resist.\”

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Switching from a fuel tax to a vehicle-miles tax to finance highways?

The U.S. government imposes a tax of 18.4 cents/gallon on gasoline as a main source of financing for the Highway Trust Fund. However, the tax rate hasn\’t been raised since 1993, so inflation has eaten away at its real value. In addition, as fuel economy improves, miles travelled are rising faster than fuel consumption. Thus, the Highway Trust fund has been spending roughly $10 billion more per year since 2008 on highway projects than the fuel tax takes in. Thus, there have been proposals to switch from a fuel tax to a vehicle-miles tax as a way of funding highways. Here are a some thoughts about this policy: 
1) Both a fuel tax and a vehicle-miles tax can be viewed as user fees–that is, those who use the roads are paying for their maintenance and upkeep.
2) A vehicle-miles tax would probably raise more money than fuel tax over time, because vehicle-miles are rising more than fuel consumption. In the Winter 2010-2011 issue of the Rand Review, Paul Sorenson, Liisa Ecola, and Martin Wachs illustrate this point with a figure.
 3) The administrative apparatus for collecting the fuel tax is in place, and there are severe issues with how a vehicle-miles tax would be implemented. Sorenson, Ecola, and Wachs write:  “Mileage-based road use fees could be implemented in various ways, but three options appear to offer the greatest promise: (1) estimating mileage based on a vehicle’s fuel economy and fuel consumption, (2) metering mileage based on a device that combines cellular service with a connection to the onboard diagnostics port, and (3) metering mileage based on a device that contains a global positioning system (GPS) receiver.\” The first method seems a little rough-and-ready, and might need to be collected once a year, perhaps when auto registration is renewed. It would be much more visible to the public than the existing fuel tax. The other two methods raise legitimate privacy concerns: should the government really have the power to track where all cars have gone? One way or another, collection costs are likely to be higher for a new vehicle-miles tax.  

4) A vehicle-miles tax does not reward driving a fuel-efficient automobile–which may help the poor.             The Congressional Budget Office published in March 2011 a comparison of a vehicle-miles tax vs. the existing fuel tax in “Alternative Approaches to Funding Highways.” “VMT taxes are qualitatively similar to fuel taxes in their implications for equity. Like fuel taxes, they satisfy the user-pays principle, but they impose larger burdens relative to income on people in low-income or rural households. However, to the extent that members of such households tend to drive vehicles that are less fuel efficient, such as pickup trucks or older automobiles, those highway users would pay a smaller share of VMT taxes than of fuel taxes.” 
5) Trying to sort out the relevant externalities is tricky. The CBO suggests that costs imposed by highway users can be divided up into costs more related to miles travelled and costs more related to fuel use. \”Mileage-related costs, which include the costs associated with pavement damage, congestion,
accidents, noise, and emissions of local air pollutants by passenger vehicles, in fact account for the majority
of total costs. (The costs associated with local air pollution from passenger vehicles are considered mileage
related because those emissions, unlike emissions from trucks, are regulated on a per-mile basis.) Fuel-related costs include the costs of local air pollution from trucks, climate change, and dependence on foreign oil.\” I\’m not sure that a single policy can sensibly address costs of road maintenance and construction, environmental costs of fossil fuels, and costs of congestion. Trucks are much harder on pavement than cars. Contributions to congestion depend on when and where you drive. Pollution is affected by the type of car you drive, not just by miles traveled.
Here\’s a useful CBP table summarizing arguments about taxes on fuel versus taxes on vehicle miles traveled. 
 

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Report of the Global Commission on Drug Policy

The Global Commission on Drug Policy seems to be a more-or-less self-appointed group of \”world leaders,\” including former Presidents of Brazil , Colombia, Mexico and Switzerland, along with Kofi Annan, Richard Branson, George Shultz, Paul Volcker, and others. Its Report is a call to \”end the criminalization, marginalization and stigmatization of people who use drugs but who do no harm to others.\”

The report has facts, comparison studies, and citations that should make it of interest to those on all sides of this issue. For example, you can get a quick overview of areas that have decriminalized or legalized use and possession of various drugs, including Portugal, which in 2001 \”became the first European country to decriminalize the use and possession of all illicit drugs.\”

One figure that interested me showed the rise in consumption in certain well-known illegal drugs in the last decade or so.

Another figure shows a ranking of psychoactive drugs according the actual and potential harms they could cause to society, as defined by a team of scientists publishing in The Lancet a few years ago. The color classifications, on the other hand, represent the seriousness with which each of these drugs are treated in international treaties. Thus, heroin and cocaine are ranked as highly risky, and international law treats them that way. But the items ranked fourth, fifth, and eighth on the list by the experts–alcohol, ketamine, and tobacco–are not subject to international control. Like many aspects of drug policy, it\’s one of those things that makes you go hmmmm.

Thanks to Larry Willmore\’s \”Thought du Jour\” blog for the pointer.

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Mark Bils on price measurement

Brent Meyer of the Federal Reserve Bank of Cleveland has a nice interview with Mark Bils of the University of Rochester, focusing on the subject of price measurement. Here are some comments from Bils:

On why price measurement matters: \”My interest in price measurement really came out of discussions I had with [Stanford economist] Pete Klenow. Our interest was always less in thinking about inflation and prices. It was rather on the fact that whatever you mismeasure on prices affects how you measure real incomes and economic growth. … Because if you overestimate inflation by 1 percent, then instead of being, say, 1 percent per year real growth, it is really 2 percent per year. Well, that means the growth rate is doubled!\”

On inflation and quality change in health care prices: \”If I compare healthcare costs today versus in the year 1800, well, I could go out and buy a bunch of leeches today for almost nothing. And I could have the healthcare I had in 1800. If you had a certain condition and you had $10,000 to get treated at today’s health prices, or $10,000 to get treated at 1960s prices with 1960s technology, I don’t think it’s so obvious that people would want to go back in time to get their important health conditions dealt with. In that sense, you say, I don’t know if there’s inflation. It’s pretty hard to say that there’s been a lot of inflation over the long haul in healthcare.\”

On quality improvements and car prices: \”My first car was a 1983 Accord, which cost $9,600. It was a great car, but it didn’t have any of the safety equipment that you have today. It didn’t have power windows. It didn’t have air conditioning. It didn’t have many features. If you took that same car—it did get good gas mileage, actually—and you tried to sell it as a new car today, I don’t think you would get $9,600 for it, if you had to compete with what’s out there.\”

On why some changes in consumer prices affect macroeconomic national income more than others: \”A consumer price index isn’t an ideal measure of what’s happening to real income. That’s partly why I think that gasoline is a problem—because it’s so much an imported good. When its price goes up, that’s really a big loss in real income. Whereas when it’s a good that’s produced here, the loss in real income is that it takes more resources to produce it. If our efficiency drops in producing food, and then the food prices go up, that’s a real loss in income. If there’s an upward shock in prices, then the farmers—the people selling the food—do at least get some benefit from the price increases.\”

On the imprecision of hedonic adjustments to price measurements: \”There’s a classic example for vehicles. If you look at gas efficiency, miles per gallon, everything else equal, people would rather get better gas mileage. There’s not much question about that. But if you’re using a hedonic equation, and you say everything else that I observe, how much more are people willing to pay for better fuel efficiency? You actually get a negative number. If I take two vehicles, the characteristics I enter for them, plus miles per gallon/fuel efficiency, I’ll see the one that gets better miles per gallon tends to go for a lower price. … [T]here are very limited characteristics that we’re entering about the vehicle. So all these unmeasured characteristics that people like in their cars tend to be in a luxury car, and we’re not recording all those. They may not care so much about the fuel efficiency; they want performance of the engine. So when I, as a price measurer, look just at this, I’ll price fuel efficiency negatively. That means that if all the cars in the country got more fuel efficient, and we employed the hedonics literally, we would say inflation went up. Even with computers there are problems like this. These hedonic coefficients jump around a lot.\”

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The Case Against Price Gouging Laws

Michael Giberson of Texas Tech University has written a nice readable essay on \”The Problem with Price Gouging Laws.\” Part of the essay rehearses standard economic arguments over such laws, but with a nice variety of examples and discussion from both economists and philosophers. The case for price gouging laws, of course, is that raising the price for selling necessary goods during an emergency is morally offensive. But economists are congenitally open to the possibility that, upon deeper reflection, people\’s first quick reactions about what is \”right\” or \”wrong\” may be misleading.  Price gouging laws have the following predictable consequences:

Discourage bringing supplies into certain areas. As one example, there is a chain of convenience stores in Tennessee called Weigle\’s. It sells gasoline, and it buys that gasoline on the spot market–not under long-term contracts. In 2008, when Hurricanes Gustav and then Ike tore through the Gulf of Mexico and shut down oil drilling, Weigle\’s ran out of gas. They trucked gas in from other cities, but the extra costs meant that they raised the price of gas by about $1/gallon. This let to an investigation by the state attorney general, which was eventually settle without an admission of wrongdoing, but with a mixture of payments  to the state and consumer refunds. The next time a similar  situation arises, one wonders whether Weigle\’s  will choose to pay the higher costs of trucking in gasoline from other cities. In South Carolina during the same episode, a number gas stations apparently just closed their doors, rather than risk facing charges of price gouging. More generally, if you want people from the cities surrounding a disaster area to bring in ice and food and batteries and other supplies for sale, then you need to be concerned that price gouging laws will discourage them from doing so.

Discourage conserving on key resources. If prices rise during an emergency, people have an incentive to buy only what they need, and not to stock up. As a result, supplies will run out more slowly and remain available for more people. Imagine a situation in which prices of hotel rooms are not allowed to rise, at a time when many evacuated families are looking for a room. A large family might reserve two rooms at the capped rate, but decide to crowd into one room at a higher rate–thus leaving a room available for another family.

Concentrate economic losses on certain economic actors. Price gouging laws often impose costs on merchants, whose costs rise in times of emergencies. They impose larger costs on smaller firms, who have a harder time getting resupplied, than they do on large national chains that have a built-in ability to shift supplies from elsewhere.

Concentrate economic losses on the disaster area. One study sought to analyze what would have happened in the aftermath of Hurricanes Katrina and Rita, if price-gouging laws had been in place. It found that such a law would have caused greater losses in the disaster areas, because if would have discouraged suppliers in neighboring areas from bringing in supplies. However, the neighboring areas would have moderated any costs to the neighboring areas, because supplies from those areas weren\’t being shipped to the disaster area. A web of economic transactions acts as a mechanism for spreading costs of shortages over a wider geographic area.

Before reading this article, I hadn\’t realized that the creation and spread of price-gouging laws is a relatively recent development. Giberson writes: \”The first state law explicitly directed at price gouging was enacted in New York in 1979, in response to increases in home heating oil prices during the winter of 1978–1979. …
Just three states passed similar laws in the 1980s: Hawaii in 1983, and Connecticut and Mississippi in 1986. Then, 11 more states added anti-price gouging laws or regulations in the 1990s and 16 states followed in the 2000s. When price gouging laws are revised, the tendency is for the scope of the law to be broadened, the penalties to become more punitive, and the conditions under which the laws are applied to become less restrictive.\”

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Africa\’s economic development

In the 2010 Annual Report of the Globalization and Monetary Policy Institute at the Dallas Fed, Janet Koech has an essay on Africa–Missing Globalization\’s Rewards? Compared with growth stories like China and India, economic growth in Africa remains anemic. Yet I\’ve been wondering for a few years, based on little hints here and there, whether economic growth in Africa countries might be picking up. The modest upturn in Africa\’s exports and foreign direct investment since about 2000 as a share of world totals are one such hint:

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Long-Term Unemployment in the U.S.

Andreas Hornstein and Thomas A. Lubik of the Richmond Fed write about \”The Rise in Long-Term Unemployment: Potential Causes and Implications.\” They define long-term unemployment as lasting more than 26 weeks. They write: “The share of long-term unemployment [as a proportion of total unemployment]  peaked at 46 percent in the second quarter of 2010, and averaged a bit more than 43 percent for all of 2010. This peak value for the share of long-term unemployment is significantly higher than the previous peak of 26 percent that was attained following the 1981–82 recession. Finally, mean duration of unemployment had increased to about 35 weeks by the middle of 2010, again a substantial increase over the previous peak for mean unemployment duration of 21 weeks after the 1981–82 recession. Never before in the postwar period have unemployed workers been unemployed for such a long time.”

Here\’s an illustrative figure. The left axis measures the unemployment rate. The right axis measures what share of the unemployed are long-term unemployed–more than 26 weeks.

Much of the rise in overall unemployment is due more people entering long-term unemployment than in the past, and to those who have been long-term unemployed having a harder time finding jobs than in the past. This is a potentially major change for the U.S. economy. This figure shows that over the 1968 to 2006 period, U.S. workers were employed in any given month had one of the highest chances compared to other countries of losing that job in that month, but at the same time, a U.S. worker who was unemployed in any given month also had the highest chance of finding a job that month compared to other countries.

The very high rates of long-term unemployment, and the difficulties that the long-term unemployed are having in finding jobs, suggests that the true unemployment picture may be even more grim than the headline statistics suggest.

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How much are automatic stabilizers affecting current deficits?

When the economy hits a recession, tax revenues drop automatically, without any change in legislation. Spending on certain programs to help those in need rises automatically, as more people draw on those programs, without any change in legislation. How much of the current budget deficits are due to discretionary changes in tax or spending policy, and how much to these kinds of automatic changes?

The Congressional Budget Office addresses this question in an April 2011 report. The dark blue line shows the actual budget deficits and surpluses. The light blue line shows what the budget deficits or surpluses would have been if the automatic stabilizers had not occurred. Thus, the gap between the two lines is the measure of the effect of the automatic stabilizers.

 The effect of the automatic stabilizers is large in recent years. The CBO writes: \”In 2010,
CBO estimates, automatic stabilizers added the equivalent of 2.4 percent of potential GDP to the deficit, an
amount somewhat greater than the 2.1 percent added in 2009.3 According to CBO’s baseline projections, the contribution of automatic stabilizers to the budget deficit will decrease as a share of potential GDP—to 2.1 percent in 2011, 1.7 percent in 2012, and 1.5 percent in 2013 … . That contribution will then continue to fall—to 1.0 percent in 2014, 0.5 percent in 2015, and 0.1 percent in 2016—consistent with CBO’s
projection for output to come back up near potential output by 2016.\”

It\’s also interesting to note that the budget surpluses of the late 1990s were made larger because of automatic stabilizers: that is, the unsustainably booming economy of that time brought in extra tax revenue and held down the need for supportive social spending in those years. 

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More on Teaching Monetary Policy After the Recession and Crisis

John C. Williams of the San Francisco Fed discusses “Economics Instruction and the Brave New World of Monetary Policy.” I blogged a couple of weeks ago with some of my own thoughts about how to teach monetary policy after the events of the last few years. Here are some thoughts from John: 
“Today the Board of Governors web site lists 12 monetary policy tools. Nine of them didn’t exist four years ago. The good news is that six of those tools are no longer in existence, reflecting the improvement in financial conditions.”
“Now, there’s no question that Keynes, Friedman, and Tobin were among the greatest monetary theorists of all time. Their theories are elegant statements of fundamental economic principles. As such, they deserve to be taught for a long time to come. But viewing them as definitive in today’s world is like thinking that rock and roll stopped with Elvis Presley. The evolution of money and banking since the 1950s is at least as dramatic as what’s happened with popular music—not that I want to compare the Fed with Lady Gaga.”
“The Federal Reserve has added $1.5 trillion to the quantity of reserves in the banking system since December 2007. Despite a 200 percent increase in the monetary base—that is, reserves plus currency—measures of the money supply have grown only moderately. Over this period, M1 increased 38 percent, while M2 increased merely 19 percent. In other words, the money multiplier has declined dramatically. Indeed, despite all the headlines proclaiming that the Fed is printing huge amounts of money, since the end of 2007 M2 has grown at a 5½ percent annual rate on average. That’s only slightly above the 5 percent growth rate of the preceding 20 years.”
“But now banks earn interest on their reserves at the Fed and the Fed can periodically change that interest rate. This fundamental change in the nature of reserves is not yet addressed in our textbook models of money supply and the money multiplier. Let’s think this through. At zero interest, bankers feel considerable pressure to lend out excess reserves. But, if the interest rate paid on bank reserves is high enough, then banks no longer feel such a pressing need to “put  those reserves to work.” In fact, banks could be happy to hold those reserves as a risk-free interest-bearing asset, essentially a perfect substitute for holding a Treasury security. If banks are happy to hold excess reserves as an interest-bearing asset, then the marginal money multiplier on those reserves can be close to zero. In other words, in a world where the Fed pays interest on bank reserves, traditional theories that tell of a mechanical link between reserves, money supply, and ultimately inflation no longer hold.”
“Instead, the Fed provided additional stimulus by purchasing longer-term securities, another policy tool absent from standard textbooks. From late 2008 through March 2010, the Fed bought $1.7 trillion in such instruments. Then, in November 2010, we announced we would purchase an additional $600 billion in longer-term Treasury securities by the end of June 2011. … I estimate that these longer-term securities purchase programs will raise the level of GDP by about 3 percent and add about 3 million jobs by the second half of 2012. This stimulus also probably prevented the U.S. economy from falling into deflation.”

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McKinsey on economic gains from the Internet

A group at the McKinsey Global Institute has published: “Internet matters: The Net’s sweeping impact on growth, jobs, and prosperity.”  They look at the 13 economies that together make up 70 percent of the world economy. Here are a few highlights:


<!–[if !mso]> st1\\:*{behavior:url(#ieooui) } <![endif]–>“Internet-related consumption and expenditure is now bigger than agriculture or energy, and our research shows that the Internet accounts for, on average, 3.4 percent of GDP in the 13 countries we studied. … The Internet\’s total contribution to the GDP is bigger than the GDP of Spain or Canada, and it is growing faster than Brazil.” 

 “[I]n the mature countries we studied, the Internet accounted for 10 percent of GDP growth over the past 15 years. … And over the past five years, the Internet’s contribution to GDP growth in these countries doubled to 21 percent.

 “[A] simulation shows that an increase in Internet maturity similar to the one experienced in mature countries over the past 15 years creates an increase in real per capita GDP of $500 during this period. It took the Industrial Revolution of the 19th century 50 years to achieve the same results.”

\”[A] detailed analysis of the French economy showed that while the Internet has destroyed 500,000 jobs over the past 15 years, it has created 1.2 million others, a net addition of 700,000 jobs or 2.4 jobs created for every job destroyed. This conclusion is supported by McKinsey\’s global SME [small and medium enterprise] survey, which found 2.6 jobs were created for every one destroyed.\”

“In total, the consumer surplus generated by the Internet in 2009 ranged from  €7 billion ($10 billion) in France to €46 billion ($64 billion) in the United States.”

\”The United States captures more than 30 percent of global Internet revenues and more than 40 percent of net income.\”