Thursday, July 28, 2016


A new essay "Macro-Finance," based on a talk I gave at the University of Melbourne this Spring. I survey many current frameworks including habits, long run risks, idiosyncratic risks, heterogenous preferences, rare disasters, probability mistakes, and debt or institutional finance. I show how all these approaches produce quite similar results and mechanisms: the market's ability to bear risk varies over time, with business cycles. I speculate with some simple models that time-varying risk premiums can produce a theory of risk-averse recessions, produced by varying risk aversion and precautionary saving, rather than Keynesian flow constraints or new-Keynesian intertemporal substitution.

Wednesday, July 27, 2016

How to step on a rake

How to step on a rake is a little note on how to solve Chris Sims' stepping on a rake paper.

This is mostly of interest if you want to know how to solve continuous time new-Keneysian (sticky price) models. Chris' model is very interesting, combining fiscal theory, an interest rate rule, habits, long term debt, and it produces a temporary decline in inflation after a rise in nominal interest rates.  

Tuesday, July 12, 2016

Blueprint for America

"Blueprint for America" is a collection of essays, organized, edited and inspired by George P. Shultz. You can get an overview and chapter by chapter pdfs here. The hardcover will be available from Amazon or Hoover Press October 1.

Some of the inspiration for this project came from the remarkable 1980 memo (here) to President-elect Ronald Reagan from his Coordinating Committee on Economic Policy.

Like that memo, this is a book about governance, not politics.  It's not partisan -- copies are being sent to both campaigns. It's not about choosing or spinning policies to attract voters or win elections.

The book is about long-term policies and policy frameworks -- how policy is made, return to rule of law, is as important as what the policy is --  that can fix America's problems. It focuses on what we think are the important issues as well as policies to address those issues -- it does not address every passion of the latest two-week news cycle.

The book comprises the answers we would give to an incoming Administration of any party, or incoming Congress, if they asked us for a policy package that is best for the long-term welfare of the country.

The chapters, to whet your appetite:

Saturday, July 9, 2016

Immigration sentiment

Above, a lovely graph from The Conversation. A common story says that opposition to immigration comes from people in high-immigrant communities, who suffer externalities from the presence of many immigrants. It is not true.

Wednesday, July 6, 2016

NYT on zoning

Conor Dougherty in The New York Times has a good article on zoning laws,
a growing body of economic literature suggests that anti-growth sentiment... is a major factor in creating a stagnant and less equal American economy.
...Unlike past decades, when people of different socioeconomic backgrounds tended to move to similar areas, today, less-skilled workers often go where jobs are scarcer but housing is cheap, instead of heading to places with the most promising job opportunities  according to research by Daniel Shoag, a professor of public policy at Harvard, and Peter Ganong, also of Harvard.
One reason they’re not migrating to places with better job prospects is that rich cities like San Francisco and Seattle have gotten so expensive that working-class people cannot afford to move there. Even if they could, there would not be much point, since whatever they gained in pay would be swallowed up by rent. 
Stop and rejoice. This is, after all, the New York Times, not the Cato Review. One might expect high housing prices to get blamed on developers, greed, or something, and the solution to be government-constructed housing, "affordable" housing mandates, rent controls, low-income housing subsidies (which protect incumbent low-income people, not those who want to move in to get better jobs) and even more restrictions.

No. The Times, the Obama Administration, California Governor Gerry Brown, have figured out that zoning laws are to blame, and they're making social stratification and inequality worse.

Monday, June 27, 2016

Brexit or Fixit

Many commenters compare Brexit to the American revolution. I think the constitutional convention is a better analogy for the moment and challenge ahead. A first attempt at union resulted in an unworkable Federal structure. Europe needs a constitutional convention to fix its union.

The EU's first attempt was basically aristocratic/technocratic. Brussels tells the peasants what to do. The EU  needs a hardy dose of accountability, representation, checks and balances -- all the beautiful structures of the US Constitution. What little thought the EU put in to these matters is clearly wanting.

America did not wait for a state to leave. But, though even the Pope admits the EU structure wasn't working, the EU needed this wake up call. Bring the UK to the convention, and bring them back. Fixit. (#Fixit?)

Saturday, June 25, 2016

Transport innovation

What is it?

I saw this in the parking lot of the hotel where I'm staying. Inspection: yes, it's the chassis of an early 1970s VW, with motor and transmission in place. The motor appears functional. It's connected to the gas cans. Yet, this is a trailer. Why? (Hint: it's parked next to a new Toyota CRV electric car.)

Wednesday, June 22, 2016

Rajan on cash transfers and corruption

Raghu Rajan, who just announced he is stepping down as Governor of the Central Bank of India, gave a very interesting speech, that bears among other things on the question of social programs vs. cash transfers.

A big problem with government provided assistance in India is that the provision is corrupt:
Our [India's] provision of public goods is unfortunately biased against access by the poor. In a number of states, ration shops do not supply what is due, even if one has a ration card – and too many amongst the poor do not have a ration card or a BPL card; Teachers do not show up at schools to teach; The police do not register crimes, or encroachments, especially if committed by the rich and powerful; Public hospitals are not adequately staffed and ostensibly free medicines are not available at the dispensary; …I can go on, but you know the all-too-familiar picture.
Raghu has a thoughtful observation on what keeps this system going:

Friday, June 17, 2016

Syverson on the productivity slowdown

Chad Syverson has an interesting new paper on the sources of the productivity slowdown.

Background to wake you up: Long-term US growth is slowing down. This is a (the!) big important issue in economics (one previous post).  And productivity -- how much each person can produce per hour -- is the only source of long-term growth. We are not vastly better off than our grandparents because we negotiated better wages for hacking at coal with pickaxes.

Why is productivity slowing down? Perhaps we've run out of ideas (Gordon). Perhaps a savings glut and the  zero bound drive secular stagnation lack of demand (Summers). Perhaps the out of control regulatory leviathan is killing growth with a thousand cuts (Cochrane).

Or maybe productivity  isn't declining at all, we're just measuring new products badly (Varian; Silicon Valley). Google maps is free! If so, we are living with undiagnosed but healthy deflation, and real GDP growth is actually doing well.

First, the productivity slowdown has occurred in dozens of countries, and its size is unrelated to measures of the countries’ consumption or production intensities of information and communication technologies ... Second, estimates... of the surplus created by internet-linked digital technologies fall far short of the $2.7 trillion or more of “missing output” resulting from the productivity growth slowdown...Third, if measurement problems were to account for even a modest share of this missing output, the properly measured output and productivity growth rates of industries that produce and service ICTs [internet] would have to have been multiples of their measured growth in the data. Fourth, while measured gross domestic income has been on average higher than measured gross domestic product since 2004—perhaps indicating workers are being paid to make products that are given away for free or at highly discounted prices—this trend actually began before the productivity slowdown and moreover reflects unusually high capital income rather than labor income (i.e., profits are unusually high). In combination, these complementary facets of evidence suggest that the reasonable prima facie case for the mismeasurement hypothesis faces real hurdles when confronted with the data.
An interesting read throughout. 

[Except for that last sentence, a near parody of academic caution!]  

Wednesday, June 15, 2016

Financial Choice

If you're interested in policy rather than politics, the package of legislative proposals coming out of Congress are a lot more interesting than the Presidential race at the moment. Speaker Paul Ryan is rolling out "A Better Way" package and Rep. Jeb Hensarling has just announced a "financial CHOICE act" to fundamentally reform Dodd-Frank. (Most quotes are from Jeb Hensarling's speech at the Economic Club of New York. See also  NYT coverage.)

These efforts will, I think, become much more important later on. The presidential race will decide whether this agenda can survive the instant veto that it faces now.  (This is a non-partisan comment. Hilary Clinton could likely assure a landslide by announcing she will work with Paul Ryan to craft and pass it.)

In any case, it defines a clear program that may be the focus of economic policy under a presidency of either party. And I think that's healthy as well.  We are still living in the shadows of Franklin Roosevelt's 100 days, and an increasingly imperial presidency. But the current need is not for a flurry of new legislation and executive orders to address a crisis. We need a steady clean-up of the legal and regulatory mess of the last few decades. For that project, it may be better for policy leadership to come from Congress, and by careful and patient drafting of actual legislation.

The legislation is still being drafted, which is why it would be lovely if more of the media and blogosphere were paying attention rather than to the latest antics of the presidential candidates. The congressional staff writing these things are paying attention and the proposals can be refined!

Today, a look at the Financial CHOICE act.

More capital, and the carrot of less regulation
...there is a growing consensus surrounding the idea of a tradeoff between heightened capital levels and a substantially lower regulatory burden....[We] will relieve financial institutions from regulations that create more burden than benefit in exchange for meeting higher, yet simple, capital requirements...Think of it as a market-based, equity financed Dodd-Frank off- ramp... the option remains with the bank.

Monday, June 13, 2016

Lottery Winners Don't Get Healthier

Alex Tabarrok at Marginal Revolution had a great post last week, Lottery Winners Don't get Healthier (also enjoy the url.)
Wealthier people are healthier and live longer. Why? One popular explanation is summarized in the documentary Unnatural Causes: Is Inequality Making us Sick?
The lives of a CEO, a lab supervisor, a janitor, and an unemployed mother illustrate how class shapes opportunities for good health. Those on the top have the most access to power, resources and opportunity – and thus the best health. Those on the bottom are faced with more stressors – unpaid bills, jobs that don’t pay enough, unsafe living conditions, exposure to environmental hazards, lack of control over work and schedule, worries over children – and the fewest resources available to help them cope. 
The net effect is a health-wealth gradient, in which every descending rung of the socioeconomic ladder corresponds to worse health.
If this were true, then increasing the wealth of a poor person would increase their health. That does not appear to be the case. In important new research David Cesarini, Erik Lindqvist, Robert Ostling and Bjorn Wallace look at the health of lottery winners in Sweden (75% of winnings within the range of approximately $20,000 to $800,000) and, importantly, on their children. Most effects on adults are reliably close to zero and in no case can wealth explain a large share of the wealth-health gradient:
In adults, we find no evidence that wealth impacts mortality or health care utilization.... Our estimates allow us to rule out effects on 10-year mortality one sixth as large as the crosssectional wealth-mortality gradient.
The authors also look at the health effects on the children of lottery winners. There is more uncertainty in the health estimates on children but most estimates cluster around zero and developmental effects on things like IQ can be rejected (“In all eight subsamples, we can rule out wealth effects on GPA smaller than 0.01 standard deviations”).
(My emphasis above)

Alex does not emphasize the most important point, I think, of this study.  The natural inference is, The same things that make you wealthy make you healthy. The correlation between health and wealth across the population reflect two outcomes of the same underlying causes.

Wednesday, June 8, 2016

How to raise GDP 10%, and reduce inequality too

Chang-Tai Hsieh and Enrico Moretti have a very nice new working paper "Why do Cities Matter?"
..increased wage dispersion lowered aggregate U.S. GDP by 13.5%  Most of the loss was likely caused by increased constraints to housing supply in high productivity cities like New York, San Francisco and San Jose. Lowering regulatory constraints in these cities to the level of the median city would expand their work force and increase U.S. GDP by 9.5%. 
Roughly, the same worker, working the same job, in San Jose or San Francisco, earns double what he or she earns somewhere else in the country.  Here is their plot of wages across cities:

Sure: Chang-Tai Hsieh and Enrico Moretti

The right tail there isn't just missing -- it was absent in 1964. There weren't any cities (MSA's) with 50% higher wages than average in 1964. That's New York, San Francisco and San Jose now.

What does this have to do with growth?

Tuesday, June 7, 2016

Universal Basic Income

Universal Basic Income is in the news. Charles Murray wrote a thoughtful piece in the Wall Street Journal Saturday Review. The Swiss overwhelmingly rejected a referendum -- but on a proposal quite different from Murray's.

Murray proposes that "every American citizen age 21 and older would get" $10,000 per year "deposited electronically into a bank account in monthly installments." along with essentially a $3,000 per year health insurance voucher.

The most important part of Murray's proposal: UBI completely replaces
 Social Security, Medicare, Medicaid, food stamps, Supplemental Security Income, housing subsidies, welfare for single women and every other kind of welfare and social-services program, as well as agricultural subsidies and corporate welfare. 
There is a lot to commend this idea. First, it would reduce the dramatic waste in the current system:
Under my UBI plan, the entire bureaucratic apparatus of government social workers would disappear
Moreover, the bulk of government spending now does not go to people who are really poor. SSI and medicare go to old people, many of whom are quite well off. Housing subsidies such as the mortgage interest deduction go to people with big mortgages and big tax rates -- nor poor people. Murray doesn't really emphasize this point, but his proposal is far more progressive than the current transfer system.

Second, it would reduce the very high disincentives of the current system, which traps people.
 Under the current system, taking a job makes you ineligible for many welfare benefits or makes them subject to extremely high marginal tax rates. Under my version of the UBI, taking a job is pure profit with no downside until you reach $30,000—at which point you’re bringing home way too much ($40,000 net) to be deterred from work by the imposition of a surtax.

Thursday, June 2, 2016

WSJ growth oped -- full version

WSJ Oped. Now that 30 days have passed, I can post the whole thing. Previous post.

Ending America’s Slow-Growth Tailspin

Sclerotic growth is America’s overriding economic problem. From 1950 to 2000, the U.S. economy grew at an average rate of 3.5% annually. Since 2000, it has grown at half that rate—1.76%. Even in the years since the bottom of the great recession in 2009, which should have been a time of fast catch-up growth, the economy has only grown at 2%. Last week’s 0.5% GDP report is merely the latest Groundhog Day repetition of dashed hopes.

The differences in these small percentages might seem minor, but over time they have big consequences. By 2008, the average American was more than three times better off than in 1952. Real GDP per person rose from $16,000 to $49,000. And those numbers understate the advances in the quality of goods, health and environment that came with growth. But if U.S. growth between 1950 and 2000 had been the 2% of recent years, instead of 3.5%, income per person in 2000 would have risen to just $23,000, not $50,000. That’s a huge difference.

Looking ahead, solving almost all of America’s problems hinges on re-establishing robust economic growth. Over the next 50 years, if income could be doubled relative to 2% growth, the U.S. would be able to pay for Social Security, Medicare, defense, environmental concerns and the debt. Halve that income gain, and none of those spending challenges can be addressed. Doubling income per capita would help the less well off far more than any imaginable transfer scheme.

Tuesday, May 31, 2016

Summers on roadblocks to infrastructure

The bureaucrats of Massachusetts have done the nation a wonderful service, by parking an abject lesson in America's infrastructure sclerosis right in front of Larry Summers' office.

Summers and Rachel Lipson have written a remarkable Op-Ed in the Boston Globe, and Larry a deeper follow-on piece on the Washington Post Wonkblog, detailing the 5 year struggle to repair a bridge that took 11 months to build in 1911.

The narrow story:
How, we ask, could our society have regressed to the point where a bridge that could be built in less than a year one century ago takes five times as long to repair today?
In order to adhere to strict historical requirements overseen by the Massachusetts Historical Commission, the Massachusetts Department of Transportation had to order special bricks, cast by a company in Maine, to meet special size and appearance specifications from the bridge’s inception in 1912.
...extensive permitting and redesigns haven’t helped. 
And the rest reads like a typical Wall Street Journal oped anecdote of regulatory incompetence, fodder for my next weekly summary.

Larry's Post follow on is deeper:
Investigating the reasons behind the bridge blunders have helped to illuminate an aspect of American sclerosis — a gaggle of regulators and veto players, each with the power to block or to delay, ...
At one level this explains why, despite the overwhelming case for infrastructure investment, there is so much resistance from those who think it will be carried out ineptly. 
Stop for a moment here. This sentence is a watershed moment. Larry is one of our foremost public-intellectual economists. He's been arguing for years for infrastructure spending, first as "shovel-ready" stimulus to fight the recession, lately as the remedy for "secular stagnation." So far, he's been arguing mostly for more money, and not highlighting regulatory roadblocks. The Democratic party (not Larry) line is that infrastructure is the fault of stingy Republicans who won't spend the money.

But here is Larry, listening, and urging his readers to listen. Savor the sentence: "This explains why.. there is so much resistance from those who think it will be carried out ineptly." How often, in American public life these days, do we see a prominent, party-aligned, public intellectual listen hard and understand what's bothering the other side? No, it's not that they are stingy, mean-hearted, evil, or whatever. It's that they don't trust the money to be spent on the right thing, in the right place, in finite time. They have a point.

Wednesday, May 25, 2016

Bush v. Reagan on Immigration

Scott Summner posted this beautiful exchange between Ronald Reagan and George Bush Sr. on immigration. Direct link (youtube).

Scott titles the post "when the GOP still had some decency," which I think he should more accurately state as "when the two leading GOP presidential candidates still had some decency." There are many people in the party -- in Congress, governors, state legislators, losing Presidential candidates, in Republican think tanks and so forth --with quite sensible ideas on immigration, and with the kind of personal decency Scott notices in the video, and lacking of the presidential candidates today.  There are also many decent and sensible Democrats too.

In this era that the battles within parties are as important as those between them, we have to get out of the habit of tarring whole parties with the behaviors and attitudes of some people in them.

Scott also characterizes the debate as "Bush stakes out a very liberal position on immigration, and then Reagan responds from a position even further to the left.." That's not quite accurate either. While it's accurate that the "left" wants to allow "undocumented immigrants" access to schools and services,  they typically do not want to open labor markets. Both Bush and Reagan explicitly welcomed people to come and work. Letting people come and not letting them work is a recipe for disaster. These are now libertarian positions, not right vs. left.

But I'm quibbling. Thanks Scott for a great video.

Equity financed banking video

Video of my talk at the Minneapolis Fed's "Ending Too Big to Fail" symposium. A link to the video (youtube) in case you don't see the above embedded version. The event webpage, with links to the other talks and the agenda.  Summary: AM: Dodd Frank is a big failure, we need a big fix. PM: We'll get it to work with little fixes here and there. I posted the text of my talk earlier.

Saturday, May 21, 2016

Ideas had sex

Adam Smith. Source: WSJ
Why are we so much better off than our ancestors? Why did this process only start where and when it did, in Western Europe, not in Rome or China?

Deirdre McCloskely has an excellent essay in the Saturday Wall Street Journal Review.

Her answer: "Ideas started having sex," a glorious sentence she attributes to Matt Ridley.
"The idea of a railroad was a coupling of high-pressure steam engines with cars running on coal-mining rails. The idea for a lawn mower coupled a miniature gasoline engine with a miniature mechanical reaper. "
And so on. She is exactly right. We tend to focus on the original idea, the basic science. That's necessary, but 99% of growth comes from elaboration, implementation, and the marriage of ideas -- sex in the sense of genes combining and making new things.

What's the bar for these hookups?
The answer, in a word, is “liberty.” Liberated people, it turns out, are ingenious.
...equality. ...not an equality of outcome... equality before the law and equality of social dignity.
Though, as she points out at length, the social dignity, property rights, and equality of entrepreneurs has always been a dicey matter.

Friday, May 20, 2016


Like most economists, I was a bit baffled by the Administration's announcement of stricter overtime rules. The WSJ, and Jonathan Hartley and many others cover the obvious consequences on jobs, business formation and destruction, and so forth. A bit less mentioned, it reduces employee flexibility. If you like working more hours one week and less the next -- perhaps you have child or parent care responsibilities -- you're going to be stuck working an 8 hour day.  It's part of the general regulated ossification of American employment. Or, it could be one more inducement to substitute machines for people or make people independent contractors.

Why are they doing it? The government says it wants more jobs, yet there is no area in American life with larger impediments between a willing employer and employee than labor.

I'm trying to bend over backwards to understand a worldview under which this is a sensible idea.

One possibility. Suppose this is your image of work: Take as given that a person has a job, and the employer will keep that job going, and won't change the terms of the job -- lower the base wage, allow people to take overtime, etc. Take as given that the terms of the job are a pure bilateral negotiation, and there is money somewhere to absorb extra costs without raising prices.  Take as given also that the worker is in a bad negotiating position, and you, the benevolent central department of labor, care about moving this negotiation in the worker's way. Then, a rule like this is a way of strengthening the worker's bargaining position and driving some resources the worker's way out of the employer's pocket.

The counterargument is really just that all this "take as given" is false.

Here is an effort to put that debate in econ 101 supply and demand diagrams. Let's think of the rule as a mandated higher wage, like a minimum wage. The classic analysis says you get fewer jobs.

Now, how might you not lose jobs? The implicit assumption in my paragraph above is that the labor demand curve is vertical. Employers will hire the same number of people for the same hours no matter how much they have to pay. And they'll all stay in business too.

If that were the case, as you see, we wouldn't lose any jobs. There would be some unemployment, as more people want to work or employees want more hours than they can get. But I think advocates of these policies don't mind. Getting people to go out and look for jobs might not be so terrible.

Another way to apply econ 101 is to think of the new rules as new costs imposed on the employer. If employers have to bear more costs, their demand for workers drops down by the amount of the extra costs. Again, adding costs reduces employment. Once again, what are they thinking?

Well, again, suppose that the demand curve is vertical. Now employers simply bear the cost, grumble, but there is no reduction in the number of employees and hours.

Of course, with the assumptions made bare, we can think of lots of reasons that demand curves do slope, employers cut down on workers if they have to pay more direct or indirect costs, and companies don't have infinite funds coming from nowhere. But perhaps by showing implicit assumptions, there is some room for discussion that gets somewhere. I would be interested in hearing serious defenses of the vertical demand curve assumption.

Update: Good grief, Noah,  of course "to understand the true impact of overtime rules, we probably have to include more complicated stuff!" Who ever said otherwise? Isn't "econ 101" clear enough that this is a an extremely simple starting place? And aren't you the guy complaining about excess mathiness,  big black boxes in economics, and people who don't even try to understand the opposing arguments?

Tuesday, May 17, 2016

Equity-financed banking

I gave a talk at the Minneapolis Fed's "Ending Too Big to Fail" symposium, May 16. Agenda and video of the event here.

My  talk is based on "towards a run-free financial system," and a bit on a new structure for federal debt, and blog readers will notice many recycled ideas. But it incorporates some current thinking both on substance and on marketing -- the proposal is so simple, most of the work is on meeting objections.

Here's my talk. This is also available as a pdf here.

Equity-financed banking and a run-free financial system


We have to define what “sytstemic” and “crisis” mean before we can try to fix them.

My premise is that, at its core, our financial crisis was a systemic run. The mechanism is familiar from Diamond and Dybvig, and especially Gary Gorton’s description of how “information-insensitive” assets suddenly lose that property and become illiquid.

You see a problem at a bank – a word I will use loosely to include shadow-banks, overnight debt, and other intermediaries. You wonder, what about my bank? You don’t really know. The point of short-term debt is that you don’t generally pay attention to the bank’s assets. But you also have the right to take your money out at any time, and the last one out gets the rotten egg. When uncertain, you might as well forego a few basis points of interest and get out now. Everyone does this, and the bank fails.

Runs at specific institutions, caused by identifiable problems, are not really a danger. My story includes a specific “contagion,” that troubles at one institution spread to another, because they cause people to wonder about the other bank’s assets. That “systemic run” element means that banks cant’ easily sell assets to raise cash, or issue new equity.

This description is important for what it denies, and thus for “problems” we don’t have to “solve.”

It’s not a chain of dominoes: A fails, B loses money, B falls, and so forth, so by saving A the whole system is saved.

Contrariwise, even saving A is not enough to assure investors that B’s assets are ok. In fact, saving A might verify investor’s worries about B’s assets, and set off a run!

It’s not huge losses on particularly unsafe assets. Bank assets are not that risky. Bank liabilities are fragile. Small losses spark large runs.

Our crisis and recession were not the result of specific business operations failing. Failure is failure to pay creditors, not a black hole where there once was a business. Operations keep going in bankruptcy. The ATMs did not go dark.

In my premises, the 2000 stock market bust was not a crisis, because it was not a run. Yes, there were huge losses. But when stocks plunge, all you can do is go home, pour a drink, yell at the dog, and bemoan your dumb decisions. You can’t demand your money back from the issuing company, and you can’t drive the company to bankruptcy if it does not pay. Panic selling, even if “irrational,” even if it causes “herding” by others, even if it drives prices down, is not a crisis, and it’s not a run, because the issuing company doesn’t have to do anything about it.

If we want to stop crises, we have to describe when we will say “good enough” and stop trying to fix things in the name of crisis prevention. My premise: an economy with booms and busts, risks taken, and losses transparently absorbed by falling prices, is good enough for now.

If we try to create a financial system in which nobody ever loses money, we will just create a system in which nobody ever takes any risk, and does not fund any remotely risky investment opportunity. That is the direction we are going. And steps that actually matter to fixing crises are getting lost in the effort rush to “fix” every perceived financial “problem.”

(A small random sample of current causes being commingled with crisis prevention, some worthy but separate, some silly: Fannie and Freddie, the community reinvestment act, “predatory lending,” insufficient down payments, FICO scores, Wall Street "greed," executive compensation, credit card fees, disparate-impact analysis, the last names of auto-loan customers, the terms of student loans, hedge fund fees, active management and its fees, “herding” and “crowding” by equity portfolio managers (OFR), over-the-counter versus exchange-traded derivatives, swap margins, position limits, risk-weights, credit ratings, the Volker rule, insider trading, global imbalances, savings gluts, bubbles in houses and stocks, and the ridiculous tiny type on my credit-card agreement.)

I do not mean that other financial regulation is not necessarily bad, or even that one shouldn’t contemplate policies to reduce stock market volatility. But if we actually want to fix crises, or end TBTF, we have to separate those other measures into everyday regulation.

A better world

Given these premises, the central weakness in financial system is clear: fragile, run-prone liabilities.

The answer then is simple too: we should have no more large-scale funding of risky or potentially illiquid assets by run-prone securities – short term debt in particular, but any promise that is fixed-value, first-come first-served, if unpaid instantly bankrupts the company, and in volumes that could even remotely trigger such bankruptcy.

(The caveats here exempt bills, receivables, trade credit, and so on, which are fixed value but not run-prone. “Funding” is the important qualifier. You can trade in short term debt without funding the bulk of investments with it.)

Banks and shadow banks must get the money they use to hold risky and potentially illiquid loans and securities overwhelmingly from run-proof, floating-value assets – common equity mostly, some long term debt. (I say “hold” specifically to distinguish it from “originate” or “make” loans, which are then securitized and sold. )

Once we have done this, financial crises are over. A 100% equity-financed institution cannot fail, and cannot suffer a run. Fail means fail to pay your debts, and if you have no debts you cannot fail.

(OK, technically you can take on such a huge derivatives position that you can lose more than 100% of equity, but it takes very little attention from regulators and analysts to make sure that doesn’t happen.)

Such an institution needs next to no risk regulation, beyond the regular transparency we demand of any public corporation.

Any remaining fixed-value demandable assets must be backed entirely by short-term government debt, or reserves. These are run-proof because there is no doubt on the value and liquidity of the assets (at least for the US, and away from sovereign debt worries, which I also put off the table for now.)


The major objection is the flow of credit. If banks can’t issue conventional deposits and unconventional short-term debt, they won’t have money to lend and the economy will dry up, the objection goes. Others object similarly that without bank “transformation” of maturity and risk, economic growth would be slower.

This perception is false. Not one cent more or less money needs to be provided, not one iota more risk needs to be shouldered, not one cent less credit need be extended. And I think the case is strong that growth will be substantially higher than the current run-prone but highly regulated system. Let’s look.

Structure (1) is a simplified version of today’s “bank.” There are a lot of complex or illiquid assets. The bank is too complicated to go through bankruptcy. It is funded by very little equity and a huge amount of debt. The debt is prone to runs. (“People” here includes non financial business and institutions such as pension funds and endowments.)

Structure (2) is the simplest equity-financed bank. Banks issue only equity. Households hold that equity, in a diversified form, potentially through a mutual fund or ETF.

In this structure, households provide the same amount of money, and shoulder the same amount of risk, and the bank makes the same amount of loans. But runs and crises are now eliminated.

You will laugh, but I’d like to take this structure seriously. With today’s technology, people can have floating-value accounts.

This was not technically possible in the 1930s, when our country chose instead the path of deposit insurance and risk regulation. But now, you could easily go to an ATM, ask for $20, and it sells $20 of bank shares at the current market value, within milliseconds. “Liquidity” now is divorced from “fixed-value” and “runnable.” Even better, you could go to the ATM, or swipe your card or smartphone, and instantly sell shares in an ETF that holds mortgage-backed securities. This is a “bank,” providing transactions services based on a pool of mortgages and shows that money still flows from people to mortgages. But with floating value, it is run proof.

Unlevered bank equity would have 1/10 or less the volatility it has today. So, we’re talking about something like 2% volatility on an annual basis. Shouldering 2% price volatility is not hard for the majority of depositors (especially dollar-weighted). To argue otherwise, you need some fundamentally non-economic, psychological theory; you need to assert that the same households who are up to their ears in debt, handle 401(k) stock investments, health care copayments, cable and phone bills, and vacation in Las Vegas, can’t somehow stomach 2% volatility in their bank accounts.

(Wait, you ask, the Modigliani-Miller theorem fails for banks, no? The MM theorem for risk is an identity, not a theorem. Risk is not created, destroyed or transformed, it is simply parceled up differently and people end up holding all of it one way or another (even as taxpayers). The contentious part of the MM theorem is whether the price of risk or cost of capital depends on how you slice it. A pizza sliced 10 ways has the same calories, but might sell for more or less than whole.)

But if you want, we can even keep exactly the household assets we have today. Consider structure 3. Banks still issue 100% equity, but that equity is held in a mutual fund, ETF, or similar holding company, which in turn issues debt and equity.

The bank – complex, full of illiquid assets, Ben Bernanke’s specialized human capital, hard to resolve – still can’t fail. The fund can fail. But this failure can be resolved in a morning, and still make it to a 3-martini lunch and golf. The fund’s assets are publicly traded bank equity and nothing else. The bank’s liabilities are common equity and debt. The equity holders get zero, the debt holders get the bank equity. It can be done by computer.

The funds do have debt. But there is little risk of a systemic run on the funds, because their assets are supremely liquid, and visible on a millisecond basis. The failure of one fund need not inspire a run on the next one.

One might object to structure (2) that the Modigliani Miller theorem fails for banks, so it would imply a higher cost of equity. If so, structure (3), by giving households exactly the same assets as they have not, must give exactly the same cost of capital as now — minus the value of taxpayer guarantees.

Structure (3) emphasizes that the issue is not whether “transformation” must occur, whether people really need to hold a lot of fixed-value debt. The issue is whether “transformation,” if it is needed, must be tied to bankruptcy and liquidation of the institution handling the complex assets. One can cook up stories why this must be the case — corporate finance and banking theorists are a clever lot — but are such stories remotely understood and well-tested enough to justify either our occasional crises, or our massive regulatory response? I think not, but I’ll leave that case to be made by our panelists, if they are so inclined.

Structure (3) is a rhetorical point, not a proposal. I do not think it is necessary or desirable to exactly replicate the securities on both ends of the financial system. The point is just that eliminating financial crises by moving to equity-financed banking does not require any new money, any less credit, any less economic growth or any different risk taking. People will likely choose different assets in my world, and thereby improve on it.

Structure (4) elaborates. Not all bank assets are complex and illiquid. Once we remove short-term financing, I suspect that securitized debt and other liquid securities will move off bank balance sheets. They will migrate to long-only floating-value mutual funds and ETFs, and people will move money out of savings accounts and bank CDs into those very safe investment vehicles. The banks will be smaller, holding only those complex and illiquid risks that can’t easily be securitized.

On the other side, banks now have about $2.3 trillion of reserves, (May 5 H.4.1) and $1.2 trillion of demand deposits. Narrow deposit taking is here! We just need to move the deposits and their backing reserves to bankruptcy-remote vehicles (which banks can still operate for a fee, if that makes sense).

How much risk-free assets do people really need? We can provide them up to $14 trillion and counting with narrow deposits backed directly or indirectly (through the Fed) by Treasury debt.

The Fed’s huge balance sheet is a great innovation. Better yet, the Treasury should issue fixed-value floating rate debt so we can all have “reserves.” The last 8 years have taught a revolutionary lesson in monetary economics: huge quantities of interest-bearing money are not inflationary. We can live the Friedman optimal quantity of money, and displace all the private interest-bearing moneys that fell apart in the crisis. As our ancestors got rid of run-prone banknotes in favor of treasury notes, we can get rid of run-prone debt in favor of treasury and fed interest bearing-electronic money. Let’s do it.

How do we get there

We’ve defined and limited the problem, outlined a better world, but we’re still not ready to write regulations. We should check for failures and unintended consequences of current regulations before we go adding new ones.

Our government subsidizes debt, in numerous ways. Let’s start by not simultaneously subsidizing something and also regulating against its use! We can leave that to energy policy.

The tax deductibility of interest payments is an obvious distortion. It’s not the whole story, as nonfinancial corporations don’t all lever this much, but it’s a part of it. I’d rather just get rid of the whole corporate tax, which eliminates demand for a hundred other tax distortions. But treating dividends and interest equally, or better yet reversing the treatment — deduct dividends, not interest — would help.

Implicit and explicit debt guarantees are a bigger part of the distortion in favor of debt. But, while it’s easy to say “end debt guarantees,” I fear the government will always bail out ex-post, and that inability to precommit is an important justification for limiting debt debt. ( V. V. Chari and Patrick Kehoe have elegantly made this case, in “A Proposal to Eliminate the Distortions Caused by Bailouts” Minneapolis Fed Working Paper.)

A lot of law, regulation and accounting subsidizes debt as a liability by privileging it as an asset. Liquidity regulations encourage institutions to hold very short-term debt, with a run option to save themselves individually in times of trouble. Well, that incentivizes someone else to issue that debt, and encourages the fallacy of “sell if things go bad” risk management. Accounting regulations also treat run-prone short-term debt as safe as cash.

Using floating-value funds for transactions purposes would trigger short-term capital gains taxes and an accounting nightmare. That needs to be fixed if we want free liquidity.

In sum, throughout the regulatory system, we should treat non-government short-term debt as poison in the well, both as an asset and as a liability, and we should remove the impediments to the use of liquid floating-value assets. Will this take some effort? Sure. But just carrying the tens of thousands of pages of regulations over to the Dodd-Frank bonfire will take some effort.

Regulatory relief would be a potent carrot and it is my strongest suggestion. We could say, any institution that is financed by more than (say) 75% equity and long term debt is exempt from asset risk regulation, systemic designation, bank regulation and so forth; it will be treated like a non-financial company. I suspect they would come running. MetLife’s suit and other companies’ efforts to downsize suggests that banks really do not like regulation and will do a lot to rearrange their operations to avoid it.

This suggestion reflects a deeper problem: Where is the safe harbor in Dodd-Frank? Where does it say “this is how we want you to set up a systemically safe financial institution. If you do this, you’re doing a good job, and we’ll leave you alone.” Nowhere. Not even an equity ETF, about the most run-proof structure in creation, is exempt.

Adding a safe harbor is an especially attractive way to move to better policy. If we need to repeal Dodd-Frank, we’re asking a lot. Too many people have too much invested in it. If we just add to Dodd-Frank its missing definition of “systemic,” and thus a definition of “not systemic,” a specification of how an institution can be exempt from detailed regulation, they will run for it, and the rest can die on the vine.

At last a bit of regulation

Finally, if after removing all the subsidies and inducements for debt, and a regulatory safe harbor, banks are still using too much run-prone financing, ok, we get to add a bit of stick.

The usual approach to boosting capital combines complex regulation, taking the form of a limit on a ratio of complex numbers, with extensive discretion and regulatory remediation. The ratios don’t work for all sorts of reasons. The denominator is the big problem. Simple leverage — debt to assets ratios — is silly. We require equity on holding reserves, and a stock vs a call option have much different risk for the same asset value. Risk weights violate the fundamental principle of finance, that a portfolio is less risky than the sum of its parts. Risk weights are deeply distorting investing decisions – loans carry large risk weights, while securities formed of the same loans carry small risk weights. Greek debt is still 0 risk weight.

And what level of capital is “safe?”17.437%? 35.272%? Really, the answer is “so much that it doesn’t matter,” and “more is always better.” Since costs and benefits do not suggest a hard and fast number, why regulate one – and then endlessly argue about it?

We need something simple, transparent, and that avoids these pathologies. The best I can think of is a Pigouvian tax, say 5 cents for each dollar of short-term debt (less than a year) and 2 cents for longer term debt. By taxing the amount of debt, arguments about the denominator vanish. So we don’t have to get in to riskweights, leverage, book values market values, and so forth.

Everywhere in economics, charging a price is better than a quantitative limit.

You will ask, just what is the right tax? I don’t know. I suspect however, that the benefits of short-term financing are much less than banks claim when they are trying to convince regulators to lower a quantitative limit. If they faced even a quite low tax, I suspect we would see a swift rediscovery of the Modigliani-Miller theorem. In any case, we don’t have to decide that ahead of time. Adjust the tax rate as needed until you get the capital you want.

As it is sensible to demand more capital of more “dangerous” firms, so the tax could rise on some simple measures of danger. I distrust any accounting measures, so following Chari and Kehoe’s recent suggestion, the tax could be a rising function of the ratio of short-term debt to the market – not book -- value of equity. The market value of equity is easily measurable. Let the firm figure out whether to issue more equity, retain more earnings, find a buyer, restructure debt, pay the tax for a while, or whatever they want to do.

Most importantly though, we are not trying to carefully craft a way for banks to get by on the minimal amount of capital. The point is that capital is not expensive, socially if not privately. We don’t want to jigger the absolute minimum amount of the tax, we want to induce banks to shift overwhelmingly to floating-value run-proof liabilities.

The current path

This all may seem a bit radical, so I think it’s worth emphasizing just how broken the current system is.

Since the 1930s, we have tried a fundamentally different approach to stopping runs and financial crises, emphasizing minimal equity and lots of debt. When depositors run, really the only way to stop it is for the government to guarantee debts. But, once people expect debt guarantees, banks to take too much risk, and their creditors lend without regard to that risk. So, we tried to substitute regulatory supervision of asset risk for both ends of market information processing and discipline. It’s not enough, we have another crisis, guarantee more debt, and so on. The little old lady swallowed a fly, a spider to catch the fly, as the song goes, and now she is trying to digest the horse.

That we are having a conference on “ending too big to fail” reflects he widespread perception that we have not ended this cycle, the “resolution authority” will not work, and it will institutionalize creditor bailouts rather than precommit against them—which might be impossible and unwise anyway.

Regulation quickly failed its first test after the 2008 subprime crisis. Europe’s bank regulators, with that crisis fresh in the rear view mirror, still allowed Greek debt at zero risk weights, and promptly bailed out the French and German banks who were over exposed. Will the same regulators artfully prick asset bubbles, diagnose imbalances, macro-prudentially raise capital standards, promptly resolve nearing failures, and sternly haircut debt holders… next time?

We are devoting enormous resources and suffering large economic distortions to regulate the risk of bank assets. But bank assets aren’t risky! A diversified, mostly marketable portfolio of loans and mortgage backed securities is far safer than the profit stream of any company.

So why are we, as a society, investing so much in regulating some of the safest corporate assets on the planet? Well, because they’re leveraged to the hilt, and we’re holding the bag. We don’t have to.

And asset risk regulation is now spilling over into efforts to regulate asset prices themselves. For example, the OFR proposed to regulate equity asset managers, even though they just trade equity on customer’s behalf. Why? Because the managers might sell, drive asset prices down; and someone might have borrowed money on those assets that asset risk regulators didn’t notice. The Fed is discussing “macroprudential” policy to allocate credit to target house prices, and raising interest rates to manage stock prices.

The result is an increasingly uncompetitive and sclerotic financial system. We are the financial system of zero interest rates where nobody who actually needs one can get a loan.

Already, financial innovators are springing up around the banking system, in peer to peer lending, finance tech, and so on. These give me hope. Maybe equity-financed banking will spring up like weeds around the ruins of the big banks. But those don’t have to be ruins.

If it really does cost 25 bp more for a mortgage in my world, and if we really want to subsidize home mortgages, we can do so by writing checks to homeowners, on budget, rather than set up a dangerous and sclerotic financial system.


I got great comments at the conference from panelists Michael Hasenstab, Michael Keen, Donald Marron, and Thomas Phillips. A few points that come out of the discussion:

100% Equity is not necessary. I focus on this option because it is, in fact, cleanest, and I want to make the case that 100% equity is possible and reasonable. Once you accept that, then 75% equity can work too. It would be just about bulletproof: the institutions would have to be at risk of losing 75% of its value before a run could start.

To emphasize, not all debt or fixed value debt is equally dangerous. Your gas bill is a fixed value claim, but the gas company can’t bankrupt you tomorrow if they call and say “we want our money” and you don’t pay up.

The transition sounds hard. Issuing gobs of equity sounds costly. But again, look at structure (3). No new money is needed. We are simply replacing debt with equity. In fact, we could do it in a day. The Bank’s current liabilities are transferred to the fund, in return for newly issued equity. Nobody has to go to the market! That’s not necessary, but I think it makes clear that we don’t need more money or a lot of discombobulation. In fact, I think banks would slowly redeem debt for equity without much trouble.

Michael, as a manager of a bond fund, emphasized the necessity of large banks with global reach to be reliable counterparties and market makers on all sorts of assets. But equity-financing helps them! If equity financed, banks can be as “big” as anyone wants, without causing risks. We don’t need to break up the banks or fear size.

Michael Keen gave a great introduction to tax issues. The tax code is also a bunch of patches applied to cure the consequences of other taxes. He pointed out that the total tax wedge includes the taxes paid by the bank, and the taxes on interest paid by investors. My head hurts, and I can’t help but never to the fact that Eliminating corporate and rate of return taxes, leaving a simple consumption tax, solves all these problems!

Michael also thought in some detail about how to make equity deductible, and even with debt. This has troubled me: allowing a deduction for dividends like interest sounds nice, but we want to encourage banks to keep dividends, which builds capital. He outlined “ACE” rules that allow banks to deduct a “notional cost of equity,” usually a risk free rate plus a few percent. I asked later, why not deduct the actual return.

Donald Marron gave quite a few examples in which the government simultaneously taxes and subsidizes, including carbon, tobacco, and sugar.

Donald pointed out that it’s not always best to regulate via a price rather than a quantity. This is a good question, but I think run-prone securities are a good case for price regulation. Like pollution, the regulator doesn’t really know what the costs of compliance are, and there are lots of creative ways for the business to rearrange things to reduce the pollution.

Donald pointed out that the word “tax” is pollution in our politics. Also “tax” rates have to be voted by congress. Agencies can impose “fees.” Economists understand “taxes” in terms of incentives, politics understands “taxes” as income transfers and ignores incentives. He’s spot on. Forever more, let us call it a “Pigouvian fee” on debt!

Thomas Phillipon questioned whether mutual funds are truly run-free. He has a point, there is a small incentive to run with big losses given the option to redeem at NAV. Answer: exchange tried funds, or an exchange traded backstop, in which you can or must sell your shares to another investor rather than demand money from the fund solves the problem. ETFs are really run free!

Thomas also gave a long and detailed explanation of why leverage ratios or leverage charges don’t work. That’s exactly why I propose to tax debt itself, not a leverage ratio.

In a later section, David Skeel pointed out that Lehman when it failed, had 25,000 employees — fewer than the current compliance staff at citigroup.

I closed with a warning: my vision of a monetary system based on short-term government debt depends on government solvency. If Greece comes to the US, and banks are deeply involved in government debt, considered risk free, we’re in really deep trouble. Insulating a financial system from sovereign debt problems is a separate, and important, question.

Update: A correspondent sent a thoughtful email advocating floating-value equity-like securities  for many cases on the asset side as well. Then, from twitter, "a few more steps and whole world for sharia compliant financing ie 100% equity both on asset and liability side." I'm not sure if that is praise or criticism.