TEKNOIOT: Commentary
Showing posts with label Commentary. Show all posts
Showing posts with label Commentary. Show all posts

7 Sept 2020

Don't Believe the Economic Pessimists - Barokong

Source: Wall Street Journal
No matter who wins Tuesday’s presidential election, now ought to be the time that policy makers in Washington come together to tackle America’s greatest economic problem: sclerotic growth. The recession ended more than seven years ago. Unemployment has returned to normal levels. Yet gross domestic product is rising at half its postwar average rate. Achieving better growth is possible, but it will require deep structural reforms.

The policy worthies have said for eight years: stimulus today, structural reform tomorrow. Now it’s tomorrow, but novel excuses for stimulus keep coming...

Keep reading here, the Wall Street Journal Oped. I'll post the whole thing in 30 days as usual.

Somehow the WSJ thinks anyone is interested in growth and serious policy on the eve of the election. Or maybe they were just tired of Trump vs. Clinton and needed to fill space.  At any rate, it might give you a little reprieve from the election coverage.

23 Aug 2020

The Tax-and-Spend Health-Care Solution - Barokong

A Wall Street Journal Oped, From July 29 2018. Now that 30 days have passed, I can post the whole thing.

The Tax-and-Spend Health-Care Solution

Honest subsidies beat cross-subsidies. They’d encourage competition and innovation.

By John H. Cochrane

Why is paying for health care such a mess in America? Why is it so hard to fix? Cross-subsidies are the original sin. The government wants to subsidize health care for poor people, chronically sick people, and people who have money but choose to spend less of it on health care than officials find sufficient. These are worthy goals, easily achieved in a completely free-market system by raising taxes and then subsidizing health care or insurance, at market prices, for people the government wishes to help.

But lawmakers do not want to be seen taxing and spending, so they hide transfers in cross-subsidies. They require emergency rooms to treat everyone who comes along, and then hospitals must overcharge everybody else. Medicare and Medicaid do not pay the full amount their services cost. Hospitals then overcharge private insurance and the few remaining cash customers.

Overcharging paying customers and providing free care in an emergency room is economically equivalent to a tax on emergency-room services that funds subsidies for others. But the effective tax and expenditure of a forced cross-subsidy do not show up on the federal budget.

Over the long term, cross-subsidies are far more inefficient than forthright taxing and spending. If the hospital is going to overcharge private insurance and paying customers to cross-subsidize the poor, the uninsured, Medicare, Medicaid and, increasingly, victims of limited exchange policies, then the hospital must be protected from competition. If competitors can come in and offer services to the paying customers, the scheme unravels.

No competition means no pressure to innovate for better service and lower costs. Soon everybody pays more than they would in a competitive free market. The damage takes time, though. Cross-subsidies are a tempting way to hide tax and spend in the short run, but they are harmful over years and decades.

We have seen this pattern over and over. Until telephone deregulation in the 1970s, the government wanted to provide telephone landlines below cost. It forced a cross-subsidy from overpriced long distance and a telephone monopoly to keep entrants out and prices up. The government wanted to subsidize small-town air service. It forced airlines to cross-subsidize from overpriced big-city services and enforced an oligopoly to keep entrants from undercutting the profitable segments. But protection bred inefficiency. After deregulation, everyone’s phone bills and airfares were lower and service was better and more innovative.

Lack of competition, especially from new entrants, is the screaming problem in health-care delivery today. In no competitive business will they not tell you the cost before providing service. In a competitive business you are bombarded with ads from new companies offering a better deal.

The situation is becoming ridiculous. Emergency rooms are staffed with out-of-network anesthesiologists. Air ambulances take everyone without question, and Medicare, Medicaid and exchange policies underpay. You wake up with immense bills, which you negotiate afterward based on ability to pay. The cash market is dead. Even if you have plenty of money, you will be massively overcharged unless you have health insurance to negotiate a lower rate.

Taxing and spending is not good for the economy. But it’s better than cross-subsidization. Taxing and spending can allow an unfettered competitive free market. Cross-subsidies must stop competition and entry at the cost of efficiency and innovation. Taxing and spending, on budget and appropriated, is also visible and transparent. Voters can see what’s going on. Finally, broad-based taxes, as damaging as they are, are better than massive implied taxes on very few people.

This is why continued tinkering with the U.S. health-care system will not work. The system will be cured only by the competition that brought far better and cheaper telephone and airline services. But there is a reason for the protections that make the system so inefficient: Allowing competition would immediately undermine cross-subsidies. Unless legislators swallow hard and put the subsidies on the budget where they belong, we can never have a competitive, innovative and efficient health-care market.

But take heart—when that market arrives, it will make the subsidies much cheaper. Yes, the government should help those in need. But there is no fundamental reason that your and my health care and insurance must be so screwed up to achieve that goal.

Mr. Cochrane is a senior fellow of the Hoover Institution at Stanford University and an adjunct scholar of the Cato Institute

Dollarize Argentina - Barokong

Argentina should dollarize, says Mary Anastasia O'Grady in the Wall Street Journal -- not a peg, not a currency board, not an IMF plan, just give up and use dollars.

Another currency crisis is roiling Argentina... The peso has lost half its value against the U.S. dollar since January. Inflation expectations are soaring.
The central bank has boosted its overnight lending rate to an annual 60% to try to stop capital flight. But Argentines are bracing for spiraling prices and recession.
...the troubles have been brewing for some time. On a trip to Buenos Aires in February, I got an earful from worried economists who said Mr. Macri was moving too slowly to reconcile fiscal accounts.
In 2016 and 2017 the government continued spending beyond its means and borrowing dollars in the international capital markets to finance the shortfall. That put pressure on the central bank to print money so as not to starve the economy of low-priced credit ahead of midterm elections in 2017....
A sharp selloff of the peso in May was followed by a new $50 billion standby loan from the International Monetary Fund in June. With a monetary base that is up over 30% since last year, in a nation that knows something about IMF intervention, that was like waving a red cape in front of a bull.
The peso was thus vulnerable when currency speculators launched an attack on the Turkish lira last month and the flight to the dollar spilled over into other emerging markets, including Argentina. After decades of repeated currency crises, Argentines can smell monetary mischief. A peso rout ensued.
Conventional Wisdom these days -- the standard view around the Fed, IMF, OECD, BIS, ECB, and at NBER conferences -- says that countries need their own currencies, so they can quickly devalue to address negative "shocks." For example, conventional wisdom says that Greece would have been far better off with its own currency to devalue rather than as part of the euro. I have long been skeptical.

It's not working out so great for Argentina. As Mary points out, short term financing means there can be "speculative attacks" on the currencies of highly indebted countries that run their own currencies, just as there can be runs on banks. And Conventional Wisdom, silent on this issue advocating a Greek return to Drachma, was full in that the Asian crises of the late 1990s were due to "sudden stops," and such speculative machinations of international "hot money."

Well, says CW, including the IMF's "institutional view," that means countries need "capital flow management," i.e. governments need to control who can buy and sell their currency and and who can buy or sell assets internationally.  Yet Venezuela and Iran are crashing too, and not for lack of capital flow "management." My understanding is Argentina does not allow free capital either. Moreover, if there is a chance you can't take your money out, you don't put it in in the first place. There is a reason the post Bretton Woods international consensus drove out capital restrictions.

So I agree with Mary -- dollarize. Just get it over with. What possible benefit is Argentina getting from clever central bank currency manipulation, if you want a dark word, or management, if you want a good one? Use the meter and the kilogram too.

There is a catch, however, not fully explicit in Mary's article. The underlying problem is fiscal, not monetary. To repeat,

"Mr. Macri was moving too slowly to reconcile fiscal accounts. ...In 2016 and 2017 the government continued spending beyond its means and borrowing dollars in the international capital markets to finance the shortfall."
So, I think it's a bit unfair for Mary to complain that Argentina's problem is that it "has a central bank." I don't know what any central banker could do, given the fiscal problems, to stop the currency from crashing.

If the government dollarizes, it can no longer inflate or devalue to get out of fiscal trouble. Argentina has pretty much already lost that option anyway. If the government borrows Pesos, inflating or devaluing eliminates that debt. But if the government borrows in dollars, a devaluation or inflation taxes a much smaller base of peso holders to try to pay back the dollar debt.

Still, a dollarized government must either pay back its bills or default. That's how the Euro was supposed to work too, until Europe's leaders, seeing how much Greek debt was stuffed into French and German banks, burned the rule book.

So the underlying problem is fiscal. With abundant fiscal resources, the government could have borrowed abroad to stop a run on the Peso. And without those resources, dollarization will not solve its debt and deficit problem. Dollarization will force the government to shape up fast, which may be Mary's point.

Dollarization will insulate the private economy from government fiscal troubles. This is a great, perhaps the greatest, point in its favor. Even if the government defaults, companies in a fully dollarized, free capital flow economy, can shrug it off and go about their business. Forced to use pesos, subject to sharp inflation, devaluation, capital and trade restrictions, the government's problems infect the rest of the economy.

Last, CW likes devaluation and inflation because it supposedly "stimulates" the economy through its troubles surrounding a crisis. That strikes me as giving a cancer patient an espresso. Argentina is getting both inflation and recession, not a stimulative boom out of its inflation.

Dollarization is not a currency board, which Argentina also tried and failed. A currency board is a promise to keep the peso equal to the dollar, and to keep enough dollars around to back the pesos. Alas, it does not keep dollars around to back all the governments' debts, so the government soon enough will see the kitty of dollars and grab them, abrogating the currency board. Dollarization means the economy uses dollars, period, and there is no pool of assets sitting there to be grabbed.

22 Aug 2020

Fed Nixes Narrow Bank - Barokong

A narrow bank would be a great thing. A narrow bank takes deposits, and invests 100% of the money in interest-paying reserves at the Fed. (The Fed, in turn, mostly invests in US treasuries and agency securities.)

A narrow bank cannot fail*. It cannot lose money on its assets. A narrow bank cannot suffer a run. If people want their money back, they can all have it, instantly. A narrow bank needs essentially no asset risk regulation, stress tests, or anything else.

A narrow bank fills an important niche. Individuals can have federally insured bank accounts which are (mostly) safe. But large businesses need to handle cash way above the limits of deposit insurance. For that reason, they invest in repurchase agreements, short-term commercial paper, and all the other forms of short term debt that blew up in the 2008 financial crisis. These are safer than bank accounts, but, as we saw, not completely safe. A narrow bank is completely safe. And with the option of a narrow bank, the only reason for companies to invest in these other arrangements is to try to harvest a little more interest. Regulators can feel a lot more confident shutting down run-prone alternatives if a narrow bank is widely available.

The most common objection to equity-financed banking is that people and businesses need deposits. Well, narrow banks provide those deposits, and can do so in nearly unlimited amount. Narrow banking, providing completely safe deposits, opens the door to equity-financed banking, which can invest in risky assets and also be immune from financial crises.

Why not just start a a money market fund that invests in treasuries? Since deposit -> narrow bank -> Fed -> Treasuries, why not just deposit -> money market fund -> treasuries, and cut out the middle person? Well, a narrow bank is really a bank. A money market fund cannot access the full range of financial services that a bank can offer. If you're a business and you want to wire money to Germany this afternoon, you need a bank.

Suppose someone started a narrow bank. How would the Fed react? You would think they would welcome it with open arms. Not so.

TNB, for "The Narrow Bank" just tried, and the Fed is resisting in every possible way. TNB just filed a complaint against the New York Fed in District Court, which makes great reading. (The complaint is publicly available here, but behind a paywall, so I posted it on my webpage here.) Excerpts:

2. “TNB” stands for “the narrow bank”, and its business model is indeed narrow. TNB’s sole business will be to accept deposits only from the most financially secure institutions, and to place those deposits into TNB’s Master Account at the FRBNY, thus permitting depositors to earn higher rates of interest than are currently available to nonfinancial companies and consumers for such a safe, liquid form of deposit.
3. TNB’s board of directors and management have devoted more than two years and substantial resources to preparing to open their business, including undergoing a rigorous review by the State of Connecticut Department of Banking (“CTDOB”). The CTDOB has now granted TNB a temporary Certificate of Authority (“CoA”) and is fully prepared to permit TNB to operate on a permanent basis.
4. However, to carry out its business—indeed, to function at all—TNB needs access to the Federal Reserve payments system.
5. In August 2017, therefore, TNB began the routine administrative process to open a Master Account with the FRBNY. Typically, the application procedure involves completing a one-page form agreement, followed by a brief wait of no more than one week. Indeed, the form agreement itself states that “[p]rocessing may take 5-7 business days” and that the applicant should “contact the Federal Reserve Bank to confirm the date that the master account will be established.”
6. This treatment is consistent with the governing statutory framework. Concerned by preferential access to Federal Reserve services by large financial institutions, Congress passed the Depository Institutions Deregulation and Monetary Control Act of 1980 (the “Act”). Under the applicable provision of the Act, 12 U.S.C. § 248a(c)(2), all FRBNY services “shall be available” on an equal, non-discriminatory basis to any qualified depository institution that, like TNB, is in the business of receiving deposits other than trust funds.
7. TNB did not receive the standard treatment mandated by the governing law. Despite Connecticut’s approval of TNB—as TNB’s lawful chartering authority—and the language of the governing statute, the FRBNY undertook its own protracted internal review of TNB. TNB fully cooperated with that review, which ultimately concluded in TNB’s favor. At the same time, the FRBNY also apparently referred the matter to the Board of Governors of the Federal Reserve System (the “Board”) in Washington, D.C.
8. In December 2017, TNB was informed orally by an FRBNY official that approval would be forthcoming—only to be called back later by the same official and told that the Board had countermanded that direction, based on alleged “policy concerns.”
9. TNB’s principals thereafter met with staff representatives of the Board, as well as the President of the FRBNY, to explain that there was no lawful basis to reject TNB’s application for a Master Account. On information and belief, the FRBNY and its leadership agreed with TNB and were prepared to open a Master Account.
10. Though TNB had satisfactorily completed the FRBNY’s diligence review, the Board continued to thwart any action by the FRBNY to open TNB’s Master Account, reportedly at the specific direction of the Board’s Chairman.
11. Having delayed the process for nearly one year—effectively preventing TNB from doing business—the FRBNY has repeatedly refused either to permit TNB to open a Master Account or to state that the FRBNY will ultimately do so.
12. The FRBNY’s conduct is in open defiance of the statutory framework, its own prior positions, and judicial authority. See Fourth Corner Credit Union v. Fed. Reserve Bank of Kan. City, 861 F.3d 1052, 1071 (10th Cir. 2017) (“The plain text of § 248a(c)(2) indicates that nonmember depository institutions are entitled to purchase services from Federal Reserve Banks. To purchase these services, a master account is required. Thus, nonmember depository institutions . . . are entitled to master accounts.”) (Bacharach, J.) (emphasis added).
13. Further, the FRBNY’s actions, especially in the context of other recent conduct by the Board,1 have the effect of discriminating against small, innovative companies like TNB and privileging established, too-big-to-fail institutions—the very dynamic that led Congress to pass the Act in the first place.
14. TNB therefore brings this action for a prompt declaratory judgment that it is entitled to a Master Account.
Why does the Fed object?

The Fed may worry about controlling the size of its balance sheet -- how many reserves banks have at the Fed, and how many treasuries the Fed correspondingly buys. If narrow banks get really popular, the Fed might have to buy more treasuries to meet the need. Alternatively, the Fed might have to discriminate, paying narrow banks less interest than it pays "real" banks, in order to keep down the size of the narrow banking industry. It would then face hard questions about why it is discriminating and paying traditional banks more than it pays everyone else. (It's already a bit of a puzzle that it often pays interest on reserves larger than what banks can get anywhere else, even treasuries.)

But why does the size of the balance sheet matter? Why does it matter whether people hold treasuries directly, hold them via a money market fund, or hold them via a narrow bank, which holds reserves at the Fed, which holds treasuries?

"Money" is no longer money. When the Fed pays interest on huge amounts of excess reserves, the size of the balance sheet no longer matters, especially in this regard. If people want to hold more treasuries indirectly through a narrow bank and the Fed, and correspondingly less directly, why should that have any stimulative or depressing effect at all? Even if you do think QE purchases -- supply-driven changes in the balance sheet -- matter, it is not at all clear why demand-driven changes should matter.

The Fed already allows a "reverse repo program,"  in which 160 institutions such as money market funds to hold reserves. It currently pays those 20 basis points (0.2%) less than it pays banks, to discourage participation.

The second argument, made during the discussion about reverse repos, is that narrow banks are a threat to financial stability, not a guarantor of it as I have described, because people will run to narrow banks away from repo and other short term financing in times of stress.

This is, in my view, completely misguided. Again, narrow banks are just an indirect way of holding treasuries. There is nothing now stopping people from "running" to treasuries directly, which is exactly what they did in the financial crisis.

Furthermore, the Fed does not, in a crisis, seek to force people to hold illiquid assets having a run. The Fed pours liquid assets into the system like Niagara falls, and buys illiquid assets from them, all in massive quantities.

Moreover, the whole point of the narrow bank is that large businesses don't hold fragile run-prone short term assets in the first place. By paying interest on reserves, and allowing more and more people to enjoy run-proof government money, there is less gasoline in the financial system to begin with. If the Fed is worried about financial crises, it ought to encourage narrow banks and give others a gold star for using them rather than shadier short-term assets in the first place.

The emptiness of both arguments is easy to see from this: Chase and Citi are narrow banks -- married to investment banks. Both take deposits, and invest them as interest paying reserves at the Fed. Right now there are more reserves than checking accounts in the banking system as a whole. If there were some threat to monetary policy or financial stability from banks being able to take deposits and funnel them in to reserves, we'd be there now. The only difference is that if Chase and City lose money on their risky investments, they drag down depositors too and the government bails out the depositors. The narrow banks are not separated from the investment banks in bankruptcy. A true narrow bank just separates these functions.

Shadier speculations are natural as well.

Banks are making a tidy profit on their current activities. JP Morgan Chase pays me 1 basis point on my deposits, as it has forever, and now earns 1.95% on excess reserves. The "pass through" from interest earned to interest paid to depositors is very slow. This is a clear sign of lack of competition in the banking system. The Fed's reverse RP program was put in place, in part, to pressure banks to act a bit more competitively, by allowing an almost-narrow bank to take investor money and put it in reserves. The Fed is now scaling that program back.

That the Fed, which is a banker's bank, protects the profits of the big banks system against competition, would be the natural public-choice speculation.

Perhaps also my vision of a run-proof essentially unregulated banking system isn't as attractive to the Fed as it should be. If deposits are handled by narrow banks, which don't need asset risk regulation, and risky investment is handled by equity-financed banks, which don't need asset risk regulation, a lot of regulators and "macro-prudential" policy makers, who want to use regulatory tools to control the economy, are going to be out of work.

To be clear, I have no evidence for either motivation. But the facts fit, and large institutions are not always self-aware of their motivations.

Whatever the reason, it is sad to see the Fed handed such an obvious boon to financial stability and efficiency, and to slow walk it to regulatory death, despite, apparently, clear legal rights of the Narrow Bank to serve its customers.

*Well, almost. For the Fed to fail, there would have to be a large-scale US default on treasury debt. Even so, Congress could exempt the Fed by recapitalizing it, making good its losses. So Congress would have to decide that it won't even recapitalize the Fed, so that reserves also default. If there is one bank that really is too big to fail, it's the Fed, as its failure would bring down the entire monetary system. Literally, all of the ATMs and credit card machines go dark. This is a pretty improbable event.

Update: Endi below asks "Why do you say that with the existence of narrow banks, equity-financed banks would be immune from a financial crisis?" See "A Blueprint for Effective Financial Reform", "Equity-financed banking and a run-free financial system," "Toward a run-free financial system",  All here.

Update 2: Matt Levine at Bloomberg has excellent coverage. Michael Derby at WSJ too. As Matt and a commenter below explain,  I got ahead of myself on TNB. This particular company is not planning to offer banking services or retail deposits. They won't even wire money for you. The reason: if they were to do so, they would face lots of anti-money-laundering regulations. This particular business is focused on giving money market funds and other large institutions access to the 1.95% that the Fed pays on reserves, which is more than the 1.75% that money market funds can get via reverse repo at the same Fed, or (paradoxically) the rate that short term treasuries have been offering lately.

Update 3: an excellent WSJ editorial. The Fed remains silent. My forecast: The Fed will remain silent, fight the lawsuit with obfuscation and delay.  It can surely let this rot in the courts for a decade or more. By that time the TNB folks will be out of money and have to give up, and any potential copycats will get the message.

Cause, effect, and carbon - Barokong

“As fires rage up and down the state of California, costing our taxpayers billions of dollars and threatening our families’ health—- the need for California to move to 100% clean, renewable energy could not be more urgent,” said Mr. de León in a statement.
Sen. Kevin de León, a Democrat who is waging a long-shot run for a U.S. Senate seat against incumbent Dianne Feinstein.
Reported in the Wall Street Journal

The context is

California passed legislation Tuesday that would make it the first large state to mandate completely carbon-free electricity generation, with a target of 2045.
My understanding is that nuclear does not count as "carbon free."

Just to belabor the obvious, the central part of our state has been living under a blanket of smoke most of the summer. Smoke causes an immediate and local pollution problem, which is a direct threat to human health -- fine particulate matter.  Yet the state has cut its firefighting air fleet and budget over the past few years, and also let fuel accumulate in forests over the winter.

California contributes maybe 1% of global carbon emissions. Guesstimate for yourself how much California carbon-free energy by 2045 will do to reduce wildfires in your grandchildren's lifetime.  "Urgent?"

If you think global warming is real, and that it will increase wildfires, it seems you would be rushing to spend money on putting out fires.

Instead, our state government seems to regard wildfires as punishments for our carbon sins, that only praying to the Temple of Carbon with largely symbolic billions of dollars can salve. Actually doing something about problems the West has always had -- wildfires -- that may be moving north a bit due to global warming seems to be regarded as an immoral act.

I am also interested by the fantastical cause-and-effect thinking going on here, and the flight from any vaguely quantifiable dollars per unit of effect. And this from the self-described "party of science."

Supply-side health care - Barokong

The discussion over health policy rages over who will pay -- private insurance, companies, "single payer," Obamacare, VA, Medicare, Medicaid, and so on -- as if once that's decided everything is all right -- as if once we figure out who is paying the check, the provision of health care is as straightforward a service as the provision of restaurant food, tax advice, contracting services, airline travel, car repair, or any other reasonably functional market for complex services.

As anyone who has ever visited a hospital knows, this is nowhere near the case. The health care market in the US is profoundly screwed up. The ridiculous bills you get after the fact are only one sign of evident dysfunction. The dysfunction comes down to a simple core: lack of competition. Airlines would love to charge you the way hospitals do. But if they try, competitors will come in and offer clearer, simpler and better service at a lower price.

Fixing the supply of health care strikes me as the policy win-win. Instead of the standard left-right screaming match, "we're spending too much," "you heartless monster, people will die," a more competitive health care market giving us better service at lower cost, making a cash market possible, makes everyone's goals come closer.

But even health insurance and payment policy is simple compared to the dark web of restrictions that keep health care so uncompetitive. That is deliberate. Complexity serves a purpose -- it protects anti competitive behavior from reform. It's hard for observers like me to understand what's really going on, what the roots of evident pathology are, and what policy steps (or backward steps) might fix them.

Into this breach steps a very nice article in today's WSJ, "Behind Your Rising Health-Care Bills: Secret Hospital Deals That Squelch Competition"  by Anna Wilde Mathews. Excerpts:

Dominant hospital systems use an array of secret contract terms to protect their turf and block efforts to curb health-care costs. As part of these deals, hospitals can demand insurers include them in every plan and discourage use of less-expensive rivals. Other terms allow hospitals to mask prices from consumers, limit audits of claims, add extra fees and block efforts to exclude health-care providers based on quality or cost.
The effect of contracts between hospital systems and insurers can be difficult to see directly because negotiations are secret. The contract details, including pricing, typically aren’t disclosed even to insurers’ clients—the employers and consumers who ultimately bear the cost.
Among the secret restrictions are so-called anti-steering clauses that prevent insurers from steering patients to less-expensive or higher-quality health-care providers. In some cases, they block the insurer from creating plans that cut out the system, or ones that include only some of the system’s hospitals or doctors. They also hinder plans that offer incentives such as lower copays for patients to use less-expensive or higher-quality health-care providers. The restrictive contracts sometimes require that every facility and doctor in the contracting hospital system be placed in the most favorable category, with the lowest out-of-pocket charges for patients—regardless of whether they meet the qualifications.

The restrictions in some hospitals’ contracts mean “you must always include them,” said Chet Burrell, former chief executive of CareFirst BlueCross BlueShield, which offers coverage in Maryland and the D.C. area. “If their costs are 50% higher for the same service, you have to include them. That cost is directly built into premiums…in the end the buyer of the service pays that.”

Hospital systems with restrictive language in their contracts can also protect their position by limiting rivals’ ability to draw patients based on lower prices, insurance executives said.
In some cases, contract clauses prevent patients from seeing a hospital’s prices by allowing a hospital operator to block the information from online shopping tools that insurers offer. Because of such restrictions, some health-insurance enrollees can’t find prices for hospital systems, including BJC HealthCare in St. Louis and NewYork-Presbyterian.
The article is full of these great details, but less clear (understandably) on the fundamental mechanism driving this behavior. One pattern I see is that lack of competition is necessary to buck up government-mandated cross-subsidies. (Previous posts here and here.) The government mandates that hospitals cover indigent care, and medicare and medicaid below cost. The government doesn't want to raise taxes to pay for it. So the government allows hospitals to overcharge insurance (i.e. you and me, eventually). But overcharges can't withstand competition, so the government allows, encourages, and even requires strong limits on competition.

You get a flavor for that here:

... hospitals often receive extra charges, known as “facility fees,” that are supposed to cover the extra costs associated with care given in a hospital setting, including regulatory and safety standards that apply to hospitals. Hospitals can often impose these fees after they acquire an off-site clinic or office.
American Hospital Association executive vice president Thomas Nickels said facility fees, which are also paid by Medicare, are needed to cover the extra costs that hospitals must shoulder, including treating any patient who needs care. “We have far more regulatory requirements, legal requirements, facility and structural requirements” than other providers, he said
Indeed. But in a competitive system, high cost producers are driven out, whether that high cost is real or regulatory.

Medicare and Medicaid abet this cross-subsidy by paying higher rates for the same service offered in a hospital than they do at an outpatient clinic, and more at a clinic than in a doctor's private office.  Hospitals have cleverly reacted to this opportunity:

Hospital systems have also been snapping up other types of providers, including doctor practices, clinics and outpatient surgery centers, and raising these providers’ prices. A study published in April in the Journal of Health Economics found that doctors’ prices increased on average by 14.1% after they became part of hospital systems.
In many cases, insurer-hospital contracts allow hospitals to move these new acquisitions immediately to the hospitals’ reimbursement rates—which are typically far more generous for the same services. That leads to a fast markup in prices.
SourceL WSJ
The nice graph to the left illustrates this phenomenon.

The tone of the article leads naturally to the usual morality play of nefarious behavior and greed. That's the wrong lesson. Hospitals do have to satisfy the government's demand for cross subsidies, and if they must compete they can't do it.

This won't be fixed by more regulation, or the FTC going after hospitals to force them to be more competitive while the rest of the health care system forces them to be less competitive.

I am reminded of two old Soviet Union jokes.

1) The border guard catches an American trying to smuggle in jeans. (Selling jeans in Russia used to be very profitable.) He demands a bribe. The American answers indignantly, "what kind of communist are you, demanding personal bribes?" The Russian answers, "you Americans should be pleased to see entrepreneurship! That's the capitalist system, no?" The American answers, "no, the capitalist system is greed subject to the discipline of competition."

Medicine is missing the discipline of competition.

2) The Soviet citizen goes in to buy his car. The manager says, "your car will be ready in 10 years." The man answers, "is that in the morning or the afternoon?" The manager says, "how can you possibly care, that's 10 years from now?" The man answers, "that's when the plumber is coming too."

I made two minor appointments with the Stanford health care system. I called the first, and the first available appointment was December 12, three months out. I called the second, and the nice lady answering the phone said "Our first appointment is December 12." She didn't understand why I guffawed when I answered, "Is that in the morning or the afternoon?"

I also made an appointment to see a private doctor to get an FAA medical exam. (That's another example of a complete waste of time and money, but that's for another day.) There is no insurance, you pay for these out of pocket, and a lot less than any bill from Stanford hospitals. The lady who answered the phone said, "do you want to come in this afternoon or tomorrow?"

21 Aug 2020

Cross subsidies and monopolization, explained - Barokong

I found a beautiful, clear, detailed, fact-based, and devastating explanation of how forced cross-subsidies, monopolized markets, and lack of competition conspire to strangle the American health care system.

No, this was not on some goofy libertarian website. It was in the official Voter Information Guide, for the ultra-progressive state of California, authored by "the legislative analyst." Whether the analyst is a secret libertarian struggling to get the word out, or simply that this is so much the way of doing things in California that nobody notices the scandal of it all, I do not know.

Starting on p. 62, with my emphasis

911 EMERGENCY MEDICAL TRANSPORTATION

Ambulances Provide Emergency Medical Care and Transportation . When a 911 call is made for medical help, an ambulance crew is sent to the location. ... (Ambulances also provide nonemergency rides to hospitals or doctors’ offices when a patient needs treatment or testing.)

Private Companies Operate Most Ambulances.  ...State law requires ambulances to transport all patients, even patients who have no health insurance and cannot pay. ...

Commercial Insurance Pays More for Ambulance Trips Than Government Insurance Pays. The average cost of an ambulance trip in California is about $750. Medicare and Medi-Cal pay ambulance companies a fixed amount for each trip. Medicare pays about $450 per trip and Medi-Cal pays about $100 per trip. As a result, ambulance companies lose money transporting Medicare and Medi-Cal patients. Ambulance companies also lose money when they transport patients with no insurance. This is because these patients typically cannot pay for these trips. To make up for these losses, ambulance companies bill patients with commercial insurance more than the average cost of an ambulance trip. On average, commercial insurers pay $1,800 per trip, more than double the cost of a typical ambulance ride.
Not stated, just why do commercial insurers put up with this? The answer is, that you need government approval to run an insurance company in California, and an insurer who said "we're not paying for that" won't be allowed to do business in California.

Also not stated, just what happens to you if you don't have health insurance but actually are the type who pays your bills? Good luck.

THE EMERGENCY AMBULANCE INDUSTRY

Counties Select Main Ambulance Providers. County agencies divide the county into several zones. The ambulance company that is chosen to serve each zone has the exclusive right to respond to all emergency calls in that area. If you want to know why there is no competition in the 911 ambulance industry, now you know. I don't know about private, non-911 ambulances. Is this all just exploiting the convenience of 911? Can you get a competitively priced ambulance ride if you know who to call?

The company generates revenue by collecting payments from patients’ insurers. In exchange, the ambulance company pays the county for the right to provide ambulance trips in that area. The county typically chooses the ambulance company through a competitive bidding process....
So cash strapped counties are in on the business of fleecing insurance companies, and through them, people and businesses who pay premiums.

Kotlikoff on the Big Con - Barokong

In preparing some talks on the financial crisis, 10 years later, I ran across a very nice article,The Big Con -- Reassessing the "Great" Recession and its "Fix" by Larry Kotlikoff. (Here, if the first link doesn't work.)

Larry is also the author ofJimmy Stewart is Dead – Ending the World's Ongoing Financial Plague with Limited Purpose Banking, from 2010, which along with Anat Admati and Martin Hellwig'sThe Bankers' New Clothes is one of the central works outlining the possibility of equity-financed banking and narrow deposit-taking, and how it could end financial crises forever at essentially no cost.

Larry points out that the crisis was, centrally a run. He calls it a "multiple equilibrium."  Financial institutions have promised people they can have their money back in full, at any time, but they have invested that money in illiquid and risky assets. When people all do that at the same time, the system fails. Such a run is inherently unpredictable. If you know it's happening tomorrow, you run to get your money out and it happens today.

This is a common view echoed by many others, including Ben Bernanke. What's distinctive about Larry's essay is that he pursues the logical conclusion of this view. If the crisis was, centrally, a run, all the other things that are alluded to as causes of the crisis are not really central.  Short-term debt, run-prone liabilities are gas in the basement. Just what causes the spark, how big the firehouse is, are not central, as without gas in the basement the spark would not cause a fire.

Larry puts it all together nicely by starting with the 2011 Financial Crisis Inquiry Commission report:

"There was an explosion in risky subprime lending and securitization, an unsustainable rise in housing prices, widespread reports of egregious and predatory lending practices, dramatic increases in household mortgage debt, and exponential growth in financial firms’ trading activities, unregulated derivatives, and short-term “repo” lending markets, among many other red flags. Yet there was pervasive permissiveness; little meaningful action was taken to quell the threats in a timely manner. "
Larry then takes apart each of these non-culprits, as below.

In my view, the understanding that the crisis was a run, that without a run there would have been no crisis, somewhat like the 2000 tech stock bust, and that lots and lots more capital is the only real answer, has emerged slowly over the last 10 years. Larry's essay is good for putting all the others to rest.

The insight is also optimistic. It is possible to fix one clear simple thing -- too much short-term debt, not enough capital. If all the long list of vague maladies named by the crisis commission need to be fixed by super-powerful and financially clairvoyant regulators, the job is hopeless despite the immense government expansion that would entail.

In many of these items, I think Larry oversteps a bit. The argument only needs to be that "these things might have been problems, indeed, they might have caused a recession, but without a run, induced by short-term debt, there would have been no financial crisis." Larry goes on to cast doubt whether any of them are problems at all, which is fun and provocative but more than necessary. Moreover, Larry really goes on to view recessions themselves as multiple equilibria, which is an interesting and provocative idea, but not necessary.

Larry's essay is even more to the point today. I'm at theFinancial Cycles and Regulation conference at the Bundesbank. Every paper so far takes it for granted that there is such a thing as a "financial cycle," a buildup of "excessive" or "imbalanced" debt that precedes an inevitable round of default and crisis. It is the regulator's job to manage such "debt cycles" actively. Larry's essay disagrees from the word go. It's nice to have two diametrically opposed ideas in mind.

Larry's List follows. If you get bored, skim to the bottom for his more provocative ideas on runs.

1) Liar Loans, No Doc Loans, NINJA Loans and Other Subprime Mortgages

There just weren't that many subprime defaults, especially before the crisis hit. (And, I would add, defaults not insured by fannie, freddie, etc.)

2) The “Unsustainable” Rise in Housing Prices

House prices have risen and fallen before. And, I might add, many are sustained. If you're waiting for houses in Palo Alto or Manhattan to fall to, say Joliet IL levels, you may have a long wait ahead of you.

Larry makes an interesting comparison of real house prices with real GDP,

.. real house prices can rise for years, indeed, decades. They did so essentially every year for the 32 years between Q1 1975 and Q1 2007. The rise was both smooth and gradual with real house prices only 64 percent higher in Q1 2007 than they were in Q1 1975 – this despite real GDP rising by 170 percent over the same interval.

The comparison between real house price and real GDP is unusual. Larry writes

In any case, it's not a financial crisis without short-term debt.

Certainly, a temporary drop in house prices could have produced a contraction in construction.... Moreover, a decline in a given sector doesn’t augur an economy- wide recession.

And, an important point

a drop in the price of homes does not adversely impact most homeowners. Yes, the value of their asset falls. ...

But you still get to live in the house. If you could pay the mortgage before, you still can.

if we’re talking about a nationwide decline in house prices, as we are with the GR, even those who moved experienced no economic harm because their ability to buy at a lower price offset their need to sell at a lower price.

The house price drop was great news for young people who live in apartments, as the stock price drop was great news for their retirement investment opportunities. Yes, there are theories in which the losers impact the economy asymmetrically, such as Mian and Sufi's, but we're straying away from the point here. A house price "bubble" and "burst" is not per se a reason for a financial crisis.

As in many of these "causes" it's important to distinguish events before October 2008 from those afterwards. Yes, there was a huge recession, and that caused house price declines, job losses, mortgage defaults, and so forth. But causes of the crisis have to come first.

3) Ratings Shopping

"overrating affected less than one half of one percent of the U.S. bond market. Furthermore, this small figure surely overstates the importance of ratings shopping as many of the downgrades were caused by the GR itself,"

4) Increased Bank Leverage

"Sky-high bank leverage is another part of the standard GR explanation....Bank leverage actually fell over the period 1988 through 2008.16 Equity rose from 6 percent of bank assets in Q1 1988 to 10 percent in Q1 2008."

Be careful here. Larry's point is that there was no voluntaryincreasein leverage, and especially as measured and monitored by regulators, and no such increase was a key cause of the crisis.  That doesn't mean the overall amount of leverage is fine. Larry's main point, as mine, is that the banking system has way too much leverage overall.

5) Too Little [Regulatory] Capital

"According to Cox [ Christopher Cox, Chairman of the U.S. Securities and Exchange Commission (SEC)..], Bear Stearns was well capitalized when it failed, with a capital ratio over 13 percent and a debt-equity ratio of 6 to 1. Indeed, it appears that Bear Stearns could have easily passed the current Dodd-Frank stress test immediately prior to its demise. Consider this statement from Chairman Cox.
"The fate of Bear Stearns was the result of a lack of confidence, not a lack of capital. When the tumult began last week, and at all times until its agreement to be acquired by JP Morgan Chase during the weekend, the firm had a capital cushion well above what is required to meet supervisory standards calculated using the Basel II standard. "
Lehman was also well capitalized prior to its demise. It had tier-1 capital of 11 percent when its creditors pulled the plug. An 11 percent capital ratio is close to the current banking system’s tier-1 capital ratio of 12.3 percent, calculated based on the Federal Reserve’s recent stress tests. This indicates that today’s banking system is no safer than was Lehman Brothers when it was driven out of business."

Again, in this draft, Larry doesn't emphasize enough that the point is adecline in capital, aweakeningof regulations, or a decline in regulatory capital. His and my overall point is that capital needs to be much, much larger overall, and that will stop runs. But the event of the crisis was a combustion of the regular old gas in the basement, not an addition of lots of new gas.

6) Egregious and Predatory Lending

i.e.

"adjustable-rate mortgages, mortgages with balloon payments, interest-only mortgages, piggy-back, and so-called pay-option ARM loans."

of these,

"...in 2007, before the GR, the foreclosure rate was 5 percent. Its lowest value, between 2002 and 2007, was 3 percent, which was observed in Q3 2005.If one assumes that all of the 2 percentage-point increase in subprimes involved predatory lending, we’re still talking about predatory lending causing, at most, 0.3 percent more mortgages to definitely default, namely, enter foreclosure. This is simply too small a figure to matter to the overall economy. Indeed, given the size of the 2007 mortgage market, it represents just $32 billion. In 2007, U.S. GDP was $14.4 trillion. The economy’s 2007 total net wealth was $68 trillion."

The Dodd-Frank act piled every suggested fix to every perceived financial problem in one place. Even if one regards predatory lending as a problem, even if one does not regard competition as the best disinfectant and guarantor of good treatment, even if one thinks it needs fixing, Larry's point is that such a fix has nothing to do with stopping crises.

7) Dramatic Increases in Household Mortgage Debt

Surely, the addition of over $750 billion in mortgage debt in the course of 6 short years must represent a priori evidence that a massive recession was in the works. Not so. ... The increase in borrowing to purchase homes was not associated with a massive spending spree on the part of the American public. Indeed, the share of GDP consumed by the public remained fixed at roughly 67 percent between early 2002 and late 2007.

What about household debt payment service as a share of disposable personal income? There was an increase prior to the GR, but nothing extraordinary. Between Q4 2001 and Q4 2007, the ratio troughed at 12.1 percent in Q2 2004 and peaked in Q4 2007 at 13.2 percent. A 13.2 percent ratio is small and the increase from trough to peak is only 9 percent

As with houses, your debt is my asset. Larry is verging here into causes of the recession rather than the crisis. There is a case for asymmetries, but the first-order mistake is to think that just because I am in debt we all are in debt.

8) Exponential Growth in Trading Activity by Financial Firms

Here, again, we have a supposed reason for the Great Recession that has no counterpart in economic theory. If Joe and Sally sell the same share of stock back and forth to each other an infinite number of times in, say, a second, nothing real will happen to Joe and Sally or the economy.

9) Unregulated Derivatives and the Repo Market

The reigning narrative – that derivatives were misunderstood and over rated by compliant rating companies – has been questioned in a recent study by economists Juan Ospinal and Harald Uhlig. They examined 8,615 residential mortgage-backed securities (RMBS) over the period 2007-2013, almost all of which were rated AAA. Through 2013, the cumulative loss on these “toxic” securities was only 2.3 percent. Some three quarters of the AAA-rated RMBS had essentially zero losses through 2013. On a principal-weighted basis, the average loss rate was only 0.42 percent.

I think the logic here is that if securities were overpriced, then they should have fallen. That they did not is interesting. Of course, if they had fallen that is not necessarily evidence of overpricing, as there was a huge recession after the run!

Here again I think a big qualification is in order. The run on repo was a central part of the crisis, and I think Larry and I agree that way too much such run-prone financing was the key cause of the crisis. Again, I think the point Larry is making is that the financial system as constructed is always vulnerable, that the crisis was not brought on by some sudden and preventable increase in debt.

10) Investors Mispriced/Ignored Risk

11) Unaligned CEO Incentives

Yet another explanation for the GR is that CEOs of financial institutions had too little “skin in the game.” Jimmy Cayne, former head of Bears Stern, would surely disagree. Cayne lost close to $1 billion as his bank collapsed. Ken Lewis, CEO of the Bank of America, had $190 million to lose by making wrong decisions and succeeded in losing $142 million. Lehman Brothers’ Dick Fuld received most of his 2007 compensation in the form of Lehman Brothers’ stock.

12) Democratization of Finance

Under this theory, government sponsored enterprises (Fanny and Freddie) and government regulators were too permissive with banks in their quest to help the poor get into affordable housing. ...if this were the chief or even a major cause of the GR, subprime mortgages would need to have played a much larger role than they did.

13) The Federal Reserve Kept Interest Rates Too Low

Thirty-year mortgage interest rates were certainly lower between 2000 and 2007 than in the prior quarter century. But they weren’t that low especially adjusted for inflation. In the 1990s, the real 30-year mortgage rate averaged 7.91 percent. It averaged 6.27 between January 2000 and December 2007. This decline is hardly something to write home about, let alone pretend is the underlying GR culprit.

Runs

..the foundational bank-run models --- Bryant (1980), Diamond-Dybvig (1983), Pech and Shell (2003) and related models – admit multiple equilibrium in which financial-market collapse arises absent any fundamental financial- or real-sector problem...  from the perspective of these models, the question is not whether the banking system will fail, but when. Hence, it’s passing strange that the FCIC report makes no mention whatsoever of either paper, let alone the theory underlying bank runs.

(My emphasis.) Larry goes on for several pages documenting spreading panic. An earlier quote is good here

SEC Chairman, Mary Schapiro’s, 2010 testimony to the House Financial Services Committee...includes this statement.
The immediate cause of Lehman's bankruptcy filing on September 15, 2008 stemmed from a loss of confidence in the firm's continued viability resulting from concerns regarding its significant holdings of illiquid assets and questions regarding the valuation of those assets. The loss of confidence resulted in counterparties and clearing entities demanding increasing amounts of collateral and margin, such that eventually Lehman was unable to obtain routine financing from certain of its lenders and counterparties

The banks failed because they could. And they could fail because they were leveraged. They falsely promised to make repayments regardless of the circumstances.

Unsafe at Any Speed, and the limits on bailouts

The overall level of leverage is way too high. This reinforces my earlier interpretation of Larry's comment about leverage not being the problem -- there was way too much leverage, but its increase did not directly cause a crisis.

The next part is really interesting.

The Federal Reserve is also leveraged. In the aftermath of Lehman’s collapse, the Fed effectively insured not just checking and saving accounts, but also money market funds. These obligations were officially and, respectively, FDIC and Treasury obligations. They ran to some $6 trillion. But neither institution had $6 trillion in ready cash to make good on its insurance. Hence, the Fed would have been on the hook. Indeed, had things gotten worse, there would surely have been a run on the life insurance industry’s cash-surrender value policies, which, at the time, also totaled roughly $6 trillion.
Now imagine, as discussed in Kotlikoff (2010), that the government’s explicit and implicit pledges of insurance had been called by the public. I.e., suppose the public had, despite the promises of government insurance, headed straight to the banks, money market funds, and insurance companies to empty out their accounts and cash out their cash-surrender value policies. In this case, the Fed would have had to print $12 trillion virtually overnight. The M1 money supply at the time was just $1.5 trillion. Hence, this would have produced fully-justified fears of hyperinflation leading everyone to run for their money before prices soared
The U.S. has yet to experience a run on its central bank. But this is common in countries like Argentina, ...

Larry is, of course, an expert on all the explicit and implicit credit guarantees our government offers. I was unaware that $6 trillion of "cash surrender value policies" existed, and given the bailouts of other insurance policies we would certainly have seen them bailed out too. Fannie and Freddie guarantee most mortgages.

Though it does represent promises of payment, I don't think this really is "leverage" of the Federal Reserve. The government has, in essence, written a lot of put options, which is a different thing.

What happens in an even more massive run, with more massive bailouts is an interesting question. It's not as simple as "print [ing] $12 trillion overnight." The Fed issues reserves, convertible to cash, but always in return for something else. So, this would have put a big strain on the Fed's legal limitations of what collateral it can accept and from who.

The Fed mostly deals with commercial banks. Imagine a massive run on commercial banks, perhaps stemming from a rumored cyberattack that emptied one of them out. The Fed would have to lend against the entire portfolio of bank assets, not just liquid securities. Goodbye Badgehot.

As Larry points out, really the FDIC and Treasury are the ones guaranteeing non-bank debts.  The Treasury would have to borrow $12 billion overnight, sell it to the Fed, and then use it to bail out here and there. The ban on direct Fed-Treasury purchases would make this very hard, and would probably have to be scrapped.

But the huge increase in money would clearly be a temporary increase in money demand, and not obviously inflationary. Moreover, the Treasury, Fed, FDIC, etc. would take on assets. If these operations could be reversed after the panic passes -- if there is not a tremendous amount of actual lost value, as there was not last time, the money could be soaked up again. Even if not, the operation would not be inflationary if people thought the government could retire the debt and soak up the interest-paying reserves by future surpluses. We get inflation -- and Argentina gets inflation -- if and only if this nightmare involves a large fiscal transfer, that the US government cannot or will not pay off, that is financed by a permanent increase in non-interest-paying money.

US Federal debt is about $10 trillion larger than in 2008, and we're running $1 trillion deficits, with no end in sight. The reliability of the fiscal resources to make good on all these put options is, I think, a serious problem, and the heart of the potential inflation Larry describes.

The Role of Opacity

Bear Stearns was among the first to be picked off by those who stood to gain by a financial collapse because it was viewed as particularly opaque
The fact that Bear’s stock was valued at $60 per share one week before JP Morgan bought it for $2 per share (less a $29 billion sale of Bear’s troubled assets to the Fed valued at far less than $29 billion) tells us that no one knew anything about Bear’s assets, either before it died or when it died. Its valuation was, it seems, purely a matter of conjecture. Before it didn’t, the market apparently though Bear’s assets were worth something because everyone else thought its assets were worth something. This too is the stuff of multiple equilibria

Gary Gorton likens financial crises to a salad bar, where someone says "there's a news report of e-coli in the (inaudible)". So what do you do? Absent information on which ingredient has the e-coli, and the time or inclination to investigate, you go order a hamburger.

Now ask yourself, where is there a mountain of debt that can't be repaid, much of it very short term, phoney-baloney accounting, and opaque off-balance-sheet exposures (put options)? Sovereigns.

Bottom line

The first conclusion seems to me spot on. The second one is more provocative. Here Larry signs up with multiple-equilibrium theories of recessions, as well as simple multiple equilibria associated with run-prone assets like overnight debt. It's verbally plausible. If you think there will be a recession tomorrow, you fire workers and do not invest, and there is a recession today. But you can see a crucial derivative needs to be greater than 1.0 for that to work. Lots of formal models have multiple equilibria, but I've spent 10 years putting nominal multiple equilibria back in the new-Keynesian model, and real multiple equilibria are harder to get going.

Choose your equity-financed banking flavor, and we can end financial crises forever. Just why we don't do it seems an important -- and sadly forgotten -- question.

20 Aug 2020

Europe's Banks - Barokong

My visit to Europe resulted in many interesting conversations. There was a stark contrast between the complex regulatory vision of formal presentations and papers, and the lunch and coffee discussion reflecting experience of people involved in actually regulating banks. They seemed to be quite frustrated by the state of things. Disclaimer: this is all completely unverified gossip, and remembered through a fog of jet lag. If commenters have better facts, I'm hungry to hear them.

Risk weights are ungodly complex, and not many people actually understand them, or the layers of buffers and how they are applied.

Risk weights are suspiciously low. Big banks are allowed to use their own models, calibrated on 10 years of data. That means the data have, now, 10 years of stable growth and very low default. Look, say the banks, our investments are nearly risk free.

"Micro" regulators who look at the specifics of an individual bank are prone to offset the "systemic" and "macro-prudential" efforts. Look, say the banks, we have to fulfill all these macro-prudential rules, give us a break. Regulators do.

The financial regulatory community has been preoccupied with writing reports about one thing after another. Meanwhile, the elephant remains in the room:  Italy may default or leave the euro.

Italian banks remain stuffed with Italian government bonds. I learned some new words for this: a "doom loop." If the government defaults, the banks go with it.  Some smaller foreign banks still have large investments in Italian bonds. Another new word: "Moral suasion," governments encouraging banks to buy a lot of their bonds.  I imagine the Godfather had more colorful words for it. On the other hand, Italian banks are reportedly happy for the moment, since as long as Italy doesn't actually default, they make a bundle from high interest rates. Government debt is still treated with low or no risk weights.

In case it isn't obvious here's the problem. A sovereign default is bad enough. But if the banks are stuffed with government debt, then a sovereign default brings down the banking system. Depositors lose their shirts, and the banks, who know how to distinguish good from bad borrowers, are shut down. A calamity becomes a catastrophe. And an economy with failing banks will be bringing in a lot less tax revenue and more likely to default.  Government debt in a currency union without banking union is a singularly bad investment, because as currently construed governments give deposit insurance (explicit or implicit).

All this is obvious to anyone looking at it, and leads to a big sigh about "political pressure." 10 years on, and Europe can't quite bring itself to say that sovereign debts are risky. Understandably. This is a club of equals, and it's awfully hard to say that some debts are better than others.

But this elephant has been careening around the room for 10 years. There was a Greek crisis which should have gotten some attention!

Some want a full banking union, breaking local bank regulation and allowing large transnational  banks to operate fully, breaking the doom loop. Some want full fiscal union to go with monetary union. The current model, pressure from the rest of Europe for governments not to borrow so much, and thus to never face a potential sovereign default, has clearly failed.

In my view, monetary union without fiscal union works fine, so long as we all understand that governments can default, and their debt should be treated just as risky (and sometimes junk) corporate debt on bank balance sheets. And, of course, if capital requirements were doubled, tripled, or more, so that banks could sail through a sovereign default, the problem would solve itself.

It occurs to me that simply removing risky local government debt from banks would go a long way to solving the problem. Defaultable government debt should be held via floating-NAV mutual funds, not via bank accounts.

Additionally, there is a big kerfuffle going on that Italy's central bank owes Germany's a lot of money.   Italians see this coming, and there is a lot of capital flight out of Italy. When an Italian writes a check from an Italian bank to buy an apartment in Germany, the money flows from Italian bank to Italian central bank, to German central bank, to German bank. Except the Italian central bank essentially makes a promise to pay rather than actually paying. Italy is basically expanding government debt in this way. I don't totally understand it, nor did most people I talked to about it, and there is a wide disagreement whether this is another debt or just an accounting glitch. Still, that most people at a financial regulation conference know this is a big problem and nobody is quite sure what it means is telling.

With this background of lunchtime and coffee conversations, the written products of the financial regulation community have a surreal quality. The illusion of technocratic competence is always present in bank regulation discussions, but even more stark with this backdrop.

Look for example at the website of theFinanical Stability Board and the issues it thinks are important. As one example, the summary of FSB priorities for the Argentine G20 Presidency. It starts well enough, "Vigilant monitoring to identify, assess and address new and emerging risks." But what's the number one such risk? You would think, in honor of the Argentine presidency, with Italy the number one topic of conversation at lunch, and with who knows who owes who what in China, it would be "sovereign risk." Nope. Crypto-assets is number 1: "The FSB will identify metrics for enhanced monitoring of the financial stability risks posed by crypto-assets and update the G20 as appropriate." Then,

Disciplined completion of the G20’s outstanding financial reform priorities....During the course of the year the deliverables to the G20 will include the following areas: the correspondent banking Action Plan including improving the access of remittance providers to banking services; a toolkit for firms and supervisors on the use governance frameworks to reduce misconduct in the financial sector; leverage measures for investment funds to support resilient market-based finance; guidance on financial resources available to support central counterparty (CCP) resolution to deliver resilient and resolvable CCPs; a cyber security lexicon to support consistency in the work of the FSB, standard-setting bodies, authorities and private sector participants; and the private sector-led Task Force on Climate-related Financial Disclosures’ report on voluntary implementation of its recommendations to highlight good practice and foster wider adoption.
Sovereign risk is not mentioned once in this document. And I did not find it anywhere on the FSB website.

If you read between the lines, there is a very worthy reaction to this tendency to produce complex hot air that changes with each presidency:

Pivoting to policy evaluation to ensure the reform programme is efficient, coherent and effective. The FSB is increasingly pivoting away from design of new policy initiatives towards dynamic implementation and rigorous evaluation of the effects of the agreed G20 reforms.

State of thought on financial regulation - Barokong

I'm at a conference on "Financial cycles and regulation" at the Deutsche Bundesbank. Beyond the individual papers, I find the conversation interesting.

Groups of researchers develop a common language and a common set of assumptions. This is productive -- to push a research frontier we have to agree on a few basic ideas, rather than argue about basics all the time. I, as an outsider, parachute in, and learn as much what the shared assumptions are, as I do about particular points in elaboration of the program.

Here,  it is pretty much taken for granted that there is such a thing as a "financial cycle." It's in the conference title, after all! That means a "cycle" of credit expansion, usually "unwarranted," "excessive," or an "imbalanced," followed by a bust. It is also agreed that it is the job of financial regulators to manage this "cycle."

In his Keynote speech, Claudio Borio of the BIS described a sort of Taylor rule, in which monetary and financial policies should respond systematically to the "credit gap." Jan Hannes Lang described a model for estimating that "credit gap." Marco Lombardi applied Jim Stock's time-deformation models to characterize the "financial cycle." Michael McMahon showed a very elegant model in which banks over-lend and hence society over-invests in good times. The government bails out in bad times, so the discount factor for investment excludes bad-time outcomes.  (All paper titles at the above program link, papers aren't posted yet but you can google them.)

I parachute in from the outside. Understanding this language and shared set of assumptions is important.  I'm a bit skeptical, of course. Yes, there is regression evidence that large debts and high prices forecast crises. But there is always supply and demand in economics, always the possibility of a boom rather than a bubble. "Large" is not always "excessive." And the passage from an interesting set of historical correlations to structural understanding to something stable enough, and without unintended consequences, for policy exploitation seems to have passed while I was napping. As McMahon pointed out, credit controls in the 1970s were not a huge success. But these are just the skeptical questions of a newcomer. I come to conferences to listen primarily.

My own view is that the crisis was a run, and the central way to stop runs is with lots more capital and lots less short-term debt. Then you can have booms and busts without runs. I note ruefully that capital is under attack in the US, and that 10 years after the crisis, so much for those countercyclical buffers. Karsten Müller presented some nice regression evidence that governments typically loosen regulations just before elections, as the US just did.  Systematic countercyclical capital remains remains a dream in the eyes of many writers especially at the Fed, BIS, and other institutions. Monetary and "macro-prudential" policy that successfully and systematically lowers house and asset price volatility is even further away. How much nicer if the financial system were run-proof and did not require so much management.

At least though, this little discussion reflects a large agreement that capital is the central buffer and so much else in current regulation is not very useful.

Testimony 2 - Barokong

On the way back from Washington, I passed the time reformatting my little essay for the Budget committee to html for blog readers. See below. (Short oral remarks here in the last blog post, and pdf version of this post here.)

I learned a few things while in DC.

The Paul Ryan "A better way" plan is serious, detailed, and you will be hearing a lot about it. I read most of it in preparation for my trip, and it's impressive. Expect reviews here soon. I learned that Republicans seem to be uniting behind it and ready to make a major push to publicize it. It is, by design, a document that Senatorial and Congressional candidates will use to define a positive agenda for their campaigns, as well as describing a comprehensive legislative and policy agenda.

"Infrastructure" is bigger in the conversation than I thought. But since there is no case that potholes caused the halving of America's trend growth rate, do not be surprised if infrastructure fails to double the trend growth rate. It's also a bit sad that the most common growth idea in Washington is, acording to my commenters, about 2,500 years old -- employment on public works.

Washington conversation remains in thrall to the latest numbers. There was lots of buzz at my hearing about a recent census report that median family income was up 5%. Chicagoans used to get excited about the 40 degree February thaw.

The quality can be very very good. Congressman Price, the chair of my session, covered just about every topic in my testimony, and possibly better. Congressional staff are really good, and they are paying attention to the latest. If you write policy-related economics, take heart, they really are listening.

The questions at my hearing pushed me to clarify just how will debt problems affect the average American. What I had not said in the prepared remarks needs to be said. If we don't get an explosion of growth, the US will not be able to make good on its promises to social security, health care, government pensions, credit guarantees, taxpayers, and bondholders. Something's got to give. And the growing size of entitlements means they must give. Even a default on the debt, raising taxes to the long-run Laffer limit, will not pay for current pension and health promises. Those will be cut. The question is how. If we wait to a fiscal crisis, they will be cut unexpectedly and by large amounts, leaving people who counted on them in dire straits. Greece is a good example. If we make sensible sustainable promises now, they will be cut less, and people will have decades to adjust.

Ok, on to html testimony:

Growing Risks to the Budget and the Economy.

Testimony of John H. Cochrane before the House Committee on Budget.

September 14 2016

Chairman Price, Ranking Member Van Hollen, and members of the committee: It is an honor to speak to you today.

I am John H. Cochrane. I am a Senior Fellow of the Hoover Institution at Stanford University 1 . I speak to you today on my own behalf on not that of any institution with which I am affiliated.

Sclerotic growth is our country's most fundamental economic problem. 2 From 1950 to 2000, our economy grew at 3.6% per year. 3 Since 2000, it has grown at barely half that rate, 1.8% per year. Even starting at the bottom of the recession in 2009, usually a period of super-fast catch-up growth, it has grown at just over 2% per year. Growth per person fell from 2.3% to 0.9%, and since the recession has been 1.3%.

The CBO long-term budget analysis 4 looks out 30 years, and forecasts roughly 2% growth. On current trends that is likely an over-estimate, as it presumes we will have no recessions, or that future recessions will have not have the permanent effects we have seen of the last several recessions. If we grow at 2%, the economy will expand by 82% in 30 years, almost doubling. 5 But if we can just get back to the 3.6% postwar normal growth rate, the economy will expand by 194%, almost tripling instead. We will add the entire current US economic output to the total. In per-person terms, a 1.3% trend gives the average American 48% more income in 30 years. Reverting to the postwar 2.3% average means 99% more income, twice as much. And economic policy was not perfect in the last half of the 20th century. We should be able to do even better.

Restoring sustained, long-term economic growth is the key to just about every economic and budgetary problem we face.

Nowhere else are we talking about doubling or not the average American's income. 6

Nowhere else are we talking about doubling or not Federal revenues. Long-term Federal revenues depend almost entirely on economic growth. In 1990, the Federal Government raised $1.6 trillion inflation-adjusted dollars. In 2016, this has doubled to $3.1 trillion. Wow! Did the government double tax rates? No. The overall federal tax rate stayed almost the same -- 18.0% of GDP in 1990, 18.8% of GDP today. Income doubled.

Whether deficits and debt balloon, whether we our government can pay for Social Security and health care, defend the country, and fund other goals such as protecting the environment, depend most crucially on economic growth.

Why has growth halved? Some will tell you that the economy is working as well as it can, but we've just run out of new ideas. 7 A quick tour of the Silicon Valley makes one suspicious of that claim.

Others will bring you novel and untested economic theories: we suffer an ill-defined "secular stagnation" that requires massive borrowing and spending, even wasted spending. The "multiplier" translating government spending to output is not one and a half, and a temporary expedient which can briefly raise the level of income in a depression, but six or more, enough to finance itself by the larger tax revenues which larger output induces --a proposition long derided of the "supply side" --and it can now kick off long-term growth. 8 Like 18th century doctors to whom disease was an imbalance of humors, modern macroeconomic doctors have one diagnosis and remedy for all the complex ills that can befall a modern economy: "demand!"

I'm here to tell you the most plausible answer is simple, clear, sensible, and much more difficult. Our legal and regulatory system is slowly strangling the golden goose of growth. There is no single Big Fix. Each market, industry, law, and agency is screwed up in its own particular way, and needs patient reform.

America is middle aged, out of shape and overweight. One voice says: well, get used to it, buy bigger pants. Another voice says: 10 day miracle detox cleanse! I'm here to tell you that the only reliable answer is good old-fashioned diet and exercise.

Or, a better metaphor perhaps: our economy, legal and regulatory system has become like a hoarder's house. No, there isn't a miracle organizer system. We have to patiently clean out every room.

Economic regulation, law and policy all slow growth by their nature. Growth comes from new ideas, new products, new processes, new ways of doing things, and most of these embodied in new companies. And these upend old companies, and displace their workers, both of whom come to Washington pleading that you save them and their jobs. It is a painful process. It is natural that the administration, regulatory agencies, and you, listen and try to protect them. But every time we protect an old company, an old industry, or an old job, from innovation and competition, we slow down growth.

How do we solve this problem and get back to growth? Our national political and economic debate has gotten stale, each side repeating the same base-pleasing talking points, but making no progress persuading the other. Making one or the other points again, or louder, will get us nowhere. I will try, instead, to find policies that think outside of these tired boxes, and that can appeal to all sides of the political spectrum.

Rather than "more government" or "less government," let's focus on fixing government. We need above all a grand simplification of our economic, legal, and political life, so that government does what it does competently and efficiently.

Regulation: fix the process.

"There's too much regulation, we're stifling business. No, there's too little regulation, businesses are hurting people." Or so goes the tired argument. Regulation is strangling business investment, and especially the formation of new businesses. But the main problem with regulation is how it's done, not how much. If we fix regulation, the quantity will take care of itself. We can agree on smarter regulation, better regulation, not just "more" or "less" regulation. 9

Regulation is too discretionary --you can't read the rules and know what to do, you have to ask for permission granted on regulators' whim. No wonder that the revolving door revolves faster and faster, oiled by more and more money.

Regulatory decisions take forever. Just deciding on the Keystone Pipeline or California's high speed train --I pick examples from left and right on purpose --takes longer than it did to build the transcontinental railroad in the 1860s. By hand.

Regulation has lost rule-of-law protections. You often can't see the evidence, challenge witnesses, or appeal. The agency is cop, prosecutor, judge, jury and executioner all rolled in to one. [And, a Congressman pointed out during the discussion, recipient of collected fines.]

Most dangerous of all, regulation and associated legal action are becoming more politicized. Each week brings a new scandal. Last week 10 , we learned how the Government shut down ITT tech, but not the well-connected Laureate International. The IRS still targets conservative groups 11 . The week before, we learned how the company that makes Epi-pens, headed by the daughter of a Senator, got the FDA to block its competitors, Congress to mandate its products, and jacked up the price of an item that costs a few bucks to $600. This is a bi-partisan danger. For example, presidential candidate Donald Trump has already threatened to use the power of the government against people who donate to opponents' campaigns. 12

America works because you can lose an election, support an unpopular cause, speak out against a policy you disagree with, and this will not bring down the attentions of the IRS, the EPA, the NLRB, the SEC, the CFPB, the DOJ, the FDA, the FTC, the Department of Education, and so forth, who can swiftly put you out of business even if eventually you are proven innocent, or just slow-roll your requests for permissions until you run out of money.

This freedom does not exist in much of the world. The Administrative state is an excellent tool for cementing power. But when people can't afford to lose an election, countries come unglued. Do not let this happen in the US.

Congress can take back its control of the regulatory process. Write no more thousand-page bills with vague authorizations. Fight back hard when agencies exceed their authorization. Insist on objective and retrospective cost benefit analysis. Put in rule-of law protections, including discovery of how agencies make decisions. Insist on strict timelines --if an agency takes more than a year to rule on a request, it's granted. [I later learned this is called a "shot clock" in Washington, a nice metaphor.]

Health care and finance are the two biggest new regulatory headaches. The ACA and Dodd-Frank aren't working, and are important drags on employment and economic growth. Simple workable alternatives exist. Implement them.

The real health care problem is not how we pay for health care, but the many restrictions on its supply and competition. 13 If hospitals were as competitive as airlines, they would work darn hard to heal us at much lower --and disclosed! --prices. If the FDA did not strangle new medicines and devices, even generics, prices would fall.

Competition is always the best disinfectant, guarantor of good service and low prices. Yet almost all uncompetitive markets in the US are uncompetitive because some law or regulation keeps competitors out.

Rather than guarantee bank debts, and unleash an army of regulators to make sure banks don't risk too much, we should instead insist that banks get their money in ways that do not risk crises, primarily issuing equity and long-term debt. Then banks can fail just like other companies, and begin to compete just like other companies. 14

"The planet is dying, control carbon!" "Your crony energy boondoggles and regulations are killing the economy!" Well, that argument is not getting us anywhere, is it? The answer is straightforward: A simple carbon tax in exchange for elimination of all the growth-killing, intrusive, cronyist, and ineffective micromanagement. We can continue to argue about the rate of that tax, but it will both reduce more carbon, and increase more growth, than the current ineffective policies --and stagnant debate.

None of these recommendations are ideological or partisan. These are just simple, clean-out-the-junk, workable ways to get our regulatory system to actually work, for its goal of protecting consumers and the environment, at minimal economic and political damage.

Social programs: Fix the incentives.

"Cut spending, or the debt will balloon!" "Raise spending or people will die in the streets!" That's getting nowhere too. And it ignores central problems.

In many social programs, if you earn an extra dollar, you lose a dollar or more of benefits. Many programs have cliffs, especially in health care and disability, where earning one extra dollar triggers an enormous loss. Even when one program cuts benefits modestly with income, the interaction of many programs makes work impossible. 15 No wonder that people become trapped. We need to fix these disincentives. Doing so will help people better. If we fix the incentives, though it may look like we spend more, in the end we will spend less --and encourage economic growth as well as opportunity.

Spend more to spend less. "Spending is out of control! We need to spend less or there will be a debt crisis!" "Oh there you go being heartless again. We need to invest more in programs that help Americans in need." I feel like I'm at a dinner party hosted by a couple in a bad marriage. This isn't getting us anywhere.

It is important to limit Federal spending. However, we tend to just limit the appearance of spending by moving the same activities off the books. Off-the-books spending does the same economic damage. Or more.

For example, we allow an income tax deduction for mortgage interest, in order to subsidize homeownership. From an economic point of view, this is exactly the same thing as collecting higher taxes, and then sending checks to homeowners. It looks like we're taxing and spending less than we really are. But from an economic growth point of view, it's the same thing.

Actually, it's worse, because it adds unfairness and inefficiency. Suppose a colleague proposes a bill to you: The U.S. Treasury will send checks to homeowners, but high income people get much bigger checks, as will people who borrow a lot, and people who refinance often and take cash out. People with low incomes, who save up to buy houses, or don't refinance, get a lot less. You would say, "You're out of your mind!" But that's exactly what the mortgage interest deduction achieves!

If we were to eliminate the mortgage deduction, and put housing subsidies on budget, where taxpayers can see where their money is going, the resulting homeowner subsidy would surely be a lot smaller, much more progressive, helping lower income people, better targeted at getting people in houses, and less damaging of savings and economic growth. Both Republicans and Democrats should rejoice. Except the headline amount of taxing and spending will increase. Well, spend more to spend less.

We allow a tax deduction for charitable deductions. This is exactly the same thing as taxing more, but then sending checks to non-profits as matching contributions --but much larger checks for contributions from rich people than from poorer people. Then, many "non-profits" spend a lot of money on private jet travel, executive salaries, and political activities. Actual on-budget federal spending, convoluted and inefficient as it is, at least has a modicum of oversight and transparency. If we removed the deduction, but subsidized worthy charities, with transparency and oversight, we'd do a lot more good, and probably overall tax less and spend less. Except the headline amount of taxing and spending might increase. Well, spend more to spend less.

Mandates are the same thing as taxing and spending. Many European countries tax a lot, and then provide services, like health insurance. We mandate that employers provide health insurance. It looks like we're taxing and spending less, but we're not. A health insurance mandate has exactly the same economic effects as a $15,000 head tax on each employee, financing a $15,000 health insurance voucher.

Economics pays no heed to budget tricks. Spending too much rhetorical effort on lowering taxes and spending induces our government to such tricks, with the same growth-destroying effects. If you want economic growth, treat every mandate as taxing and spending.

Taxes: break up the argument.

The outlines of tax reform have been plain for a long time: lower marginal rates, broaden the base by getting rid of the massive welter of special deals. But it can't get done. Why not?

When we try to fix taxes, 16 we argue about four things at once: 1) What is the right structure for a tax code? 2) What is the right level of taxes, and therefore, of spending? 3) What activities should the government subsidize -- home mortgages, charitable contributions, electric cars, and so on? 4) How much should the government redistribute income?

Tax reforms fail because we argue about all these together. For example, the Bowles-Simpson commission got to an improvement on the structure of taxes, but then the reform effort fell apart when the Administration wanted more revenue and congressional Republicans less.

I am back at my dysfunctional dinner party. Sometimes, in politics as in marriage, it is wise to bundle issues together, each side accepting a minor loss to ensure what they see as a major gain. You clean up your socks, I'll clean up my makeup. Sometimes, however, we bundle too many issues together, and the result is paralysis, as each side vetoes a package of improvements over a small issue. Then, it's better to work on the issues separately.

So, let's fix taxes by separating these four issues, in four commissions possibly, or better in four completely separate sections of law.

1) Structure. Agree on the right structure of the tax code, with its only goal to raise revenue at minimal economic distortion, but leave the rates blank.

2) Rates. Determine the rates, without touching the structure of the tax code. A good tax code should last decades. Rates may change every year, and likely will be renegotiated every four. But those who want higher or lower rates know they can agree on the structure of the tax code.

3) Separate the subsidy code from the tax code. Mortgage interest subsidies? Electric car subsidies? Sure, we'll talk about them, but separately. Then, we don't have to muck up raising revenue for the government with subsidies, and the budgetary and economic impact of subsidies can be evaluated on their own merits

4) Separate the redistribution code from the tax code. Then we don't muck up raising revenue for the government with income transfers.

The main point is that by separating these four elements of law, each with fundamentally different purposes, we are much more likely to make coherent progress on each. You need not oppose beneficial aspects of an economically efficient tax simplification, say, if you wish to have a greater level of redistribution --well, at least any more than you might oppose any random bill in order to force your way on that issue.

Some thoughts on how each of these might work:

Structure. The economic damage of taxation is entirely about "marginal'' rates --if you earn an extra dollar, how much do you get to enjoy it, after all taxes, federal, state, local, sales, estate, and so forth. Economics has really little to say about how much taxes people pay. The economists' ideal is a tax system in which people pay as much as the Government needs --but each extra dollar earned is tax-free. Politics, of course, focuses pretty much on the opposite, how much people pay and ignoring the economically-distorting margins.

Thus, if you ask 100 economists, "now, forget politics for a moment --that's our job --and tell me what the right tax code is, with the only objective being to raise revenue without distorting the economy,'' the pretty universal answer will be a consumption tax --with no corporate tax, income tax, tax on savings or rates of return, estates, or anything else, and essentially no deductions. (They will then say "but..." and go on to demand subsidies and income redistribution, at which time you have to assure them too that we'll discuss these separately.)

A massive simplification of the tax code is, in my opinion, as or more important than the rates --and it's something we're more likely to agree on. America's tax code is an obscenely complex cronyist nightmare.

For example, that's why I favor, and you should seriously consider, eliminating the corporate tax. Corporations never pay any taxes. All money they send to the government comes from higher prices, lower wages, or lower returns to shareholders --and mostly the former two. If you tax people who receive corporate profits, rather than collecting taxes from higher prices and lower wages, you will have a more progressive tax system.

But more importantly, if you eliminate the corporate tax, you will eliminate the constant stream of lobbyists in your offices each day asking for special favors.

Far too many businesses are structured around taxes, and far too many smart minds are spending their time devising corporate tax avoidance schemes and lobbying strategies. A much simpler tax code even with sharply higher rates --but very clear rates, that we all know about and can plan on --may well have less economic distortion than a massively complex code, with high statutory rates, but a welter of complex schemes and deductions that result in lower taxes.

Subsidy code. Tax expenditures --things like deductions for mortgage interest, employer provided health care, charitable contributions, and the $10,000 credit my wealthy Palo Alto neighbor got from the taxpayers for buying a Tesla -- are estimated at $1.4 trillion, 17 compare with $3.5 trillion Federal Receipts and $4 trillion Federal Expenditures. 18 Our Federal Government is really a third larger than it looks.

While the subsidy code could consist of a separate discussion of tax expenditures, it would be far better for the rules of the subsidy code to be: all subsidies must be on budget, where we can all see what's going on.

Redistribution. Even a consumption tax can be as progressive as one wants. One can use the regular income tax code with full deduction of savings and omitting capital income, thus taxing high consumption at higher rates and low consumption at lower rates.

Again, however, it might well be more efficient to integrate income redistribution with social programs. Put it on budget, and send checks to people. Yes, that makes spending look larger, but sending a check is the same thing as giving a tax break. And spending can be more carefully monitored.

Infrastructure

Infrastructure is all the rage 19 . America needs infrastructure. Good infrastructure, purchased at minimum cost, that passes objective cost-benefit criteria, built promptly, can help the economy in the long run. Soft infrastructure --a better justice system, for example --matters as much as hard infrastructure --more asphalt.

However, there is no case that the halving of America's growth rate in the last 20 years is centrally due to potholes and rusting bridges. Poor infrastructure is not the cause of sclerosis, so already one should be wary of infrastructure investment as the central plan to cure that sclerosis.

The claim that infrastructure spending will lift the economy out of its doldrums lies on the "multiplier" effect, that any spending, even wasted, is good for the economy. That is a dubious proposition, especially when the task is to raise the economy by tens of trillions, over decades.

Modern infrastructure is built by machines, and not many people; even less people who do not have the specialized skills. A Freeway in California will do little to help employment of a high school dropout in New York, or a middle-aged mortgage broker in New Jersey. Neither knows how to operate a grader.

The problem with infrastructure is not lack of money. President Obama inaugurated a nearly trillion dollar stimulus plan 8 years ago. His Administration found out there are few shovel-ready projects in America today. They're all tied up waiting for historic review, environmental review, and legal challenges.

The problem with infrastructure is a broken process. Put a time limit on historic, environmental, and other reviews. Require serious, objective, and retrospective cost-benefit analysis. Repeal Davis-Bacon and other contracting requirements that send costs soaring. If the point is infrastructure it should be infrastructure, not passing money around. You ought to be able to agree on more money in return for assurance that the money is wisely spent.

Debt and deficits

This hearing is also about budgets and debts, which I have left to the end. Yes, our deficits are increasing. Yes, every year the Congressional Budget Office declares our long-term promises unsustainable.

I have not emphasized this problem, though in my opinion it is centrally important, and I think I was invited here to say so.

Recognize that computer simulations with hockey-stick debt, designed to frighten into submission a supporter of what he or she feels is necessary government spending, are as ineffective as computer simulations with hockey-stick temperatures, designed to frighten into submission a supporter of current economic growth and skeptic of draconian energy regulation. Yelling about each, louder, is not going to be productive.

And there are many voices who tell you debt is not a problem. Interest rates are at record lows. Why not borrow more, and worry about paying it back later? So, let me offer a few out of the box observations, and suggestions that you might agree on.

It is useful to clarify why debt is a problem. The case that large debts will slowly and inexorably push up interest rates, and crowd out investment, is hard to make in this era of ultra-low rates. Debt does place a burden of repayment on our children and grandchildren, but if we have reasonable economic growth they will be wealthier than we are.

The biggest danger that debt poses is a crisis.

Debt crises, like all crises that really threaten an economy and society, do not come with decades of warning. Do not expect slowly rising interest rates to canary the coalmine. Even Greece could borrow at remarkably low rates. Until, one day, it couldn't, with catastrophic results.

The fear for the US is similar. We will have long years of low rates. Until, someday, it is discovered that some books are cooked, and somebody owes a lot of money that they can't pay back, and people start to question debts everywhere.

For example, suppose Chinese debts blow up, and southern Europe as well. Both Europe and China will start selling Treasury debt quickly. Suppose at the same time that student loans, state and local pensions, and state governments are blowing up, along with some large U.S. companies, and banks under deposit insurance. A recession looms, which the US will want to fight with fiscal stimulus. The last crisis occasioned about $5 trillion of extra borrowing. The next one could double that.

So, the U.S. needs to quickly borrow additional trillions of dollars, while its major customers --foreign central banks --are selling. In addition, the U.S. borrows relatively short term. Each year, the U.S. borrows about $7 trillion to pay off $7 trillion of maturing debt, and then more to cover the deficit.

Imagine all this happens 10 years from now, with social security and medicare unresolved and increasing deficits. The CBO is still issuing its annual warnings that our debt is unsustainable. Now, bond investors are willing to lend to the US government so long as they think someone else will lend tomorrow to pay off their loans today. When they suspect that isn't true, they pull back and interest rates spike.

But our large debts leave our fiscal position sensitive to interest rate rises. At 100% debt to GDP ratio, if interest rates rise to just 5%, that means the deficit rises by 5 percentage points of GDP, or approximately $1 Trillion extra dollars per year. If bond investors were worried about sustainability already, an extra trillion a year of deficits makes it worse. So they demand even higher interest rates. Debt that is easily financed at 1% rates is not sustainable at 5% rates and a catastrophe at 10% rates --if you have a large debt outstanding.

This is a big part of what happened to Greece and nearly happened to Italy. At low interest rates, they are solvent. At high interest rates, they are not.

Debt crises are like an earthquakes. It's always quiet. People laugh at you for worrying. Buying insurance seems like a waste of money. Until it isn't.

So, the way to think about the dangers of debt is not like a predictable problem that comes to us slowly. View the issue as managing a small risk of a catastrophic problem, like a war or pandemic.

The easy answers are straightforward. Sensible reforms to Social Security and Medicare are on the table. Fix the indexing, improve the incentives for older people to keep working. Convert medicare to a premium support policy.

The harder problems are those less recognized. Underfunded pensions, widespread credit guarantees, and explicit or implicit too big to fail guarantees add tinder to the fire. Dry powder and good credit are invaluable.

Above all, undertake a pro-growth economic policy. We grew out of larger debts after World War II; we can do that again.

You can also buy some insurance. Every American household that takes out a mortgage faces the choice: fixed rate, or variable rate? The fixed rate is a little higher. But it can't go up, no matter what happens. The variable rate starts out lower. But if interest rates rise, you might not be able to make the payments, and you might lose the house. That is what happens to countries in a debt crisis.

For the US, this decision is made by the Treasury Department and the Federal Reserve. The Treasury has been gently lengthening the maturity of its borrowings. The Federal Reserve has been neatly undoing that effort.

Both Treasury and Fed need direction from Congress. The Treasury does not regard managing risks to the budget posed by interest rate rises as a central part of its job, and the Fed does not even consider this fact. Congress needs to decide who is in charge of the maturity structure of US debt, and guide the Treasury. I hope that guidance leans towards the fixed rate plan. By issuing long-term debt --I argue in fact for perpetuities, that simply pay a $1 coupon forever with no fixed roll over date -- and engaging in simple swap transactions that every bank uses to manage interest rate risk, the U.S. can isolate itself from a debt crisis very effectively. 20 But at least ask that fixed or floating interest rate question and make a decision.

As I have warned against focusing too much attention on on-budget spending, so let me warn against too much attention on deficits rather than spending. If you focus on debt and deficits, the natural inclination is to raise tax rates. Europe's experience in the last few years argues against "austerity" in the form of sharply higher tax rates, as always adding to the disincentive to hire, invest, or start innovative businesses.

Concluding comments

I have sketched some novel and radical-sounding approaches to restoring robust economic growth. Economic growth, together with commonsense fiscal discipline are keys to solving our budget problems.

This is not pie in the sky. These are simple straightforward steps, none controversial as a matter of economics. And there really is no alternative. Ask of other approaches: Does this at all plausibly diagnose why America's growth rate has fallen in half? Does the cure at all plausibly address the diagnosis? Is the cure based on a reasonable causal channel that you can actually explain to a constituent? Does the cure have a ghost of a chance of having a large enough effect to really make a difference?

You may object that fundamental reform is not "politically feasible." Well, what's "politically feasible" can change fast in this country. This is an exciting time politically. The people are mad as hell, and they're not taking it any more. They are ready for fundamental changes.

Furthermore, it is time for Congress to take the lead. These are properly Congressional matters, and no matter who wins the Presidential election you are unlikely to see leadership in this direction.

Winston Churchill once said that Americans can be trusted to do the right thing after we've tried everything else. [NB: apparently this is an urban legend. Oh well, it's a good quip if not a quote] Well, we've tried everything else. It's time to prove him right.

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1. You can find a full CV, a list of all affiliations, and a catalog of written work at http://faculty.chicagobooth.edu/john.cochrane/index.htm. ↩

2.This testimony summarizes several recent essays. On growth and for an overview, see "Economic Growth." 2016. In John Norton Moore, ed., The Presidential Debates Carolina Academic Press p. 65-90. http://faculty.chicagobooth.edu/john.cochrane/research/papers/cochrane_growth.pdf; "Ending America's Slow-Growth Tailspin." Wall Street Journal, May 3 2016. http://www.wsj.com/articles/ending-americas-slow-growth-tailspin-1462230818, and "Ideas for Renewing American Prosperity" Wall Street Journal July 4 2014. http://online.wsj.com/articles/ideas-for-renewing-american-prosperity-1404777194. ↩

3. https://fred.stlouisfed.org/series/GDPCA, Continuously compounded annual rates of growth. Per capita https://fred.stlouisfed.org/series/A939RX0Q048SBEA ↩

4. https://www.cbo.gov/sites/default/files/114th-congress-2015-2016/reports/51580-LTBO-2.pdf ↩

5. 100*exp(30 x 0.02) = 182. 100*exp(30*0.035) = 286. ↩

6. As an example of agreement on the fundamental importance of growth among economists of all political leanings, see Larry Summers, "The Progressive Case for Championing Pro-Growth Policies," 2016. http://larrysummers.com/2016/08/08/the-progressive-case-for-championing-pro-growth-policies/ ↩

7. For an excellent recent exposition of this view, see Robert J. Gordon, The Rise and Fall of American Growth: The U.S. Standard of Living since the Civil War. Princeton University Press 2016. http://press.princeton.edu/titles/10544.html ↩

8. An influential example of these views, including self-financing stimulus: J. Bradford DeLong and Lawrence H. Summers, "Fiscal Policy in a Depressed Economy" Brookings Papers on Economic Activity. Spring 2012. https://www.brookings.edu/bpea-articles/fiscal-policy-in-a-depressed-economy/. Interestingly, DeLong and Summers condition their view on interest rates stuck at zero, a cautionary limitation that current stimulus advocates seem to have forgotten. ↩

9. See "Rule of Law in the Regulatory State." 2015. http://faculty.chicagobooth.edu/john.cochrane/research/papers/ rule_of_law_and_regulation essay.pdf ↩

10. http://www.wsj.com/articles/the-clinton-for-profit-college-standard-1473204250 ↩

11. http://www.washingtontimes.com/news/2016/sep/7/irs-refuses-to-abandon-targeting-criteria-used-aga/ ↩

12. http://www.usatoday.com/story/news/politics/onpolitics/2016/02/22/trump-ricketts-family-better-careful/80761060/ ↩

13. See "After the ACA: Freeing the market for health care." 2015. In Anup Malani and Michael H. Schill, Eds. The Future of Healthcare Reform in the United States, p. 161-201, Chicago: University of Chicago Press. http://faculty.chicagobooth.edu/john.cochrane/research/papers/after_aca_published.pdf ↩

14. See "Toward a run-free financial system." 2014. In Across the Great Divide: New Perspectives on the Financial Crisis, Martin Neil Baily and John B. Taylor, Editors, Stanford: Hoover Institution Press, p. 197-249. http://faculty.chicagobooth.edu/john.cochrane/research/papers/across-the-great-divide-ch10.pdf, and "A Blueprint for Effective Financial Reform." 2016. In George P. Shultz, ed, Blueprint for America Hoover Institution Press, p. 71 - 84. http://faculty.chicagobooth.edu/john.cochrane/research/papers/george_shultz_blueprint_for_america_ch7.pdf ↩

15. See Casey Mulligan The Redistributon Recession, Oxford University Press 2012. ↩

16. See "Here's what genuine tax reform looks like." Wall Street Journal, December 23 2015. http://www.wsj.com/articles/heres-what-genuine-tax-reform-looks-like-1450828827 ↩

17. https://www.whitehouse.gov/omb/budget/Analytical_Perspectives Table 14; http://www.taxpolicycenter.org/briefing-book/what-tax-expenditure-budget ↩

18. https://fred.stlouisfed.org/series/W019RCQ027SBEA ↩

19. See "The Clinton Plan's Growth Deficit." Wall Street Journal, August 12 2016. http://www.wsj.com/articles/the-clinton-plans-growth-deficit-1470957720. Also, for an excellent and well documented review of these issues, see Edward L. Glaeser, 2016, "If you Build it..." City Journal, Summer 2016, http://www.city-journal.org/html/if-you-build-it-14606.html ↩

20. For more details see: A New Structure For U. S. Federal Debt." 2015. In David Wessel, Ed., The $13 Trillion Question: Managing the U.S. Government's Debt, pp. 91-146. Washington DC: Brookings Institution Press. https://www.brookings.edu/book/the-13-trillion-question/ and http://faculty.chicagobooth.edu/john.cochrane/research/papers/Cochrane_US_Federal_Debt.pdf. For a clear analysis of the problem, that recommends the opposite action --shortening the maturity structure to take advantage of low rates --see Robin Greenwood, Samuel G. Hanson, Joshua S. Rudolph, and Lawrence H. Summers, "The Optimal Maturity of Government Debt" and "Debt Management Conflicts between the U.S. Treasury and the Federal Reserve," also in David Wessel, Ed., The $13 Trillion Question: Managing the U.S. Government's Debt.↩

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