Safety Nets and Entrepreneurs

David Leonhardt on the social safety net:

Guaranteeing people a decent retirement and decent health care does more than smooth out the rough edges of capitalism. Those guarantees give people the freedom to take risks. If you know that professional failure won’t leave you penniless and won’t prevent your child from receiving needed medical care, you can leave the comfort of a large corporation and take a chance on your own idea. You can take a shot at becoming the next great American entrepreneur.

This contrasts with the conservative view that government coddling corrodes individual initiative and makes people weak. Needless to say, I find the Leonhardt view more congenial. At the same time, the conservative view actually has some resonance too. It does make some intuitive sense, after all, that being bathed in public support since birth might dull one's desire for risk.1

This is why I rarely use the Leonhardt argument to support the cause of universal healthcare, though I suppose I might have slipped once or twice. Rather, I support it on efficiency grounds — national healthcare systems around the world tend to be cheaper than ours — and on basic humanitarian grounds — in a rich country I just don't think it's right for anyone to have to go without decent healthcare.

Still, I remain curious about the Leonhardt argument, which is a common one in the liberal community. Is it true? Does knowing that you have a safety net make you more likely to get up on the trapeze and try something risky and new? The analogy is wonderful, but that doesn't make it true. Surely, though, this is a testable hypothesis? Not a provable one, of course, but one where evidence can be amassed on different fronts based on measurements of social safety nets in different times and places vs. risk-taking behavior in different times and places. Has anyone ever done this? It seems like a pretty obvious thing to try to study.

1My own view, if I had to take a guess, is that neither of these is right. I suspect that risk takers are risk takers, and they pretty much do their thing based on (a) their own temperament and (b) features of society that make it more or less likely they'll make a lot of money. Fear (or lack of fear) of failure doesn't enter into it much because they don't think they're going to fail. That's the difference between risk takers and the rest of us.

The Slippery Slope

David Bernstein, who displays an admirably cynical attitude toward Supreme Court jurisprudence, thinks that when the individual mandate eventually comes before the court, it will stand or fall based largely on things having nothing to do with actual constitutional interpretation. But he also has a warning for liberals:

If the liberals on the Court, like the dissenters in Lopez, are unable to [articulate] a limiting principle that would prevent their decision from giving the federal government an essentially plenary police power to regulate virtually all human activity and inactivity, the individual mandate is doomed. The conservative majority simply will not accept a doctrine that suggests that federal power is not one of limited and enumerated powers.

Sure, I guess. But here's what gets me. The previously most expansive ruling on the commerce clause came in 1942, in Wickard v. Filburn. In that case, the Supreme Court ruled that an Ohio farmer growing wheat for his own personal use was engaged in interstate commerce and was therefore subject to federal regulation. The court's theory was pretty simple: if Filburn grew wheat above his authorized allotment, even if it was for his own personal use, that meant he would have to buy less wheat for other uses. And since wheat is traded across state lines, that meant interstate commerce was affected. Thus, even personal production of a commodity could be said to substantially affect interstate commerce.

Now comes the individual mandate, and the argument against it is that the government isn't regulating an economic activity, it's regulating an inactivity. That is, it's penalizing a decision not to buy health insurance. But if the government can penalize you for not doing something, then what can't it do?

So the argument is, roughly, this: it's one thing for the government to regulate personal economic activity. That's bad enough, but at least it's activity. But regulating economic inactivity is a bridge too far.

But what if the two cases had been swapped? Suppose the Supreme Court had approved the individual mandate in 1942 and Wickard were a 2010 case. Then the argument would be: it's one thing to make people buy health insurance. That's bad enough, but at least you're regulating participation in a highly public and largely publicly funded sector of the economy. But regulating purely private activity is a bridge too far.

In other words, it wouldn't really matter. It's not that the mandate goes further than Wickard, it's just that the mandate is slightly different from Wickard. There's no slippery slope, and the government doesn't really have any powers that it didn't have all along. If the commerce clause can forbid you from growing wheat because that will cause you not to buy wheat for other purposes, or if the commerce clause can force you to offer a room at your motel to African-Americans even though you don't want to, then it can already force you to do things you might otherwise not want to do. I imagine Bernstein is right that the government's lawyers will need to think up some plausible limiting principle, but it seems to me that the actual principle is already in place: does your activity or inactivity have a substantial effect on interstate commerce? In Wickard, in Heart of Atlanta, and now with the individual mandate, the answer is yes. You can invent a slippery slope if you want, but I don't think it really exists anywhere except in the imagination.

The Trouble With Mandates

Here are the editors of National Review on the individual mandate provision of the healthcare reform bill:

The mandate highlights the coercive and obnoxious character of Obamacare as a whole. The whole scheme works, to the extent it works, only if people are forced to buy a product they would not buy on a free market.

And here is Jim Manzi, in the current issue of National Review, explaining that Social Security as a tax-supported pension plan should be dismantled:

Instead, we should have a defined-contribution pension program requiring individuals to contribute a reasonable proportion of their income (though some flexibility should be allowed) to an array of investment vehicles to which they hold property rights.

Granted, there's no requirement that every contributor to National Review has to agree with its official editorial positions. But converting Social Security from a tax-supported program into one where people are instead required to buy private retirement annuities is a pretty mainstream conservative view. So what are we to make of the proposition that forcing people to buy retirement annuities is OK but forcing them to buy healthcare insurance isn't?

Beats me. But I figure there are two possibilities. (1) They don't really think a healthcare mandate is "obnoxious" at all. It's just a handy talking point. (2) They do think the mandate is obnoxious, and they think the same thing about private Social Security accounts. And if they ever succeed in getting them, they'll immediately file suit in federal court to have the whole program declared unconstitutional.

But which is it? Decisions, decisions.

Turning Down the Volume

What is money? What is — hold on a second. Who cares? The White House press office has emailed to tell me that President Obama just signed a new law:

S. 2847, the “Commercial Advertisement Loudness Mitigation or the “CALM Act,” which requires the Federal Communications Commission to prescribe a regulation limiting the volume of audio on commercials transmitted by television broadcast stations, cable operators, and other multichannel video programming distributors.

IT'S ABOUT DAMN TIME. Oops. Sorry about that. Anyway, assuming that the FCC adopts a decent rule, this is good news. And it only took 40 years!

Money, Money, Money

Paul Krugman asks a question:

But here’s an even more basic question: what is money, anyway? It’s not a new question, but I think it has become even more pressing in recent years.

Surely we don’t mean to identify money with pieces of green paper bearing portraits of dead presidents. Even Milton Friedman rejected that, more than half a century ago....Friedman and Schwartz dealt with this by proposing broader aggregates — M1, which adds checking accounts, and M2, which adds a broader range of deposits. And circa 1960 you could argue that those aggregates were good enough.

....The truth is that these days — with credit cards, electronic money, repo, and more all serving the purpose of medium of exchange — it’s not clear that any single number deserves to be called “the” money supply. Intellectually, this isn’t a problem; nor is there necessarily a problem maintaining monetary policy even if there isn’t any single thing you’re willing to call money.

I'm not sure if I agree with this or not. Intellectually, this does seem to be a problem. An awful lot of the technical discussion I see about stimulus and monetary policy and quantitative easing and so forth really does seem, at its core, to revolve around the question of just what counts as money these days.

So: What is money? The simplest answer is, "Anything you can pay your taxes with." Beyond that, there are things that can be converted into money so quickly that they're extremely money-like, followed by things that are increasingly less money-like. In this sense, "money" is a property, not a thing, and you can have lots of it (dollar bills, debit cards, checks) or only some of it (foreign currency, treasury bills, gold, etc.).

When I see people arguing, for example, that bank deposits earning 0.25% at the Fed are identical to treasury bills paying 0.25%, that seems to me to be an argument about the nature of money. Are those two things really identical? Or 99% identical? Or 90% identical? When interest rates change, bank deposits and treasury bills obviously become less perfect substitutes for each other. Does that mean that one or the other has become less money-like?

How money-like is debt? It depends on the debt. During the credit bubble of the aughts, debt skyrocketed, but normal monetary aggregates didn't. And yet, that debt had much the same effect as a huge increase in the money supply.

I dunno. I agree that this is not a new question, but I also agree that it's lately become a more pressing one. How can you properly do macroeconomic analysis in a world where no one even agrees anymore about what counts as money and what doesn't?

Inequality and Economic Collapses

"Inequality, Leverage and Crises," an IMF paper written by Michael Kumhof and Romain Rancière, is full of long equations populated by many Greek letters. I won't even pretend that I can evaluate it. However, their introduction is pretty easy to understand: they've constructed a simple model for financial crises that essentially proposes the following narrative: (a) growing inequality produces less money for the middle class and more money for the rich, (b) the rich loan much of this money back to the middle class so they can continue to improve their living standards even with stagnant incomes, (c) the financial sector balloons to mediate all this, and (d) the system eventually collapses since, after all, this kind of thing can't last forever. Here it is in their words:

The United States experienced two major economic crises over the past century — the Great Depression starting in 1929 and the Great Recession starting in 2007. Both were preceded by a sharp increase in income and wealth inequality, and by a similarly sharp increase in debt-to-income ratios among lower- and middle-income households. When those debt-to-income ratios started to be perceived as unsustainable, it became a trigger for the crisis.

....The key mechanism is that investors use part of their increased income to purchase additional financial assets backed by loans to workers. By doing so, they allow workers to limit their drop in consumption following their loss of income, but the large and highly persistent rise of workers’ debt-to-income ratios generates financial fragility which eventually can lead to a financial crisis. Prior to the crisis, increased saving at the top and increased borrowing at the bottom results in consumption inequality increasing significantly less than income inequality. Saving and borrowing patterns of both groups create an increased need for financial services and intermediation. As a consequence the size of the financial sector, as measured by the ratio of banks’ liabilities to GDP, increases.

The crisis is characterized by large-scale household debt defaults and an abrupt output contraction as in the 2007 U.S. financial crisis. Because crises are costly, redistribution policies that prevent excessive household indebtedness and reduce crisis-risk ex-ante can be more desirable from a macroeconomic stabilization point of view than ex-post policies such as bailouts or debt restructurings. To our knowledge, our framework is the first to provide an internally consistent mechanism linking the empirically observed rise in income inequality between high income households and poor to middle income households, the increase in household debt-to-income ratios among the latter group, and the risk of a financial crisis.

Needless to say, I find this extremely persuasive. That doesn't mean it's true, though. Hopefully lots of smart economists will seriously grapple with this and figure out if it really does explain a big part of what happened during the aughts.

What's the Deal With the Estate Tax?

Ezra Klein writes about the estate tax debate today, and he mentions all the usual talking points: it went down to zero this year as part of a political ploy by Republicans, it only affects 2% or less of estates, repeal is heavily supported by the ultra-rich, etc. etc. This is all true.

And yet, something about the estate tax debate still eludes me. Polls routinely show that a substantial majority of people favor higher income taxes on the rich. But polls also show that a substantial majority of people favor repeal or reduction of the estate tax. Here's one that says 68% favor total repeal. Here's another in which preventing an increase in the estate tax ranks as the public's highest concern for the lame duck session. And of course, there's Monday's ABC poll showing that 52% favor a reduction in the estate tax.

The wording in these polls differs, and there's no telling how many people understand what the current rules are or who the estate tax primarily affects. Still, there's a pretty consistent thread here: generally speaking, a pretty sizeable majority of the country favors the idea of repealing the estate tax or, at the least, keeping it low.

I'm not sure what to think of this. It's possible, of course, that the public has simply been brainwashed by over a decade of focused estate tax propaganda from representatives of the rich. It's also possible that most people have no idea that the estate tax only hits the extremely wealthy in the first place. But I don't think that's the whole story. Like it or not, I think that most people simply have an instinctive feeling that you should be able to bequeath your money to whoever you want. If most bequests went to, say, political parties or yacht harbor upkeep groups, things might be different. But as long as most bequests go to family members, you're dealing with a very deep, very primitive protective instinct that most people sympathize with no matter how rich you are. After all, I feel that, and I don't even have kids.

At least, that's my guess. But I'd really like to see some deeper research on this. How have attitudes changed over time? How do they differ between countries? And when you dig deeper, what do people actually say about their feelings on rich people and their estates? Until we understand this, I feel like proponents of higher estate taxes are flying a bit blind.

Quote of the Day: Budget Woes in California

The LA Times reports on Jerry Brown's remarks at a state budget forum yesterday:

"We'll present a budget on Jan. 10. It will be a very tough budget, but it will be transparent," he said. "We'll lay it out as best I can. We've been living in fantasy land. It is much worse than I thought. I'm shocked."

I'm disappointed in Jerry for being so hackneyed. It's the oldest bromide in the book. "Much worse" my ass. The California state budget is an epic disaster and he knew it perfectly well going in. I don't expect miracles, but I at least expect him to start out with just a tiny bit of honesty and candor.

The Alternate Universe of the GOP

Every once in a while I feel like I've succumbed to partisan madness and need to back off and assume a bit more good faith and sincerity from thinkers and activists on the other side. I need to treat conservative arguments with a little more respect and a little more generosity. But then I read a story like this, telling me that the four Republican members of the Financial Crisis Inquiry Commission have refused to agree to a bipartisan final report and will instead issue their own minority report:

During a private commission meeting last week, all four Republicans voted in favor of banning the phrases "Wall Street" and "shadow banking" and the words "interconnection" and "deregulation" from the panel's final report, according to a person familiar with the matter and confirmed by Brooksley E. Born, one of the six commissioners who voted against the proposal.

I don't even know what to say about this. I could write a hundred words about it or a thousand. But what's the point of pretending to take this stuff seriously? They're not, after all.

POSTSCRIPT: OK, I'll say just a wee bit more. Let's take those phrases one by one.

I could live without Wall Street. We can just call it the finance industry instead. That works fine and spares delicate sensibilities. I could even, at a stretch, live without deregulation. You have to talk about prudential regulation and leverage rules somehow, but maybe there's a way to do it without actually using that word. It's a stretch, but maybe.

But interconnection and shadow banking? It's just literally impossible to usefully discuss the financial crisis without mentioning those things. They're absolutely central to the whole story, and I don't even know what kinds of words you could replace them with. It's like writing about the New Testament without mentioning Jesus. I guess you could do it, but what's the point?

Why Are Bankers So Rich?

Tyler Cowen has a big piece about income inequality in The American Interest that's well worth reading. However, it's not really about the growth of inequality. It's about Wall Street. In particular, it's about this question: why do financial professionals make so damn much money?

The answer, of course, is that they work in an industry that's become ungodly profitable. But how? Tyler attributes it to the practice of "going short on volatility." That is, modern finance professionals mostly gamble that what happened in the past will keep happening in the future, and disasters will never happen. In most years this makes them a lot of money (because, in fact, disasters rarely happen).

But this is mysterious. After all, not everyone is going short on volatility. In fact, by definition, only half of the punters on Wall Street are doing it. The other half are taking the other side of the bet. Tyler explains this with an analogy to a bet that the Washington Wizards, one of the worst teams in basketball, won't win the NBA championship. If you make that bet year after year, you'll keep making money year after year.

This is a useful analogy precisely because it wouldn't work. After all, to make that bet, you have to find someone willing to take the other side and bet that disaster will strike and the Wizards will win. But they know just how unlikely that is, so they're going to require very long odds. On a hundred dollar bet, they'll want $100 if they win but will only be willing to pay off one dollar if you win. That won't make you rich.

So how can you make money doing this? Answer: find someone who doesn't know much about basketball and pays off two dollars on this bet instead of one. Additionally, you need to borrow money so you can make lots of bets. So instead of placing a $100 bet and making a dollar, you borrow a million dollars, make lots of bets on lots of teams, and make $20,000. It's the road to riches.

The questions this raises should be obvious. First, why would anyone be dumb enough to offer you such mistaken odds? Second, shouldn't the interest on the loan wipe out the profit from such a tiny betting margin? Third, why would anyone loan you this money in the first place, knowing that you have no chance of paying it back if disaster strikes, one of your teams wins, and you lose your entire stake?

As near as I can tell, the answer to #1 is that Wall Street traders are bad at pricing tail risk. The answer to #2 is that Wall Street hedge funds, using techniques pioneered in the mid-90s by Long Term Capital Management, have figured out ways to borrow large sums of money at virtually no cost. And the answer to #3 is that Wall Street lenders are also bad at pricing tail risk.

Or are they? Tyler argues that, in fact, both sides are betting that as long as everyone is doing this, the occasional disasters will be so epically disastrous that central banks will bail them out. They have no choice, after all, if the alternative is the destruction of the global economic system. So the tail risk is smaller than you think. Borrowers will make money in good years and default in bad years. Lenders, meanwhile, will also make money in good years, secure in the knowledge that on the rare occasions when everything goes pear shaped and borrowers can't pay back their loans, the government will make them whole. As Tyler reminds us, "Neither the Treasury nor the Fed allowed creditors to take any losses from the collapse of the major banks during the financial crisis."

But I don't find this persuasive as a behavioral explanation. The problem is that there's simply no evidence I'm aware of that Wall Street executives ever thought about this or priced it into their models. Sure, they may have been reckless or stupid. However, they weren't setting prices for financial instruments based on the idea that, yes, they were taking a genuine risk of going bust, but they could price that away because they'd get bailed out by Uncle Sugar when it happened. Rather, they really, truly, believed that they weren't exposed to very much risk. As near as I can tell, this was true on both the buy side and the sell side.

Tyler's story of private gains and socialized losses is surely true as an explanation for how the finance industry stayed highly profitable even while undergoing an epic meltdown. But I'm not sure it adequately explains why the industry became so stratospherically profitable before the meltdown. Because the problem in the pre-meltdown era wasn't that banks were taking on more and more risk, the problem was increased leverage and mispriced risk. For some reason, as Tyler puts it, "It's as if the major banks have tapped a hole in the social till and they are drinking from it with a straw."

This has always been one of the central mysteries of modern finance: Why is it so damn profitable? We're talking about an industry that's global, largely commoditized, and highly competitive. Profits should have been under extreme pressure for the past few decades. And yet, somehow, just the opposite was true. Against all theory, banks were able to consistently charge excessive prices; consistently take the better side of financial bets; and consistently persuade every other actor in the business that mispriced risk was, in fact, correctly priced. The result has been wild profitability and huge bonuses.

And where did this insane gusher of money come from? There are three possibilities: (1) banks created it, (2) their activities caused the economy to grow faster than it otherwise would have, and they reaped the benefit of that extra growth, or (3) it was somehow skimmed away from the rest of society. Possibility #1 is unlikely: banks certainly created mountains of debt, but mountains of money would show in skyrocketing monetary aggregates and high inflation, neither of which happened. Possibility #2 also seems unlikely. There's simply no evidence, either in comparisons over time or comparisons between countries, that economic growth over the past two or three decades has benefited from financial rocket science. So that leaves possibility #3: somehow, all this financial engineering was based on skimming money away from everyone else.

So, in the end, Tyler's piece really is about income inequality. The incomes of the vast middle class have lagged productivity growth by a small amount each year, and that small amount has accumulated into a gigantic pool of cash that gets funneled to a tiny number of the super rich, many of them in the finance industry.

But how? There's still a mystery here that no one has ever adequately explained. But it's important. As I've mentioned before, the primary metric for determining if financial reform is effective is the profitability of the financial industry. If it goes down a lot — by about half, I'd say — then it will have been successful. If not, then not. So far, the signs don't look good.