Monthly Archives: September 2014

Corruption at the Fed

Senators Elizabeth Warren and Sherrod Brown have called for an investigation of the Federal Reserve Bank of New York. This comes as a response to a ProPublica article by Jake Bernstein, true yeoman’s work, that exposes an all-too-cozy relationship between the Fed and Goldman Sachs. Relying on secret recordings made by a former Fed compliance attorney, he writes:

In a tense, 40-minute meeting recorded the week before she was fired, Segarra’s boss repeatedly tries to persuade her to change her conclusion that Goldman was missing a policy to handle conflicts of interest. Segarra offered to review her evidence with higher-ups and told her boss she would accept being overruled once her findings were submitted. It wasn’t enough.

“Why do you have to say there’s no policy?” her boss said near the end of the grueling session.

“Professionally,” Segarra responded, “I cannot agree.”

The New York Fed disputes Segarra’s claim that she was fired in retaliation.

As far as I can tell, this story boils down to the firing of Carmen Segarra, an “expert examiner” hired by the Fed who dared to ask questions of her Fed boss about Goldman Sachs’ nonexistent conflict of interest policy. The concern here is that Goldman Sachs has undue influence over policy making at the New York Fed–more specifically, that Fed officials aren’t willing to hold Goldman Sachs accountable.

A classic case of regulatory capture, if you ask me. And why aren’t Republicans on top of issues like this? Where’s Rand Paul? I like most Republicans, but their apparent unwillingness to involve themselves in issues like this–issues other than run-of-the-mill low taxes, less regulation, more freedom, etc.–will doom them among young voters, if it hasn’t already.

Update: Apparently Michael Lewis has covered this story for Bloomberg. He highlights the following quote that should get people’s attention:

for instance, in one meeting a Goldman employee expressed the view that “once clients are wealthy enough certain consumer laws don’t apply to them.” After that meeting, Segarra turned to a fellow Fed regulator and said how surprised she was by that statement — to which the regulator replied, “You didn’t hear that.”

Banks don’t “lend out” excess reserves

I recently came across this S&P report by S&P’s Chief Global Economist Paul Sheard debunking common misunderstandings about the Federal Reserve, QE and excess reserves. I’m posting it here to clear up misinformation about what banks do with their excess reserves at the Fed. I’ve definitely been led astray in the past by economists regarding this matter.

The key point, however, is that the existence of excess reserves in the banking system does not loosen any reserve constraint on the ability of banks to lend because there was no reserve constraint to begin with (of course, the stance of monetary policy, notably the interest-rate policy decision, does affect the demand for bank lending and the willingness of banks to lend, but, to repeat, given the interest-rate setting, the central bank supplies whatever reserves are demanded).

It might be asked: if banks cannot lend the excess reserves that the central bank provides, what is the point of the central bank supplying them? The answer to that question is simply that QE does serve to ease financial conditions. Technically, QE allows the central bank to change the composition of the aggregate portfolio held by the private sector; the central bank takes out of that portfolio the government debt and other securities it buys and replaces them with reserves and bank deposits (the latter when it buys assets directly from the public or its nonbank financial intermediaries) (10). This has an easing effect via so-called “portfolio rebalance effects,” including but not limited to the associated downward pressure that QE puts on the yield curve (11).

When the Federal Reserve buys treasuries via open market operations, they credit the sellers’ accounts at the Fed in order to complete the transaction. This drives up the level of excess reserves participating banks have on account with the Fed. These reserves will never be lent out unless, for some strange reason, banks start handing out cash whenever they lend. This doesn’t happen because, as Sheard explains earlier in the essay, banks create credit out of thin air–not out of reserves. As he explains, “Loans create deposits, not the other way around.” The only way for reserves to shrink is for the public’s demand to hold physical cash increased.

Up stocks, down fixed-capital

Thad Beversdorf with a nice piece at Voices of Libertyon why the Fed is destroying the middle class.

However, we have to remember that at the end of the day corporations are just money allocators like any hedge fund or mutual fund manager. CEOs are sworn to maximize shareholder funds. Understanding this we must expect corporations to invest based on the best risk/reward scenario available to them as we do for any other investors. Herein lies the invalidity of the Fed’s assumptions.

The Fed assumed that low borrowing costs and high equity values would drive corporate fixed capital investment. It did drive investment, but not fixed capital investment. Corporations, like all other investors, realized the stock market was being backstopped by the Fed. This essentially gave all market long side participants a free put option. In other words, the Fed was protecting folks from any downside risk by explicitly stating they were targeting higher stock prices. Thus corporations and everyone else realized the smart money was directly tied to the market.

The result, Beversdorf argues, is inflated stock prices at the expense of fixed capital investments. This promotes economic stagnation–no real growth in job-creating, fixed capital investments concurrent with strong growth in financial markets.

Another quibble with incentive talk

Matt McCaffrey has an interesting post on incentives over at the Mises Economics Blog. He writes:

Nevertheless, emphasizing incentives too much glosses over several problems: economic laws can make incentives irrelevant; incentives are in any case too narrow a concept to be the defining characteristic of economics; focus on incentives sometimes leads to a paternalistic view of economic policy.

I like where he’s headed here. I’ve had similar skepticism of incentive talk myself, which I’ve expressed on this blog (archived here). But I have a few issues with the way he presents this issue:

1. Just because incentive talk might lead to a paternalistic view of economic policy doesn’t mean it’s not worth keeping around. If we can learn things from thinking and talking about incentives, we shouldn’t avoid doing it. The paternalistic tendencies of incentive talk is just an unfortunate side-effect–one we should combat with ideas, not ignorance or prohibition.

An analogy here might be the way playing games like SimCity or Age of Empires (one of my personal favorites) contributes to command-and-control-type thinking about economic resources. In these games, players are dictators and can achieve economic success for their digital world by more or less controlling how these worlds’ people use resources. Of course, the digital people aren’t real or rational, but the point is that these games can lead players to think about economies in terms of how central controllers can use force to maximize national output.

This is an unfortunate side-effect of such games, but that doesn’t mean they aren’t worth playing or that we should avoid them. We just need to be sure we keep our heads on straight with regard to how they fail to recreate real-world economic conditions.

2. The biggest problem with incentive talk is none of the objections McCaffrey raises above, but the fact that we cannot be sure of how people respond to incentives. We can only guess based on our observations of people’s demonstrated preferences. We cannot logically deduce our way to any conclusions about how people will respond to incentives except under hypothetical, ceteris paribus conditions. This is because costs are subjective.

This means that the extent of incentive talk’s usefulness is to understand the fact that people do indeed respond to incentives. We can’t be much more specific than that. Sure, we can make predictions that on the margin, ceteris paribus policy X will result in such and such an effect. For example, raising unemployment benefits will lead more people to become unemployed or remain unemployed longer. But we can’t really know this for sure. Like I said above, costs are subjective. Raising unemployment benefits lowers the financial cost of being unemployed, but we can’t know what other incentives are at play.

For example, I can conceive of a society where sending your children to public school is generally seen as a failure (on the part of parents) because people generally look down upon dependency on government. If government were to lower the cost of public schooling (it’s free, so this would mean something like paying parents to send their kids to public school), then, the net effect might be a reduction in the number of children going to public school. Parents, of course, face the financial incentive to send their kids to public school, but they also face the other incentive of avoiding the stigma associated with sending their kids to public school.

Incentives aren’t always financial, which leads me to a related point on incentives that I thought about last night.

During class the other day (I’m at George Mason University pursuing an MA in Economics), my professor offhandedly criticized the idea that we can effect any positive change via the democratic process because politicians simply respond to incentives like everyone else. They aren’t demigods. They aren’t any less susceptible to responding to financial incentives that encourage them to take actions other than what’s best for the long-term well-being of their constituency.

But isn’t it possible that a politician might not respond to such incentives, and instead respond to incentives that reward him for taking his constituency’s long-term well-being into consideration with every vote? I can think of a few politicians that don’t respond to financial incentives from lobbyists and interest groups because they care more about long-term economic stability than short-term financial gain.

Maybe I can sum this all up this way: Policy changes alter incentives, which affects people’s behavior on the margin. But we can never be sure whether that margin is big enough that anyone falls into it, or that other changes to incentive structures–ones we might not think of, and can never always consider all of the time–don’t offset or even outweigh the changes in behavior we do predict.

My thoughts on incentives are somewhat jumbled. I’m thinking about writing a more formal piece on this topic. I’ll let you know if I find the time to do so.

Rogoff on the exaggerated death of inflation

Harvard economist Kenneth Rogoff writing on the “exaggerated death” of inflation.

I am not arguing that inflation will return anytime soon in safe-haven economies such as the US or Japan. Though US labor markets are tightening, and the new Fed chair has emphatically emphasized the importance of maximum employment, there is still little risk of high inflation in the near future.

Still, over the longer run, there is no guarantee that any central bank will be able to hold the line in the face of adverse shocks such as continuing slow productivity growth, high debt levels, and pressure to reduce inequality through government transfers. The risk would be particularly high in the event of other major shocks – say, a general rise in global real interest rates.

Global inflation rates are far lower today, on average, than they were in the early 1990s. Rogoff credits this to “massive institutional improvements concerning central banks.” But such improvements, he says, aren’t enough to stave off inflationary forces should productivity continue to slow and commodity prices continue to rise like they did in the 1970s.

I think he’s right.

ISIS, meet Mises?

John Tamny has a great column over at Forbes that pinpoints my exact frustrations with reporting on ISIS and its supposed threat to our national security. He writes:

In reality, the entity that has left and right up in arms in search of a muscular response was born in a part of the world that is one of the least productive economically, that can’t claim to create even one consumer good (the oil wealth there is largely a creation of western ingenuity) that is desired by global consumers, that can’t claim even one university that would appeal to the best and brightest. Despite this, numerous wise eyes are on ISIS?

…

Mises likely would have mocked today’s consensus precisely because the basis of ISIS’s existence is one of theft, coercion, or both

…

It doesn’t take several Foreign Affairs columnists to deduce that there probably isn’t a collection of Thomas Jeffersons and George Washingtons at the top of an entity that has Washington transfixed (ISIS). Figure our political class can’t agree on much of anything (this latest alleged terrorist threat once again a rare example of consensus), the fighting is constant, yet somehow we’re supposed to believe that a criminal organization’s activities are defined by competent consensus and quietude at the top such that failure to respond now dooms us to eventual massacre in the cities and states we live in?

Except for the fact that these are really just general common sense insights and not unique to the Austrian school, these are my thoughts exactly. For some reason, commentators seem to exempt terrorist organizations from the same challenges that face other associations of thinking people. It’s hard enough to get a family of five to agree on where to go out for dinner, let alone convince an entire army to wage a holy war that even they can see has zero prospect for success.

Take the mainstream media seriously, and you’d be led to believe that ISIS militants never doubt the legitimacy of their convictions (unlike everyone else in the world), never question their leaders’ intents (unlike everyone else in the world), and literally won’t stop until they are dead (unlike everyone else in the world). While this might be true of some of them, it’s definitely not true of all of them.

You’d also be led to believe that these people all join ISIS for the same reason and with the same individual goals. Is that true of the U.S. military? Of your local police force? Of the Republican Party? Of any association of even like-minded people? Nope.

You’ll also be convinced that, for some reason, the Islamic youths who voluntarily join ISIS aren’t like youths of every other culture in their propensity to quit when the going gets tough, look out for themselves first and foremost, and engage in reckless behavior that endangers their own well-being. No, these terrorists are alleged to be always thinking about their ultimate goal, even when they likely have no clue where to find their next meal.

I’ve heard about a lot of evil things ISIS terrorists are doing in the Middle East. I hope they stop. But there’s no reason to believe they pose a unique, never-before-seen threat to the very life of the American people.

Finally, here’s a hilariously serious Fox News report on a Texas sheriff preparing for an ISIS attack across the Mexican border. Apparently he heard ISIS was “moving around” near Juarez. And, of course, someone somewhere found a “Koran books” on the border (which can only mean ISIS, right?).

The Ebola epidemic is getting worse

According to Michael T. Osterholm, director of the Center for Infectious Disease Research and Policy at the University of Minnesota, Liberia has only 250 doctors left in the wake of the growing Ebola epidemic. The country’s population tops 4 million. From the New York Times :

Because people are now too afraid of contracting Ebola to go to the hospital, very few are getting basic medical care. In addition, many health care workers have been infected with Ebola, and more than 120 have died. Liberia has only 250 doctors left, for a population of four million.

That’s a 1:16,369 doctor-population ratio. To put that in perspective, that ratio in the United States is around 1:413.

Learn about banking from Salman Khan

No, not the Bollywood superstar. Here’s Salman Khan the educator teaching us about the multiplier effect and the money supply. I’m reposting this because I’m finding a lot of misinformation about the multiplier effect online as I’m researching for an upcoming report on the money multiplier. I’ll link to that report here once it’s published.

Even more thoughts on incentives

The topic of the War in Afghanistan came up at a recent seminar I attended. One participant claimed that President Obama pulled the troops out of Afghanistan because of political pressure. Everyone quickly nodded in agreement as he continued with the rest of his comments.

This reminded me of the argument that politicians increase spending in order to earn votes from their constituents. This is a good argument on the surface, but we can’t be sure of politicians motives for doing whatever it is they do.

In the same way, there is no telling whether Obama pulled the troops out because of political pressure. Maybe he honestly wanted to pull them out the way he did–advised by specialists, of course. No one but him can know.

This helps illuminate my growing suspicion of “incentive talk” even further. I realize my blog is filling up with posts like this, but it’s really getting to me. I hear it all the time. Economists predict with seeming certainty that if you lower the cost of X, people will do more of X. Or if you raise the cost of Y, people will substitute other things for Y.

This entire notion is based on the proposition that people are rational. They seek the lowest-cost means to their highest-valued ends. It then becomes fair game to say that policy Z will have such and such effect as people react this and that way to the new costs and benefits.

But we can’t know how people will react. I’ve said before that it is usually safe to say that subsidizing unemployment, for example, will lead to more unemployment as people on the margin choose to quit and live off unemployment benefits. But this prediction is based in our experience  of how people usually respond to things like that. We cannot logically deduce that conclusion–we can only draw on our past observations of how people respond to various incentives.

For instance, the following world is entirely conceivable to me: The federal government raises unemployment benefits by 50 percent (being unemployed pays 50 more than before). But instead of more people quitting their jobs to live off unemployment, people’s preferences are such that unemployment becomes less and less desirable as its payout rises. This could be due to, say, some prevailing religious belief that led people to consider unemployment benefits evil–that getting paid to not work is something that people should avoid at all costs. The relationship between unemployment benefits and the unemployment rate, then, becomes inverse: as benefits increase, the unemployment rate decreases.

This relates to my War in Afghanistan example above in the following way:

The guy in my seminar who said President Obama pulled troops out of Afghanistan because of political pressures assumes that President Obama wants to be politically popular–that he cares about how voters think of him. I’ve heard other people make this assumption more explicit by citing the fact that a political career depends on being re-elected, and that getting re-elected often requires politicians to do something other than what’s best for the long-term interest of their constituents. Instead, they focus on legislative action that has immediate, highly-visible results that benefit their constituents in obvious ways.

This is bunk. I’ll have to go back later and identify the exact place I read this argument, but suffice it to say that the fact that any politician who engaged in such behavior was ever defeated by an incumbent who promised to concern himself more with the long-term health of his constituency undermines this entire argument.

But even aside from that, why is it that political incentives should take precedence over other types of incentives. Religious incentives, for example, can be pretty strong. One might say that suicide bomber missions are irrational, but not from the perspective of the suicide bomber. In like manner, one might claim that to do the opposite of what the majority of voters wants is irrational for a politician, but that’s only true if the politicians goal is to win votes. What if the politician’s goal is something else, and the biggest incentives he or she responds to are unknown to anyone else?

I hope this makes sense. It’s a ramble, but unless I jot it all down quick I end up questioning myself. Talk about responses to various incentives is so pervasive that I feel somewhat vulnerable attacking it. Any thoughts?

Blowback in Syria?

From Abigail Hall, writing in The Beacon this morning regarding President Obama’s plan to arm “moderate” Syrian rebels:

Syria’s regime is unfriendly to the U.S. The country is in the midst of an ongoing civil war with a death toll considered tragic on any margin. But the idea that the U.S. can arm rebels and keep weapons in “responsible and moderate” hands is unfounded in theory and practice. If the U.S. were to send weapons to Syria, there are no guarantees how such weapons would be used, who would ultimately possess them, or how such an arrangement would change conditions over time. If Afghanistan and other U.S. ventures into the Middle East are any indication, there is a very real possibility that weapons sent to protect U.S. interests today could be used to threaten them tomorrow.

A good word. Where I’m skeptical, though, is whether what President Obama says is what President Obama does. I usually avoid foreign policy debates for this very reason–foreign policy is hopelessly complex and so much of it is conducted in secret. How do we know the information we get from the media reflects what’s actually happening on the ground? We’re all in the dark, really.