Low Interest Rates = Rape and Plunder

Via Mike Konczal, here is Carmen "Eight Centuries of Financial Folly" Reinhart indulging in a bit of folly of her own:

Reinhart is the toast of economic circles these days for speaking out about the newest way Western governments are using financial repression to liquidate their debts, particularly after a financial crisis. They’re doing this on the backs of savers, including pension funds... financial repression can lead to “the rape and plunder of pension funds,” Reinhart tells Institutional Investor. Financial repression consists of very low nominal interest rates combined with captive lending by large banks or pension funds to a government. The low, stable interest rate facilitates the servicing costs of large public debts. Sometimes modest inflation is added to the mix. This results in zero to negative real interest rates that reduce government debt. Hence, broadly defined, financial repression is a wealth transfer from savers to debtors using negative real interest rates — with the government as one of the key debtors. 

... Low interest rates are a fact of postcrash economic life, designed to kick-start greater borrowing. ... “Financial repression is an expedient way of reducing debt,” she says. For banks as well as the government, debt overhang is a major economic problem. But every tax has costs, including distortionary effects. Because financial repression punishes savers, it’s unknown to what degree it inhibits savings.

Rape and plunder? Owners of financial wealth definitionally are savers? Low interest rates are a transfer to debtors? (Are high interest rates a transfer to creditors, then?) Financial asset-owners are morally entitled to low inflation and high interest rates? Not getting the risk-free, passive income you expected is "punishment"? RAPE and PLUNDER, seriously? This article is so exactly everything that I'm against that I'm kind of speechless. All I can do is point at it and say, But! Gha! But it's! Bhehe!

* * *

In possibly related news, over at Crooked Timber, Daniel Davies contemplates the possibility that in Europe today, there might be a conflict of interests between debtors and creditors. But no there isn't, he decides, default would be equally bad for everyone:

The example that comes to my mind of a defaulting debtor that isn’t a commodity producer is Germany and their experiences with default have been absolutely awful. Graham Greene’s The Third Man is a story about the aftermath of debt default in a non-commodity economy.

Um yeah. Central Europe, 1946. Let's see, what has just happened? What's just happened in Germany (or Austria, as the case may be)? Oh yes: They've suspended payment on their bonds.

As through this world I've wandered, I've seen lots of funny men. Some of them seem to think that they are financial instruments. It gives them a funny point of view.

At Rortybomb: The Real Causes of Rising Debt

Last week I promised a discussion of my new paper with Arjun Jayadev on "Fisher dynamics" and the evolution of household debt. That discussion is now here, not here, but at Rortybomb, where Mike Konczal has graciously invited me to post a summary of the paper.

The summary of the summary is that the increase in household debt-to-income ratios over the past 30 years can be fully explained, in an accounting sense, y changes in growth, inflation, and interest rate. Except during the housing bubble period of 2000-2006, household spending relative to income has actually been lower in the post 1980 period than in preceding decades. If interest rates, inflation and growth had remained at their 1950-1980 average level, then the exact same household decisions about spending out of income would have left them with lower debt in 2010 than in 1980. And just as it wasn't more borrowing that got us higher debt, less borrowing almost certainly won't get us to lower debt. If household leverage is a problem, then the solution will have to be some mix of large-scale writedowns, higher inflation, and lower interest rates via financial repression.

But I encourage you to read the whole summary over at Rortybomb or, if you're really interested, the paper itself. Comments very welcome, there or here.


UPDATE: Now also at New Deal 2.0.

UPDATE 2: Responses by Kevin Drum, Karl Smith, Merijn Knibbe, Reihan Salam, and The New Arthurian. There's some good discussion in comments at Mark Thoma's place. And a very interesting long comment by Steve Randy Waldman in comments right here.

Why You've Got to Love New York

Because the random producer for Japanese TV that you run into, also, inevitably, plays the trombone in a Nigerian band.

That is all.

Pity the Landlord

So, speaking of rent control, here's an article on San Francisco's system. It's pretty much the usual -- the headline bleats that rent control "subsidizes the super rich," a claim for which no evidence is presented unless you count an income of $100,000 as super-rich, which in San Francisco, um, no. And then there's the sob stories of "mom and pop" landlords. Apparently, by some unexplained moral calculus, because some landlords own just a few units and have blue-collar backgrounds, the City of San Francisco should pursue higher rents as a policy goal.

Noni Richen, a former school cafeteria cook, and her husband, who once worked on the Alaskan pipeline, put their life savings into buying a four-unit Western Addition apartment building in the 1980s. “We had $20,000,” Richen said. “That was a lot of money to us, and we put that down.”

I am, let's say, unsympathetic. (How much do you think that building is worth today?) But from another perspective, this is directly relevant to the previous post. There are strong political as well as market pressures that keep asset returns above some minimum acceptable level. Is Noni Richen the liquidity trap? In a sense, yes, she is.

Anyway!

That's not what I'm writing about. What I'm writing about is the claim that a large share of rent-regualted units are occupied by high-income households, making it a perverse form of redistribution. Is that true?

I don't know about San Francisco, but in New York this is an easy question to answer. The city's Housing and Vacancy Survey gives very detailed breakdown of rental units by rent regulation status, including the residents' incomes. And... here we go:

Income	Rent-Regulated Apartments	Market-Rate Apartments	All Households
under $25,000	37.3%	27.3%	27.9%
$25,000 to $50,000	25.6%	25.5%	22.1%
$50,000 to $100,000	25.2%	28.3%	27.0%
over $100,000	6.7%	12.1%	23.1%
Median	35,531	46,000	50,038
Mean	52,157	71,307	77,940

In other words, compared with the city as a whole, rent-regulated tenants are only moderately more likely to be poor, but they are much, much less likely to be rich. So can we nip this meme in the bud, before it spreads to the East Coast? Rent control is not a subsidy for super-rich tenants at the expense of their hardscrabble landlords. It's a way of stabilizing middle-class and working-class neighborhoods in the face of gentrification, just like it says on the tin.

What is the Liquidity Trap?

In the common usage, popularized by Krugman, a liquidity trap is just a situation where the interest rate set by the central bank has reached zero. Since it can't go below that (the Zero Lower Bound), if more expansionary policy is needed it will have to take the form of fiscal policy or unconventional monetary policy -- quantitative easing and so on. But if there were some technical fix (a tax on excess reserves, say, or abolishing cash) that allowed central banks to make the policy rate negative, there would be no limit to the capacity of monetary policy to overcome any shortfall in demand. The idea -- expressed by modern monetarists in the form of the negative natural rate -- is that there are so few investment opportunities with positive expected returns that if investment rose enough to equal desired saving at full employment, the expected return on the marginal new unit of capital would be negative. So you'd need a negative cost of capital to get businesses to undertake it.

That makes sense, I guess. But it's not what Keynes meant by liquidity trap. And Keynes' version, I think, is more relevant to our current predicament.

Keynes himself doesn't use the term, and his explanation of the phenomenon, in chapters 13 and 15 of the General Theory, is rather confusing. (Lance Taylor has a much clearer statement of it in Reconstructing Macroeconomics, which I may add a summary or excerpt of to this post when I get home tonight and have the book.) So rather than quote chapter and verse, I'm just going to lay out what I understand the argument to be.

Interest, says Keynes, is not, as the classical economists said, the price of consuming in the future relative to the consuming in the present. It is the price of holding an illiquid rather than a liquid asset today. (This is one of the main points of the book.) The cost of holding an illiquid asset (a bond, let's say) is the inconvenience that it can't be used for transaction purposes, but also the opportunity cost of not being able to buy a bond later, if interest rates rise. Another way of saying the same thing: The risk of holding a bond is not just that you won't have access to means of payment when you need it; it is also the capital loss you will suffer if interest rates rise while you are holding the bond. (Remember, the price of an existing bond always moves inversely with the interest rate.)

This last factor isn't so important in normal times, when opinions about the future rates of bonds vary; if the supply of liquidity rises, there will be somebody who finds themselves more liquid than they need to be and who doesn't expect a rise in interest rates in the near future, who will purchase bonds, driving up their price and driving the interest rate down. The problem arises when there is a consensus about the future level of interest rates. At that point, anyone who holds a bond yielding below that level will be anxious to sell it, to avoid the capital loss when interest rates inevitably rise. (Or equivalently, to be able to purchase a higher yield bond when they do.) This effect is strongest at low interest rates, since bondholders not only are more likely to expect a capital loss in the future, but are getting very little interest in the present to compensate them for it. Or as Keynes says,

Nevertheless, circumstances can develop in which even a large increase in the quantity of money may exert a comparatively small influence on the rate of interest. For ... opinion about the future of the rate of interest may be so unanimous that a small [decrease] in present rates may cause a mass movement into cash. It is interesting that the stability of the system and its sensitiveness to changes in the quantity of money should be so dependent on the existence of a variety of opinion about what is uncertain. Best of all that we should know the future. But if not, then, if we are to control the activity of the economic system by changing the quantity of money, it is important that opinions should differ.

In other words, the essence of the liquidity trap is a convention about the normal level of interest rates. It's important to note that this convention is self-stabilizing -- if everyone believes that interest rates on a particular class of bond cannot be below 3 percent, say, for any extended period of time, then anyone who finds themselves holding a bond yield less than 3 percent will be anxious to sell it. And their efforts to do so will push the price of the bonds down, which itself will increase their yield back to 3 percent, so that the people who did not share the convention are the ones who end up suffering the loss.

This probably seems confusing and tedious to most readers (and tediously familiar to most of the rest.) Maybe it will be clearer and more interesting with some pictures:

10-Year Treasury Rate and the Federal Funds Rate

BAA Bond Rates and the Federal Funds Rate

The horizontal axis of this scatterplot is the Federal Funds rate. The vertical axis shows a market interest rate -- the 10-year Treasury bond rate in the first one, and the BAA corporate bond rate in the second. The heavy black diagonal corresponds to a market rate equal to the Fed Funds rate. In both cases, there's a clear positive relationship over normal ranges of policy rates -- 3 percent to 8 percent or so. But outside of this range, particularly at the bottom end, the relationship breaks down. The floor on Treasuries is a hard 3 percent or so, while the floor on BAA bonds varies from time to time but also doesn't go below 3 percent. [1] This is Keynes' liquidity trap. [2] And when you look at it, it becomes much less clear that the inability to extend the black line past the origin -- Krugman's liquidity trap -- is the problem here. What good would it do, if market rates stop following the policy rate well before that?


UPDATE: A smart, skeptical comment by Bruce Wilder leads me to reformulate the argument in a hopefully clearer way.

The necessary and sufficient condition for a liquidity trap is a consensus among market participants that nominal interest rates are more likely to rise than to fall over the relevant time horizon. Obviously, one basis for such a consensus might be that it is literally impossible for short rates to fall any further. [3] In this sense the ZLB liquidity trap is a special case of the Keynesian liquidity trap. But the Keynesian concept is broader, because conventions about the floor of interest rates can be strongly self-stabilizing, especially where they are backed up by the political power of rentiers.


[1] "The most stable, and the least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in future, the minimum rate of interest acceptable to the generality of wealth-owners. If a tolerable level of employment requires a rate of interest much below the average rates which ruled in the nineteenth century, it is most doubtful whether it can be achieved merely by manipulating the quantity of money. ... Cf. the nineteenth-century saying, quoted by Bagehot, that 'John Bull can stand many things, but he cannot stand 2 per cent.'"

[2] It also, not coincidentally, looks like the textbook LM curve. The replacement of LM with an central bank-determined interest rate curve in newer textbooks, is not progress.

[3] Note that it is not in fact the case that nominal interests cannot be negative, because in the real world cash has substantial carrying costs.

A Quick Note on Rent Regulation

I really want to write about the household debt-dynamics paper, but first a quick followup to yesterday's rant:

Even more fundamental than the arguments I mentioned yesterday, the thing about rent control is that rents contain an element of, well, rents. (Separating the two senses of the word so cleanly has got to count as a big victory for right-wing ideology in economics.) This is especially true because buildings are so fricking long-lived. The average age of a multi-unit residential structure in the United States is about 30 years. In most cities with rent regulations, it's much higher. For instance, the building I live in was built in 1902. The significance of this is that, even if an asset lasts forever, the share of its present value -- which is what matters for the decision to buy/build it -- that comes from the later years of its life goes arbitrarily close to zero. Say the discount rate is 6 percent. Then 95 percent of the value of a perpetuity comes from the returns in the first 50 years. 99.7 percent comes from returns in the first 100 years. In other words, even if the exact future rents of the building over its whole life were known with certainty, the rent being paid today would have had essentially zero effect on the decision to undertake the expense of  putting up my building 110 years ago. Which means that it is not in any way compensation for that expense. Which means -- apart from the costs of maintenance and improvements, which rent regulations always allow landlords to recoup -- the rent I am paying is pure economic rent.

(This, by the way, is how economics classes should frame the question of rent control. Students would actually learn something! -- like about discount rates, and the age of the capital stock. Just wait til I write my textbook.)

So the Econ 101 point isn't just a gross oversimplification -- tho it is that -- it's substantively wrong even in its own abstract terms. It's analyzing the market for the services of very long-lived assets as if it were the market for currently produced goods and services. In some respects, apartment buildings are analogous to intellectual property. The difference, of course, is that charging market rents doesn't (usually) result in apartments being left unoccupied, so there aren't the same kind of efficiency losses from enforcing perpetual property rights in apartment buildings that there are from perpetual copyrights. But there aren't efficiency gains, either; it's purely a distributional question. Regulation that only limited rents in buildings older than 50 years (which, as it happens, is more or less what we have) wouldn't have any effect on the supply of new housing, it would be a pure transfer from landlords to tenants.

Of course, the landlords are still in control of the buildings, so they'll allocate units somehow, just not on the basis of price. The haters will say that it will be on the basis of race/ethnicity and social ties; more plausibly, it will be on evidence of  responsibility, sobriety, steady habits, etc. (which, ok, sometimes the same thing); or maybe it will just be by luck. But in any case housing will be more available to those with less income, which is pretty much what affordable means.

(And then we should really get into the actual circumstances that precipitate rent control, namely an unforeseen increase in housing demand, together with regulations that (for better or worse) make it hard to increase the supply. Obviously, to the extent that a windfall increase in demand for housing in a given area (perhaps even in part thanks to their existing tenants) increases rents, and new entry is difficult, landlords are recipients of pure monopoly profits which can be taxed or regulated away at no social cost. That rent regulations are almost always part of a second-best solution in the context of other, development-restricting regulations that boost market rents, should also be a staple of intro textbooks. It isn't.)

The Dynamics of Household Debt

Regular readers of this blog will remember some interesting discussions here a few months ago of the dynamics of public debt. The point -- which is taught in any graduate macro course, but seldom emphasized in public debates -- is that the change in debt-GDP ratios over time depends not just on government deficits or surpluses, but also on growth, inflation and interest rates. In particular, for the US, the UK and many other countries [1], the decline in debt/GDP in the postwar decades is entirely due to growth rates in excess of interest rates, with primary surpluses contributing nothing or less than nothing.

An obvious extension of that discussion is the question, What about private debt? After all, the rise in private leverage over the past few  decades is even more dramatic than the rise in public leverage:

Sectoral Debt as Share of GDP, 1929-2010. Click to embiggen.

So what if you apply the same kind of decomposition to private debt that is done for public debt, and ask how much of the change in sector's debt in a given period is due to changes in borrowing behavior, and how much is due to changes in interest rates, growth rates, and or inflation? Surprisingly, no one seems to have done this. So Arjun Jayadev and I decided to try it, for household debt specifically, with (IMO) some very interesting results. A preliminary draft of our paper is here.

I'll have more on the content shortly, but if you're interested please take a look at the paper. We're in the process of revising it now, and any comments/questions/thoughts on making it better would be most welcome.

... or Possibly Social Scientists?

On the other hand!

If you're thinking, yes, economists have a reflexive pro-market bias, then there is one question in the Booth polls to which the answer will be surprising: Are CEOs overpaid? Remarkably, a large majority says Yes.

As a friend points out, this result would almost certainly have been very different a few years ago. The financial crisis, OWS and the new political discourse of the 99%, or something else? I don't know, but progress is progress, and it should be acknowledged, and celebrated. We on the left are a little too invested in our grumpiness sometimes, I think. A lot of people, ok, were overly optimistic about the extent to which the orthodoxies in macro would be discredited by the crisis and Great Recession. But still, something has changed.

Case in point: This paper (ht: AD) by Thomas Philippon and Ariell Reshef, on wages in the financial industry. It's the same paper, but look how the abstract changes from pre- to post-Lehman. Before:

Over the past 60 years, the U.S. financial sector has grown from 2.3% to 7.7% of GDP. While the growth in the share of value added has been fairly linear, it hides a dramatic change in the composition of skills and occupations. In the early 1980s, the financial sector started paying higher wages and hiring more skilled individuals than the rest of economy. These trends reflect a shift away from low-skill jobs and towards market- oriented activities within the sector. Our evidence suggests that technological and financial innovations both played a role in this transformation. We also document an increase in relative wages, controlling for education, which partly reflects an increase in unemployment risk: Finance jobs used to be safer than other jobs in the private sector, but this is not longer the case.

And after:

We use detailed information about wages, education and occupations to shed light on the evolution of the U.S. financial sector over the past century. We uncover a set of new, interrelated stylized facts: financial jobs were relatively skill intensive, complex, and highly paid until the 1930s and after the 1980s, but not in the interim period. We investigate the determinants of this evolution and find that financial deregulation and corporate activities linked to IPOs and credit risk increase the demand for skills in financial jobs. Computers and information technology play a more limited role. Our analysis also shows that wages in finance were excessively high around 1930 and from the mid 1990s until 2006. For the recent period we estimate that rents accounted for 30% to 50% of the wage differential between the financial sector and the rest of the private sector.

Look at the bolded phrases that appear in one abstract but not the other. In 2007, we have a story of skills, technology and compensating differentials. A year and change later, the star players are deregulation and rents, with technology demoted to "a limited role." I don't say this as a criticism of Philippon and Reshef, who deserve only credit for being willing to publicly change their beliefs in the face of new evidence. But this can cut both ways. That the same data can be, and is, used to tell such different stories, is a sign that there is something else going on here than disinterested social science.

Economists: Actively Evil Neoliberal Ideologues or Soulless Technocratic Hacks?

... or in other words, does economics (as it's currently constituted) inherently promote a vision of markets for everything and no rights but property rights? (A vision that, obviously, conforms nicely to the interests of the owners of capital.) Or is the role of economics in upholding neoliberalism mainly the work of apolitical technicians, administrators and scientists manques, who could just as comfortably supply arguments for more regulation and a larger public sector if that's what those in power were asking for?

Well, like nature vs. nurture, or whether to get the sweet brunch or the savory, it's a debate that will never be fully resolved. (Go with savory, unless you're, like, 12 years old.) But new evidence does sometimes come in.

Like those those polls of economists that the University of Chicago business school does; has everybody seen those? For those of us who've been debating this question, these things are a gold mine.

The latest question, on rent control, has Peter Dorman rightly exercised. As he points out, the question -- whether rent regulations have had "a positive impact over the past three decades on the amount and quality of broadly affordable rental housing in cities that have used them" -- omits the genuine goal of rent regulation, neighborhood stabilization:

The most compelling argument for rent control is neighborhood stabilization, the idea that social capital in an urban environment requires stable residence patterns.  If prices are volatile, and this leads to a lot of residential turnover, the result can be a less desirable neighborhood for everyone.  ... not a single textbook treatment of rent control mentions stabilization as an objective, even though this is a standard element in the real-world rhetoric surrounding this issue. 

I would just add that a diversity of income levels in a neighborhood is also a goal of rent regulation, as is recognizing the legitimate interest of long-time tenants in staying in their homes. (Not all rights are property rights!) So by framing the question purely in terms of the housing supply, the Booth people have already disconnected it from actual policy debates in a way favorable to orthodoxy. Anyway, no surprise, orthodoxy wins, with only a single respondent favoring rent regulation. (And I think that one might be a typo.) My favorite answer is the person who said, " Rent control will have similar effects to any price control." That's the beauty of economics, isn't it? -- all markets are exactly the same.

Some of the other ones are even better. Check out the one on education, which asks if all money currently being spent on K-12 education should be given out as vouchers instead. (Why not cash?) By a margin of 36 to 19 (or 41 to 23 when the answers are weighted by confidence) the economists vote, Hells yeah, let's abolish the public school system. Presumably they're mostly reasoning along the same lines as Michael Greenstone of MIT: " Competition is likely beneficial on average. Less clear that all students would benefit leading to tough questions about social welfare functions" -- which doesn't stop him from signing up in favor of vouchers. The presumed benefits of competition are dispositive, while distributional questions, while "tough" in principle, can evidently be ignored in practice. On the other hand, props to Nancy Stokely of the U of C (strongly agree, confidence 9 out of 10) for spelling it right out: "It's the only way to break the unions." (Yes, that's what she wrote.) So, hardly definitive, but definitely some ammo for Team Ideologue.

People sometimes say that academic economists just reflect the views of the country at large, or even the more-liberal-than-median views of other academics or educated professionals. And on some issues, that's certainly true. (Booth also gets a solid majority in favor of drug law reform.) But come on. Replacing the public school system with vouchers is a far-right, fringe position in almost any significant demographic -- except, it would seem, professional economists.

Back to rent control. Jodi Beggs enthusiastically endorses the consensus, but her conscience then compels her to add:

Techhhhhnically speaking [1], if none of the housing in an area was deemed “affordable” before the price ceiling, then the price ceiling could, I suppose, increase the quantity of affordable housing. (In fact, Pinelopi Goldberg specifically points this out.) [True. Goldberg's answers in general are a beacon of sanity.] In most realistic cases, however, the rent control laws are going to make builders think twice about putting up residential properties and make potential landlords think twice about getting into the rental business. 

It's awfully hard not to read the drawn out adverb as a parapraxis, indicating resistance to the heretical thought that, in fact, economic theory gives no answer to the question of whether rent control laws increase or decrease the supply of affordable housing. More concretely, Begg's "realistic cases" are a figment of her imagination, or rather her ideology; in all actual cases rent control laws, at least in major American cities (there are only a couple) only apply to units built before a certain date. In New York City, for instance, rent regulations DO NOT APPLY to anything built since 1974. Hard to believe that builders are thinking twice about putting up new buildings because of rent stabilization, when it hasn't applied to new buildings in nearly 40 years. But hey, why should you have to actually know something about the policy you're discussing, to walk through the old familiar supply and demand graphs showing why Price Controls Are Bad?

"Nothing dulls the mind," says Feyerabend, "as thoroughly as a sequence of familiar notions."



(I can't resist putting down the quote in full:

Writing... [is] almost like composing a work of art. There is some overall pattern, very vague at first, but sufficiently well defined to provide ... a starting point. Then come the details -- arranging the words in sentences and paragraphs. I choose my words very carefully -- they must sound right, must have the right rhythm, and their meaning must be slightly off-center; nothing dulls the mind as thoroughly as a sequence of familiar notions. Then comes the story. It should be interesting and comprehensible, and it should have some unusual twists. I avoid "systematic" analyses. The elements hang together beautifully, but the argument itself is from outer space, as it were, unless it is connected with the lives and interests of individuals or special groups. Of course, it is already so connected, otherwise it would not be understood, but the connection is concealed, which means that, strictly speaking, a "systematic" analysis is a fraud. So why not avoid the fraud by using stories right away?)

Get Your Gaman On

The other day, I quoted Howard Davies explaining the big macroeconomic advantage of a country like Latvia over a country like Greece:

Latvia could make austerity work because they'd been in the USSR for 50 years, they were used to unpleasant and dramatic things happening. The population would accept incredible privation. 

As a sort of followup, here's a letter from one Mr. Zachary Pessin, in yesterday's FT:

I have often thought that acclimatisation to a depressed economic environment is a state of mind that the Japanese have adjusted to... I first went to Japan in 1995 to live for a semester, then lived there full-time from 1999 to 2002. I have been every year since, save the last two. So, for 15 years I have seen how a generation of Japanese lost pride in their country, lost hope of an inspiring life and came to terms with the drudgery.

"Yikes," you're probably thinking, "Lost pride, lost hope and drudgery? That sounds awful -- we'd better figure out fast how to avoid it." Well, if that is what you're thinking, then you'd better think again. Losing hope is the whole point. The Japanese, Pessin says, are

a decade ahead of us in dealing with the world we now live in. ... Perhaps you know the Japanese term gaman, which is effectively translated as “to persevere valiantly through pain or difficulty; stoic determination”. This too will be another import from Japan, because they have been living in the House of Gaman for almost 20 years now, and we Americans are just arriving. And make no mistake, the deleveraging that must continue across the US economy for at least another five to eight years at best will keep us walking the precipice of deflation for at least that long. There will be a need for gaman.

I don't know how much pain or drudgery is in store for Zac Pessin personally, given that he is President and Chief Executive of the Distributed Capital Group; you can find him here crowing about double-digit returns on his investments in sub-Saharan Africa. But it's nice of our masters to let us know about the sacrifices we will be expected to make on their behalf.

Those who take the meat from the table
Teach contentment.
Those for whom the taxes are destined
Demand sacrifice.
Those who eat their fill speak to the hungry
Of wonderful times to come.
Those who lead the country into the abyss
Call ruling too difficult
For ordinary men.

Noah Clue

Hey you guys! You know how unemployment has been, like, real high for years now, and nobody knows why? Noah Smith has figured it out:

an economic principle often overlooked by progressives: There is sometimes a tradeoff between wages and employment levels (which is another way of saying that labor supply curves slope up and labor demand curves slope down). If economic "frictions" or the actions of policymakers hold wages up when economic forces are trying to push wages down, unemployment will often result. 

I think he learned it in an economics class!

You remember how there were these economic forces in 2007 that decided wages had to go down, but we got all these new policies to raise wages like, you know, all those wage-raising things that Bush did? Well, that's why unemployment went up by 5 points in less than two years. 

I mean, it's so simple when you think about it. "Labor demand curves slope down," that's all you need to know. We learn that the first year of micro, supply curves slope up, demand curves slope down. Demand for labor, demand for cottage cheese, doesn't matter, they're just the same. Why do they even bother offering courses in macro?

It's funny, though: Wasn't there some guy who wrote a whole book about why lower wages don't raise employment? Maynard, or some weird name like that? Well, Noah's never heard of him, or of his book (the General Theory of something?) but he can't be worth bothering with, can he? after all, he didn't even realize that demand curves slope down! Which is all you need to know.

Of course, lower wages won't help employment if there is already an excess supply of labor. If people are already willing to work for less than the going wage, telling them they should accept less than the going wage can't be the solution. What would we call a situation like that? How about ... "involuntary unemployment"? But Noah Smith is too smart for that, he knows that could never happen. He knows that markets always clear, employment is always at the intersection of the labor supply curve and the labor demand curve, so the only way to raise employment must be to move the labor supply curve downward. It's just Econ 101, and Econ 101 is never wrong.

Of course, if you think that wages are equal to the marginal product of labor, the demand curve for labor will only slope downward when the marginal product of labor is falling -- which might not be the case when output is far from potential. But Noah Smith knows that demand curves always slope downward, so there can't be any range of output over which the mpl is more or less constant.

But wait, what if labor markets are monopsonistic? Then the observed labor demand curve can slope upward. And monopsony in labor markets doesn't require a company town, all it requires is that a firm's labor costs are rising in employment. Or in other words that if a firm cuts wages moderately, it will lose some but not all of its workers. (Crazy talk, I know.) Which is the natural result of labor market models with search frictions. This is one reason why the most rigorous empirical studies of legislated wage changes show no sign of a downward sloping labor demand curve. But Noah Smith doesn't need to trouble his beautiful mind with empirical evidence, or learn any of that silly labor economics stuff, because he knows that labor demand curves slope downward. He learned it in introductory micro!

And then there's that little difference between labor and cottage cheese, that wages make up the large majority of producers' variable costs. So we have to think general equilibrium here, not just partial. Prices, in the first instance, are set as a markup over marginal costs. [1] So if you reduce money wages, you don't reduce real wages by as much, because you reduce the price level as well. That means deflation, which is ... let's see, not always super great for employment. That Maynard dude wrote something about that too, I think, and so did some other old guy, Hunter or Trapper or something. Apparently there was this crazy idea that falling wages and prices were a problem back in Ancient Rome, or maybe the 1930s (same thing). But Noah goes to a good graduate school, so he knows that no real economist bothers with dusty old stuff like that. After all it's not like there are any lessons we could learn from the Great Depression, or the Punic Wars or whatever it was. Not when we know that labor demand curves slope down!

Oh and hey, there's another difference between labor and cottage cheese! (Who'd have thought?) Wages are also a source of demand. Pop quiz for Noah Smith: Which is a more important component of final demand, consumption out of wages, or net exports? Yeah, that would be door number one. So maybe, just maybe, whatever competitive advantage lower wages yield in lower unit labor costs might be offset by lower consumption demand by wage-earners? And that's assuming that changes in wages are fully passed through into the relative price of tradables, and that trade flows are price-elastic. [2] But hey, you know what happens when you assume: it makes you an ... economist. Now, if it were the case that wages were an important source of final demand, and if output is demand-constrained, then lowering wages might not raise demand for labor, even if labor markets were fully competitive and if changes in nominal wages translated one for one into changes in real wages. But that's unpossible! because, as we all know, the demand curve for labor slopes down.

Well, but demand doesn't matter, since Noah knows -- he learned it in school -- the economy is always at full employment. If we observe fewer people working, it can't be because aggregate demand has fallen, it can only be because an artificially high price of labor has led to substitution away from labor to other factors of production. It couldn't possibly be the case that when unemployment is high, capital is underutilized as well too, could it? Because that would mean that the wage share and the profit share were both too high, which is like saying that x>y and y>x. So no, we couldn't possibly observe anything like this:

Because we know -- it's economics 101 -- that high unemployment can only ever be the result of substitution away from labor because of changes in relative prices, not a lower level of output for the economy as a whole. Altho, gosh, it sure looks like capacity utilization falls in recessions just like employment does, which would suggest that cyclical unemployment has nothing to do with the relative price of labor.

So, ok, we can forget Keynes and all that old nonsense. And let's ignore the effect of nominal wage changes on prices. And put out of our mind any question about whether the marginal product of labor is really declining over current levels of output, or about imperfect competition in labor markets. And we'll ignore the role of wages as a source of demand. And we'll unlearn any information we might have accidentally picked up about the empirical relationship between wages and employment, or about the Great Depression. And we'll stick our fingers in our ears if anyone suggests that unemployment today is associated with demand constraints on output rather than substitution away from labor. And then we can be as smart as Noah Smith! And we'll know how to fix unemployment:

In Germany, labor unions often negotiate wage cuts in order to preserve long-term employment levels. I think we should look at doing something similar.

You guys, wage concessions! Has anybody in the US labor movement ever thought of that? I bet it will work great! It's pretty ballsy of Noah Smith to stand up against Big Labor, but someone's got to, right? I mean, unions represent almost 7 percent of the private workforce. If someone is holding wages above the level that Economic Forces want them to be at, who else could it be?

Hey, I wonder if any other countries are getting advice from smart economists like Noah Smith, and are fixing all their problems by cutting wages? You know, I think there are some. How about Latvia? The authorities there were all, like, wages are going down. And guess what? While in the US unemployment has gone from 5% in 2007 to over 8% today, in Latvia it went from 5% to ... 14%? Well, who cares about some little Baltic country, let's talk about the UK. They got real wages down by 2.7 percent last years (2.1 percent nominal growth less 4.8 percent inflation.) And hey, look at employment -- it's skyrocketing continuing to fall, and now the lowest it's been since 2003.

Um.

You know what? I'm beginning to think that "labor demand curves slope down" might not be the best way to think about unemployment. Maybe it is helpful to know something about macroeconomics, after all.

[1] Or equal to marginal costs if you like; the point is the same.

[2] I've presented some evidence on whether trade flows are responsive to relative costs in practice in these posts.

The Capitalist Wants an Exit, Facebook Edition

In today's FT, John Gapper reads the Facebook prospectus. [1] And he doesn't like what he sees:

There is still time to cancel its IPO and the filing provides plenty of reasons why it ought to... It begs a question if a company trying to raise capital from investors cannot think of anything to do with the money. Yet this is Facebook’s predicament – as it admitted in its filing on Wednesday, its cash flow and credit “will be sufficient to meet our operational needs for the foreseeable future”. ... So what are its plans for the additional $5bn it may raise from an IPO? It intends to put the cash into US government bonds and savings accounts...

Gapper, looking at the IPO from the perspective of what it does for Facebook the enterprise, understandably thinks this is nuts. Why incur the costs of an IPO and the ongoing requirements of a public listing, if you have so little need for the cash that you are literally just planning to leave it in a savings account. But of  course, the purpose of the IPO has nothing to do with Facebook the enterprise.

Given that it doesn’t need capital..., why the IPO? ... Facebook’s motivation is clear: to gratify its venture capital investors and employees. This is not a cynical statement; it is a quote from Mr Zuckerberg’s letter to new shareholders. “We’re going public for our employees and our investors,” he writes. “We made a commitment to them when we gave them equity that we’d work hard to make it worth a lot and make it liquid, and this IPO is fulfilling our commitment.”

In terms of Silicon Valley’s logic, it makes sense... For the company itself, however, the logic is far less obvious. As a corporate entity, Facebook could clearly thrive without seeking new shareholders, whose main purpose is to allow the insiders to get rich and eventually exit.

 As I've written before, the function of the stock market in modern capitalism is to get money out of corporations, not put money into them. The social problem they are solving is not society's need to allocate scarce savings to the most promising investments, but wealth-owners desire to free their fortunes from particular firm or industry and keep them as claims on the social product as a whole.


[1] It's been said before, but can I just point out how unbearably stupid is the FT's policy of actively discouraging people from excerpting their articles?

Davies on the Disorder in Europe

My friend Jen writes about informal labor markets in South Africa. She was telling me the other day about street vendors who make their living buying packs of a dozen pairs of socks and selling them pair by pair. In that same spirit of finding a niche in the very last step of the distribution network, I thought I would pass on some material from a talk I attended last week by Sir Howard Davies. It's below the fold, with occasional comments from me in brackets. A lot may seem familiar, but enough was new to me -- and Davies is high enough up in this world; he'd had dinner the night before with Charles Dallara -- that I think it's worthwhile to put down my notes in full.