Hey, What’d I Miss? OTE 9/17 — 9/29

September 29th, 2014 at 9:58 am
  • Sharing some advance thoughts re Martin Wolf’s new book.
  • Pushing back on a misleading critique of a paper I wrote on inequality and growth.
  • Analyzing Chair Yellen’s decision to keep the words “considerable time” in her statement before the FOMC.
  • Explaining the biased against full employment in when-to-lift-rates debate.
  • Looking at evidence of labor market slack through the relationship between the labor force participation rate and weak wage growth.
  • Pondering our benighted US corporate code, despite the Administration’s fine start on curbing inversions.
  • Describing the arbitrariness of the Federal Reserve’s 2% inflation target.
  • Highlighting one of the best Fed speeches you’ll ever read by Charles Evans.
  • Pointing to the Obama administration’s much needed move to curb corporate inversions.
  • Feeling a bit confuzzled by some recent analysis from Brad DeLong and John Fernald on potential growth trends.

Wherein I do the DC thing of talking about a book I’ve yet to read.

September 29th, 2014 at 9:31 am

I need to read Martin Wolf’s new book, “The Shifts and the Shocks,” his diagnosis of the factors that brought on the financial crisis and his prescriptions for getting out of this terribly damaging bubble, bust, repeat cycle.

But in the meantime, it’s worth giving a read to Felix Salmon’s review in yesterday’s NYT. Salmon comes to both praise and critique Wolf, the latter in no small part for the author’s turgid writing. While many of us in this biz try to make the complex if not simple, then accessible to non-experts (Salmon himself being a great example), Wolf chooses not to bother so much with that.

But if you’re willing to slog through, the rewards are great, as few macro analysts so acutely understand the moving parts between countries, sectors, markets, governments, and central banks. Moreover, Wolf writes with a tangible sense of shock and outrage at the foolishness of policy makers who stubbornly continue to make bad economic policy choices at tremendous costs to their constituents.

The results comes out sounding like an intermediate macro textbook but with a sharp, pissed-off edge.

Coincidently, in pulling out a characteristic Wolfish passage, Salmon quotes the following, which is a theme I too have been stressing for a while now (see here and here):

“With the eurozone in internal and external balance and creditor eurozone seeking internal balance via ever-larger external imbalances in the form of current-account surpluses, debtor eurozone could only attain internal balance with ever larger external imbalances in the form of current-account deficits.”

This is a key theme of Wolf’s work, one to which I was first exposed in Ben Bernanke’s seminal paper on what he called the “global savings glut.” The key point about this work—the one I emphasized in the second link above about the downsides of running the world’s dominant reserve currency—is that the expansion of global trade has evolved in ways such that persistent imbalances in one country infect other countries.

Under such conditions, it will do little good to exhort Americans to save more so as to reduce our demand-reducing trade deficit. Our savings rates are in part set elsewhere, in much the same way southern Europe over-consumed (ran current account deficits) to offset Germany’s under-consumption (and their current account surpluses).

Few understand and emphasize these dynamics as well as Wolf, and it’s one good reason to make the perilous journey through his prose.

I’m also looking forward to learning about his ideas for repairing the system. Salmon emphasizes one idea Wolf has been pushing for awhile, full reserve banking (aka 100% reserve banking):

Modern banks hold just a small fraction of their deposits in cash. But Wolf, finding that fractional-reserve banking was a key cause of the financial crisis, says all should have much higher capital requirements, and then goes much further: He spends a lot of time describing an economy in which banks have to back up all their deposits with reserves held at the central bank.

This got me to thinking how various scholars called for full reserve banking after the Great Depression in the 1930. In fact, the current dynamics and their 1930s counterparts have commonalities: underpriced risk fueling bad underwriting leading to over-leveraging creates a large financial bubble. Regulators, co-opted by fables of self-correcting markets snooze at their switches. Inequality rises to historical highs as unregulated and over-leveraged financial markets create inflate asset prices.

Eventually, the weight of the leveraging crashes the system and the ensuing negative wealth effects ensure a deep depression in the 30s and “great recession” in the most recent case (the difference is in no small part due to policy lessons at least partially learned over that interval).

In the wreckage, reformers argue that fixing what’s broken will require restraining the chain of events in financial markets. In the 1930s, it was separating commercial and investment banking, insuring the deposits in the former, the creation of the SEC and more. Though full reserve banking was floated, FDR, among others, judged that these other measures went far enough.

The reforms following the Great Recession, like Dodd-Frank, while useful, are of a considerably smaller scale. That’s partly due to the continued existence of the FDIC and parts of the regulatory structure harking all the way back to the 1930s, but it’s also due to the greater influence of today’s financial lobbyists and market-friendly economists.

I worry that full reserve banking would ultimately go too far in reducing access to short-term credit, leading to the growth of shadowy, unregulated lending (sound familiar?). Also, in contemplating such an extensive change, one must be mindful of the absence of a functional federal government that could offset the impact of reduced credit flows with fiscal policy or public goods/infrastructure investment.

Still, I appreciate the idea as a viable position at one end of the regulatory continuum (and Wolf himself suggest that full reserve banking should be tried as a pilot project prior to full-scale adaptation). For example, staking out such a position would surely help us end up with larger capital buffer requirements for lenders that leveraged up 60:1 before the crash.

As I’ve always said, you can get a lot wrong in financial reform, but if you set and enforce the right leverage rules, you’ve got a solid first line of defense against the next bubble.

A misleading critique of my inequality and growth analysis

September 29th, 2014 at 8:51 am

Sorry, but Steve Roth’s critique of my Inequality and Growth paper for CAP is misleading and inaccurate. Moreover, he had to work pretty hard to miss my points linking inequality to macro-instability and thus persistent periods of weak growth.

Not only does Roth somehow miss my emphasis on what I think are critically important linkages between inequality and growth, ones I repeat below. What’s particularly unfortunate about his critique is that while he purports to solve the hard problem that I laid out in the piece–correlations over the long-term between inequality and macroeconomic growth are hard to find in the US data–he fails to do so.

As I stressed in my piece, this is a key missing piece of evidence, and while I don’t see how he missed the other connections I did make in my piece, I read his critique with the expectation that he had found evidence tying inequality directly to slower growth through the consumption channel. He does not.

Instead, Roth just throws up a few FRED charts that merely obfuscate, arguing that they reveal evidence of a “massive, three-decade secular decline in spending relative to wealth over 35 years — the very same period over which we’ve seen massive growth in wealth inequality.”

That’s arguing by adjectives, not evidence. If all those “massives” are operative, it should be straightforward for him to show us convincing evidence linking these dynamics lead to slower growth of GDP or more pointedly, aggregate consumption. That’s the question I tackled and I encourage him to find what I could not. That would be an important contribution.

(BTW, if someone can think of a way to examine this through a state panel, versus the national data that I and Roth use, that increase in observations and variance would surely help in the search for the signal. The IMF cross-country work certainly points in this direction, but again, the challenge is to find this relationship in the US data, give the post 1970s increase in inequality.)

But—and here’s where he works hard not to see the more nuanced linkages I try to make between inequality and growth—the absence of this macro evidence in the aggregate variables tying growth to inequality does not at all mean inequality is unconnected to negative growth outcomes.

My key point, which again, is stated clearly throughout—in the intro, I signal this as “perhaps the most interesting finding in the report”—is that inequality contributes to credit bubbles which has obviously and negative impacts on growth (this is not an original finding; I’m building off of the work I cite by others, featuring in particular an important and under-appreciated paper in this space by Cynamon and Fazzarri).

I then devote a dominant section to this destructive chain of events. From the paper:


Source: my CAP paper.

I’m not saying this is the only way inequality hurts growth. Throughout the piece I present the logic of the basic argument regarding marginal consumption propensities—the idea that concentrated wealth among those with relative low propensities to consume should show up as weaker aggregate real consumption (per capita), post mid-1970s, when inequality started rising. I don’t find this in the data, and present arguments about why not, most notably wealth effects (again, note the linkage to the bubble sequencing above).

BTW, I especially suspect this effect is operative–it certainly should be–in the current recovery, given rising inequality, weak macroeconomic growth, and little in the way of offsetting wealth effects for the broad middle class. To be clear, that wasn’t the question of my CAP piece, which was a long-run analysis, looking for this relationship over the sweep of inequality’s rise since the late 1970s.

For whatever reason, Roth misses all that, but that’s not important, especially as he seems more interested in complaining that a progressive economist failed to confirm a progressive point.

What matters here is that if someone has convincing evidence of the relative propensity point, separate and apart from the bubble/bust dynamics that I emphasize at length (and Cynamon and Fazzari identify), let’s see it. It would advance this important debate and I guarantee you, I’d be among the first to highlight it. The fact that neither I nor Roth show it doesn’t mean it’s not out there. The logic is sound. But it will take more digging to make the empirical case.

Musical Interlude: One After 909

September 26th, 2014 at 4:11 pm

The Beatles were, of course, many different things over the course of their life as a band. But at their core, they were always mates who just loved to rock out. That’s why I’ve always loved this version of One After 909. There was a lot of water under the bridge already and much more to come, but they clearly had no trouble at all getting back to their rockin’ roots.

The new inversion rules are a fine start, but the business tax code needs serious attention.

September 26th, 2014 at 9:23 am

Now that the dust has settled a bit on the Treasury’s exciting announcement of their new inversions rules, let’s kick back and cogitate a bit more on a few of the many remaining issues in the US corporate code.

Inversions: The Treasury has thus far created but a speed bump on the international tax avoidance highway. As I read it, they’ve made it harder for newly merged corporations to make their deferred earnings—profits the former US parent company was holding abroad to avoid US taxation—appear to be property of the new foreign firm. (Treasury: “Today’s notice removes benefits of these “hopscotch” loans by providing that such loans are considered “U.S. property” for purposes of applying the anti-avoidance rule.”)

I suspect that changes the marginal calculus for some firms considering inversions—most analysts view this issue of distributing foreign holdings tax free as the main motivator for many an inverter—but no one who follows this sees it as a game changer. That’s not a dis of the Treasury; as I wrote the night the rules came out, this is a bold, albeit limited, move to do what they can without Congress to partially close a loophole and protect the eroding tax base. But I expect them to return to this well, both on their own (next up, I’d guess: rule changes to block “earnings stripping”) and, in the unlikely event that they can find some dance partners, with Congress.

Debt Financing:  CEA chair Jason Furman just presented a paper on corporate tax reform, mostly reviving ideas that the administration put forth a few years ago—lower rate, broader base, minimum tax on deferred foreign earnings. In the process, he updated two charts of which you should be aware.

Suppose I told you a fable about a country that massively favored debt financing for business investment over equity financing, where “massive” implies almost a 100% difference. You might think: there’s a country that is asking for over-leveraging problems.

Well, according to Furman’s chart, that’s no fable. Since interest is a deductible expense, the marginal tax rate for debt financing in the corporate sector is negative 60%; for equity, it’s +37%. Jason notes that the “…United States has the lowest tax rate on debt-financed investment in the OECD and the largest debt-equity disparity in the OECD.” The solution, likely not coming anytime soon to a tax reform near you, is to reduce this huge tilt by limiting the amount of interest that can be deducted.


Source: CEA, Furman.

Monster Tax Havens on Steroids: If you pay any attention to the tax avoidance problem you know that there’s been a sharp rise in the amount of what Ed Kleinbard calls “stateless income,” basically stealth profits that are designed to fly under the radar of any country that might tax them. So this next chart won’t surprise you, but the magnitudes are still worth observing.

It shows the ratio of offshored US corporate profits relative to the GDP of the countries where these dollars reside. In Bermuda, the British Virgin Islands, and the Cayman’s, that ratio is over 1,000%. I hope you’ll allow me to speculate that such location decisions are not the result of corporations answering the question, “in terms of growth, innovation, and productivity, where’s the best place for us to invest our profits?”


Source: CEA, Furman.

These three points provide good examples of the extent of base erosion, incentives to overleverage, and the distorted behaviors generated by our benighted corporate code. They also show you why corporate tax reform is such a heavy political lift. Policy makers and wonks like me can talk all day about the economic benefits of squeezing these inefficiencies out of the system, but the vested interests have huge bucks invested in a) the status quo, and b) members of Congress who will do their bidding to keep things just the way they are.