Mehul Gaur: Bernie Sanders’s Financial Transactions Tax is a Bad Idea

Link to Mehul Gaur’s LinkedIn Homepage

I am delighted to host another student guest post by Mehul Gaur. This is the 6th student guest post of this semester. You can see all the student guest posts from my “Monetary and Financial Theory” class at this link.

Bernie Sanders’ proposed 0.5% tax on stock transactions is not only going to dry up liquidity in the markets, but may actually serve to lower tax revenue overall.

Bernie Sanders has been making quite a name for himself recently. After announcing his candidacy for presidency, Bernie has positioned himself to the left of the standard Democratic Party stance and proposed an estimated $15 trillion healthcare reform. One of the ways he has proposed to pay for this massive expenditure is to levy a 0.5% tax on each trade of stocks, bonds, and derivatives. Opponents of the tax argue that it would make it impossible for high-frequency trading firms to operate, put off speculators, and reduce volatility by making very low-margin computerized trades unprofitable.

If Bernie is using this as a piece of political propaganda, its genius. To someone not familiar with the financial markets (the majority of voters), it seems like a tax that provides wide social benefits at a very low cost to “those rich traders” on Wall Street. However, if Bernie is serious about implementing this, he could be doing something that would derail the financial markets and possibly cause another stock market crash.

Let’s start with what supporters of the policy are right about: It will drive high-frequency traders (HFTs) out of business. Their profit margins per trade are well below 0.5% and it will essentially eliminate the industry.

There’s just 1 tiny problem with that: It is estimated that HFTs make up somewhere between 50%-75% of all trading volume in the United States. So, by implementing this tax, one would essentially be directly eliminating at least half of the liquidity in the equity markets. But we got rid of the evil HFTs right? HFTs are widely believed to actually help the markets by both adding liquidity and reducing trading costs. Additionally, by cutting the trading volume in half one would also be reducing the potential revenue from the tax. It may also have a net negative effect on tax revenue because of reductions in capital gains taxes. Bernie did not provide any numbers on this, but as I discuss later, both of these statements have an empirical basis.

Next, the tax would affect all sorts of institutional investors (investment banks, mutual funds, hedge funds, etc.). Currently, these funds average transaction fees of 7 basis points. Adding a tax of 50 basis points would radically affect their returns and cause them to cease activity. Additionally, most 401(k)s are invested in these types of funds, so the tax would essentially be reducing the value of investors retirement accounts. Another important point to note is that by taxing bond transactions, the government is inhibiting the ability to raise capital for not only corporations, but itself.

Obviously, this is all conjecture, but it is not entirely baseless. Sweden, in 1984, introduced a 50 basis point tax on all equity transactions. In 1986, the tax was doubled to 100 basis points. After this second announcement, 60% of the traded volume of the 11 most actively traded Swedish share classes, accounting for 50% of all Swedish equity trading volume, relocated to London. By 1990, more than half of all Swedish securities trading had moved offshore. The government reacted to this by introducing a tax on fixed income securities. Within a week of the introduction of the tax, the volume of bond trading fell by over 85%, futures trading fell by 98% and the options market ceased to exist. Also, the incremental revenue generated by the equity tax was almost entirely offset by the loss in capital gains tax. (More information about this tax can be found here)

This post was inspired by my reaction to How to Avoid Another Market Crash, by Douglas Cliggott (Lecturer of Economics at University of Massachusetts Amherst). Contrary to his favorable view, I think introducing Bernie Sanders’s tax on the capital markets is a bad idea. It is one that will overall generate much greater costs than benefits. It will severely inhibit firms ability to raise capital and by reducing liquidity, may actually serve to magnify volatility in the markets. It is by no means, as Douglas Cliggott would have you think, a perfect tax.

Farqani Mohd Noor: Malaysia Should Maintain a Flexible Exchange Rate for Monetary Independence

Link to Farqani Mohd Noor’s LinkedIn Homepage

I am delighted to host another student guest post by Farqani Mohd Noor. This is the 5th student guest post of this semester. You can see all the student guest posts from my “Monetary and Financial Theory” class at this link.

The other day, my brother, a dentist, was furious on Whatsapp, complaining about the depreciating Ringgit. He said, “80% of my dental materials are imported, and they’re 25% more expensive now. But the government is not increasing allocation of funds for them. How am I supposed to give my services to the people?!”

Commodity-exporting countries are facing depreciating currencies due to the current economic landscape; US interest rates are uncertain, China is combating a housing bubble and a stock market crash, and commodity prices are fluctuating. These factors are affecting the supply and demand for currencies. Malaysia, one of the affected countries, is now selling $ 4.4 Malaysian Ringgit (MYR) for $1 USD.

My brother continued, “At this rate we will reach $5 MYR for 1 USD. Why not peg the currency?”

I fell silent, trying to formulate a witty economic response. I recall reading Milton Friedman. He said, “A country that pegs the exchange rate is essentially committing itself to adopt the economic policies of the country whose currency it is pegged to.”

The idea of pegging MYR to the USD is familiar to Malaysians as Dr. Mahathir, the former Malaysian Prime Minister, banned offshore market trading of the ringgit and pegged it to $3.8 USD during the 1997 Asian Financial Crisis. Consequently, the country recovered from the crisis faster than our Southeast Asian peers (Indonesia and Thailand). This unorthodox method was successful with the help of the central bank.

The central bank has control over MYR through foreign reserves. The $95 billion USD of foreign currency reserves in Malaysia will not sufficient to peg the currency in the long run; they will eventually run out of ammunition. The central bank will have to borrow foreign currency in efforts to meet the demand for foreign currency. Shrinking of the foreign reserves and the cost of accumulating them means more RISK in the economy. Therefore, I conclude that foreign reserves serve as an instrument for the central bank to smooth the currency but not to fix them at a certain rate.

In order to face these risks during the 1997 Asian Financial Crisis, Dr. Mahathir implemented selective capital controls in order to circulate MYR within the country. For example, investments above $10000 MYR to non-residents will require permission from the central bank. Dr. Mahathir also implemented in an expansionary fiscal policy worth $2 billion MYR for consecutive years until 2002. This was coupled with low interests rates from 11% in mid 1998 to 3% in the December 1999. These were efforts to stimulate spending during the times of recession and prevent MYR from leaving the country.

However, pegging currencies in current economic landscapes exposes Malaysia to different risks than that of 1997. Since fiscal policies are expensive, the government has to think twice of increasing spending. The government debt is much higher now than it was in 1997; it stands at more than 50% of GDP. With the introduction of Goods & Services Tax (VAT equivalent) and rationalization of subsidies, Malaysia has been going through a transitional period and prices have only begun to stabilize. Introducing more fiscal spending now will be counterintuitive to the efforts done to reduce the debt. But how will the Malaysian economy run under capital control with limited stimulus packages?

External landscapes, on the other hand, like Europe and China are also different from that of 1997. Europe is going through a difficult period, with the Greece Debt Crisis occurring during these last couple of months. China’s maturing economy is facing a sharp slowdown in exports and growth. These external economic landscapes matter because Malaysia is an exporting country – exports of goods and services measured by the World Bank is at 80% of GDP in 2014. Currently, US currency rates are appreciating against all other major currencies (not only MYR). If Malaysia’s currency is pegged against the USD, this will also appreciate the MYR against other currencies in the world. The appreciated currency will reduce major exports and destroy manufacturing businesses (main export sector) like electrical & electronic products (35% of Malaysia’s total exports), as prices will be more expensive than competitors in Thailand, Indonesia and China

Finally, The US Fed also plans on tightening monetary policies and increasing fed interest rates. These are policies that will prevent Malaysia from stimulating the country’s economy, if it decides to peg the MYR to USD. In the end, Malaysia will find itself facing a technical recession just like how Chile, and Argentina did when they pegged their currencies against USD. Malaysia needs monetary independence in order to face its own economical challenges that are different from the US. Moreover, in 1997, currency speculation created the Asian Financial Crisis. However, currently, political scandals and economical challenges are depreciating the MYR. Thus, we need policies to solve our problems and not limit them.

Given what I’ve said, Malaysia’s economic fundamentals are much stronger than it was in 1997. Thus, while pegging the currency might not be an option, I hope Malaysia can adjust to the supply and demand of MYR in the market. It’s been almost two decades since 1997, during which Malaysia has survived, recovered, and grown through the 2008 financial crisis.

But I did not have time to formulate these thoughts in a text message due to the need to write this post for class! So I replied to my brother’s comments, “Economies are cyclical. There’s a boom and a bust. Be patient in face of economic slowdown because no currency can defy economic principles especially not the MYR.”

Angus Deaton Wins Nobel Prize—Official Press Release →

Congratulations to Angus Deaton on a richly deserved Nobel Prize! 

I have intersected with Angus Deaton both early on in a common interest in precautionary saving and currently in a common interest in the economics of happiness and the construction of indices of National Well-Being. It has been a delight talking with Angus about many scientific issues in connection with a current grant proposal on measuring National Well-Being that both of us are a part of. Because of his considered judgment, I respect Angus’s opinions more than those of just about any other economist on the planet. If after clarification and a few minutes argument with him, I ever found I disagreed with him, my first thought would be that I was probably wrong.  

Greg Robb: Fed Officials Seem Ready to Deploy Negative Interest Rates in Next Crisis

Link to the article on Market Watch

Greg Robb interviewed me on Friday evening, October 9, and by the next morning had this incisive article out. You should read the entire article, but here is the part based on our interview:

Although negative rates have a “Dr. Strangelove” feel, pushing rates into negative territory works in many ways just like a regular decline in interest rates that we’re all used to, said Miles Kimball, an economics professor at the University of Michigan and an advocate of negative rates.

But to get a big impact of negative rates, a country would have to cut rates on paper currency, he pointed out, and this would take some getting used to.

For instance, $100 in the bank would be worth only $98 after a certain period.

Because of this controversial feature, the Fed is not likely to be the first country that tries negative rates in a major way, Kimball said.

But the benefits are tantalizing, especially given the low productivity growth path facing the U.S.

With negative rates, “aggregate demand is no longer scarce,” Kimball said.

Here is a quotation I sent him over email he didn’t have space to use: 

Monetary policy can’t take care of long-run growth or financial stability. But, even if we had to face again something as terrible as the Great Recession, interest rate policy alone–without any help from quantitative easing or fiscal stimulus–could provide as much aggregate demand as needed once a central bank gets cash out of the way. And it is easy to get cash out of the way by adjusting how the central bank handles paper currency. The key is to make dollars (or euro or yen) in the bank the center of the monetary system, not paper money.

For more on negative interest rates, see my bibliographic post How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide. There is a 5 minute video there you should watch first, then you can browse through many links.

Cyrus Anderson: Hot Property in China

Link to Cyrus Anderson’s Google Sites Homepage

I am delighted to host another student guest post by Cyrus Anderson. This is the 4th student guest post of this semester. You can see all the student guest posts from my “Monetary and Financial Theory” class at this link.

The People’s Republic of China should defuse the property bubble by addressing the underlying issues and taking a larger role in implementing affordable housing.

Yifan Xie writes of the woes of China’s property market in a recent Wall Street Journal article, describing the plight of RiseSun and in particular an apartment complex in Bengbu it owns. The complex is described as a ‘Toscana-style high-end community’, but there are no buyers in what is normally the season for property sales and RiseSun’s financial outlook appears risky. This downturn is not isolated to smaller cities; the cities in Fujian have not kept up the pace either. Properties sales there fell 16.3 percent in the first two months from a year earlier, according to an article in South China Morning Post.

This goes to show an excess in housing. But, this is only in higher-end housing. There are many people that would want to buy a home, but cannot afford to do so. It is not entirely the private sector’s fault. There are land shortages in many urban areas and redevelopment projects are difficult due to fragmented ownership, according to an article by Haotian Lin. But there are still problems with what property developers have done so far. Haotian Lin continues, “many of these housing projects are located at the urban fringe where infrastructure still needs to be improved and where there are not many job opportunities. This means high costs on commuting, which can make the housing ‘unaffordable’”. Quality of the residences has also been a problem. Local governments pushed developers to build the quantities stipulated by the central government, but have not ensured quality.

In order to effectively implement affordable housing, the central government will have to redesign the incentive structures and possibly take a larger role in carrying out the process. It can do more to build affordable housing in areas from which potential workplaces and other needs are accessible. To address the shortage of well located land, it could offer fairer channels for land conversion such as the successful land leasing in Shenzhen. Policymakers should also revamp the incentives the development of affordable housing, in order to help offset the high cost of land in accessible locations. This could include holding the developers and the local government officials in charge accountable for meeting some set quality standards. The other side to this is to also make it easier for consumers to buy the homes. Expanding access to housing finance is one idea, but it is not new. Some cities and provinces are taking steps in this direction. In Fujian the downpayment required for first-time buyers was lowered to 20 percent from 30 percent,  just after Jinan and Guangzhou lowered theirs. Another step would be to extend financing to migrant workers, many of who may face barriers such as the hukou permit.

According to a McKinsey report, “China’s affordable housing gap (the difference between market-rate housing costs and 30 percent of income for households in lower-income groups) equates to about $180 billion per year, or about 2 percent of GDP”. Integrating these groups will take significant effort, but in the long run, will result in a higher quality of life and a stronger economy. In the meantime, the property market could stand to benefit from this endeavor.

Ben Bernanke on Trial

Previewing his upcoming book The Courage to Act: A Memoir of a Crisis and Its Aftermath slated to come out the next day, Ben Bernanke discussed recent monetary policy history and general principles of monetary policy in the October 4, 2015 Wall Street Journal op-ed “How the Fed Saved the Economy.” He said a number of important things very well. Here are my favorite passages. I added headings, but the words in the indented bits are Ben’s. After quoting Ben, I give my take on his record at the Fed. 

The Limits of Monetary Policy

Fed critics sometimes argue that you can’t “print your way to prosperity,” and I agree, at least on one level. The Fed has little or no control over long-term economic fundamentals—the skills of the workforce, the energy and vision of entrepreneurs, and the pace at which new technologies are developed and adapted for commercial use.

What Monetary Policy Can Do

What the Fed can do is two things: First, by mitigating recessions, monetary policy can try to ensure that the economy makes full use of its resources, especially the workforce. High unemployment is a tragedy for the jobless, but it is also costly for taxpayers, investors and anyone interested in the health of the economy. Second, by keeping inflation low and stable, the Fed can help the market-based system function better and make it easier for people to plan for the future. Considering the economic risks posed by deflation, as well as the probability that interest rates will approach zero when inflation is very low, the Fed sets an inflation target of 2%, similar to that of most other central banks around the world.

The Record for the US, the UK and the Eurozone Indicates that the Great Recession Called for Monetary Stimulus

Europe’s failure to employ monetary and fiscal policy aggressively after the financial crisis is a big reason that eurozone output is today about 0.8% below its precrisis peak. In contrast, the output of the U.S. economy is 8.9% above the earlier peak—an enormous difference in performance. In November 2010, when the Fed undertook its second round of quantitative easing, German Finance Minister Wolfgang Schäuble reportedly called the action “clueless.” At the time, the unemployment rates in Europe and the U.S. were 10.2% and 9.4%, respectively. Today the U.S. jobless rate is close to 5%, while the European rate has risen to 10.9%. …

Meanwhile, the United Kingdom is enjoying a solid recovery, in large part because the Bank of England pursued monetary policies similar to the Fed’s in both timing and relative magnitude.

The Supply Side

With full employment in sight, further economic growth will have to come from the supply side, primarily from increases in productivity. … As a country, we need to do more to improve worker skills, foster capital investment and support research and development.

My Take on Ben’s Record

Ben has been criticized for many things. I think that higher equity requirements–including mortgage reform involving more equity provided by not just homeowners but other investors to get higher equity requirements for mortgages–and sovereign wealth funds are the right tools to deal with financial instability, not monetary policy, so I certainly don’t follow the chorus faulting the Fed for causing bubbles by keeping interest rates too low in 2003. (Ben was not Chair then, but he was an influential Governor.) 

Ben, however, like many of the rest of us (I definitely include myself) did not do enough to recognize building financial instability and push for higher equity requirements before things blew up in 2008. My now deceased University of Michigan colleague Ned Gramlich was one of the few within the Federal Reserve Board who recognized some of these building problems when he served as a Governor of the Federal Reserve Board. Like Alan Greenspan, Ben should have paid more attention to Ned, and Ned should have been more insistent on his point.   

In later decisions, in hindsight, Ben should probably have pressed to save Lehman. But it is not at all clear that could have arrested the crisis, since some other bank might have then failed and pulled things down.

Nevertheless, once Lehman fell, Ben’s actions were heroic, both in helping to push through the unpopular but necessary bailouts and in bringing the Fed around to a serious program of quantitative easing that helped greatly, as Ben points out in one of the passages above. 

Overall, Ben is a hero in my book. The mistakes he made are mistakes I think I would have made myself. (I know that, because I have a reasonably good memory of what I thought in real time along the way.) But what he did right was something that very few people could have done as well.

Going forward, for the future of monetary policy, my wish would be for Ben Bernanke to help in pushing for a further expansion of the monetary policy toolkit. Despite Ben’s heroic actions, the actual outcome of US monetary policy–7 years of sluggish growth and zero interest rates–was terrible in absolute terms. There is a simple reason why: the zero lower bound. As far as I know, Ben has yet to acknowledge publicly the fact that the zero lower bound is a policy choice, not a law of nature–and that ways to eliminate the zero lower bound are quite practical. See my bibliographic post “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide.” In recognizing and discussing publicly how easy it is to break through the zero lower bound, Bank of England Chief Economist Andrew Haldane is ahead of Ben. As things stand, the Bank of England is poised to do a much better job in the next serious recession than the Fed. Ben could do a lot to fix that by speaking frankly about the welcome fragility of the zero lower bound.

Anand Jetha: Slow Progress in Battery Technology Will Hold Back Electric Cars

Link to Anand Jetha’s LinkedIn Homepage

I am delighted to host another student guest post by Anand Jetha, the 3d of this semester.

The battery is the biggest obstacle in technological progress, and ultimately the barrier for the all-electric vehicle to become a major participant in the automotive market.

Every day it seems there is a new gadget that rolls out doing something amazing, something innovative. Phones get lighter, thinner, and more powerful. Laptops are built thinner than our hands. Google has cars driving themselves. Tesla provides cars that drive themselves from your garage to the curb at any time you choose, and have all your comfort settings including temperature and radio adjusted. But the thing powering that ready to go car at the curb and the cell phone in your hands has barley changed in eight years. Processing power doubles every two years according to Moore’s law, but today’s battery cannot even hold 30% more power than a battery from 2007. This means each year your electric car battery can only hold 3% more power. That’s nowhere near the 50% per year growth we see in the processing power of that self-driving electric car.

But how can that be? We have so many more electronics using battery power today including laptops, fitness trackers, smart watches, phones, Xbox/PS4 controllers, electric razors, and many more. The demand for batteries is growing significantly so why isn’t the innovation following? The problem has to do with the limits of mass when it comes to the lithium in the batteries. They just can’t be squeezed any closer together.

A recent article in the Wall Street Journal titled “Porsche Unveils Prototype Battery-Driven Sports Car” highlights the new desires for auto companies to build all electric vehicles and plug-in hybrids. The article talks about Porsche’s new “Mission E” car as well as Audi’s “e-torn Quattro” and BMW’s “i8” which all push for fully electric performance cars. They claim that the driving experience is all that still matters, not the fuel. All three are getting amazing press coverage as they keep improving the efficiency of all-electric vehicles. The problem is even with this new focus for EV, they make up less than 1% of all vehicles in the United States.

That low market share starts to make sense once the limiting factor of the battery is accounted. The most expensive part of the electric cars is the battery that powers them. They add a significant cost to making the car. Take for example the Ford Focus ST, which is their highest tier gas model that sells for $24,425. Now add a battery to it and make it a plug-in hybrid and the costs shoots up to $29,170. And that is just a hybrid, which has a smaller battery than an all-electric vehicle. After the cost comes the problem of charging the current batteries.  I can pull up to a gas station and fill my car in about 10 minutes. If I want to charge my Tesla at my house after paying to have a special charger installed, would take about 5 hours for a full charge. Our current batteries are very difficult to charge quickly. Now comes the issue of the size of the battery. The tesla gets at best 270 miles of range before I need to stop and charge for another 5 hours. Other than my interest in limiting my carbon footprint, I have no desire in driving a battery powered car that will force me to change my lifestyle.

Sure, the all-electric car is getting all kinds of converge but remember that their current market share is less than 1% in the US.  The only way automakers will be able to sell these cars as something other than status symbols is if they magically create improvements in the power source.

John Stuart Mill’s Vigorous Advocacy of Education Vouchers

John Stuart Mill was a strong proponent of mandatory education. But he was a vigorous opponent of trying to push students into public schools. The key to his opposition is the key to many people’s support of pushing students into public schools: having students attend public schools is a way to get greater conformity.   

What did John suggest? Vouchers, at least for the poor. Many people think of Milton Friedman as the originator of the idea of education vouchers. But the idea is clear in paragraph 13 of On Liberty “Chapter V: Applications.”

Were the duty of enforcing universal education once admitted, there would be an end to the difficulties about what the State should teach, and how it should teach, which now convert the subject into a mere battle-field for sects and parties, causing the time and labour which should have been spent in educating, to be wasted in quarrelling about education. If the government would make up its mind to require for every child a good education, it might save itself the trouble of providing one. It might leave to parents to obtain the education where and how they pleased, and content itself with helping to pay the school fees of the poorer classes of children, and defraying the entire school expenses of those who have no one else to pay for them. The objections which are urged with reason against State education, do not apply to the enforcement of education by the State, but to the State’s taking upon itself to direct that education: which is a totally different thing. That the whole or any large part of the education of the people should be in State hands, I go as far as any one in deprecating. All that has been said of the importance of individuality of character, and diversity in opinions and modes of conduct, involves, as of the same unspeakable importance, diversity of education. A general State education is a mere contrivance for moulding people to be exactly like one another: and as the mould in which it casts them is that which pleases the predominant power in the government, whether this be a monarch, a priesthood, an aristocracy, or the majority of the existing generation, in proportion as it is efficient and successful, it establishes a despotism over the mind, leading by natural tendency to one over the body. An education established and controlled by the State should only exist, if it exist at all, as one among many competing experiments, carried on for the purpose of example and stimulus, to keep the others up to a certain standard of excellence. Unless, indeed, when society in general is in so backward a state that it could not or would not provide for itself any proper institutions of education, unless the government undertook the task: then, indeed, the government may, as the less of two great evils, take upon itself the business of schools and universities, as it may that of joint stock companies, when private enterprise, in a shape fitted for undertaking great works of industry, does not exist in the country. But in general, if the country contains a sufficient number of persons qualified to provide education under government auspices, the same persons would be able and willing to give an equally good education on the voluntary principle, under the assurance of remuneration afforded by a law rendering education compulsory, combined with State aid to those unable to defray the expense.

It is a mistake to see this issue primarily in the US context. Education in the US will probably muddle through, and may improve dramatically either because of technological progress (see my column “The Coming Transformation of Education: Degrees Won’t Matter Anymore, Skills Will”) or in a smaller way, because a Supreme Court ruling weakens the deadening hand of teachers’ unions. What is much more important is for the developing world to shift toward voucher-supported private education rather than trying to fix a public education system in which teachers very frequently fail to show up for work. Effective and inexpensive private education alternatives are springing up in many developing countries that should be encouraged by loosened regulation first and foremost, and by a share of public expenditure on education if possible. 

The August 1, 2015 edition of the Economist has a fascinating article on this:

The $1-a-week school: Private schools are booming in poor countries. Governments should either help them or get out of their way

Here are some key passages:

Although Mathare has virtually no services like paved streets or sanitation, it has a sizeable and growing number of classrooms. Not because of the state—the slum’s half-million people have just four public schools—but because the private sector has moved in. Mathare boasts 120 private schools.

This pattern is repeated across Africa, the Middle East and South Asia. The failure of the state to provide children with a decent education is leading to a burgeoning of private places, which can cost as little as $1 a week (see article).

The parents who send their children to these schools in their millions welcome this. But governments, teachers’ unions and NGOs tend to take the view that private education should be discouraged or heavily regulated. That must change.

… when public schools exist, they often fail. In a survey of rural Indian schools, a quarter of teachers were absent. In Africa the World Bank found teacher-absenteeism rates of 15-25%. Pakistan recently discovered that it had over 8,000 non-existent state schools, 17% of the total. Sierra Leone spotted 6,000 “ghost” teachers, nearly a fifth the number on the state payroll.

… private schools are innovative. Since technology has great (though as yet mostly unrealised) potential in education, this could be important. Bridge gives teachers tablets linked to a central system that provides teaching materials and monitors their work. Such robo-teaching may not be ideal, but it is better than lessons without either materials or monitoring.

The Economist Endorses Nominal GDP Targeting and Notes that the Zero Lower Bound is a Policy Choice, Not a Law of Nature

Link to the Economist article

In a remarkable editorial, the Economist endorsed nominal GDP targeting. What is more, it is finally reporting on the zero lower bound accurately. Here are the key passages:

Endorsing NGDP Targeting as a Solution to Shifting Inflation Determination Relationships:

That is because the usual relationship between inflation and unemployment appears to have broken down. In the short run, economists think these two variables ought to move in opposite directions. High joblessness should weigh on prices; low unemployment ought to push inflation up, by raising wages.

Unfortunately, in many rich countries this standard inflation thermostat is on the blink. In 2008 economic growth collapsed and unemployment soared, but inflation only gradually sank below target. Now, by contrast, unemployment has fallen to remarkably low levels, but inflation remains anaemic. This has wrong-footed central banks.

… it makes sense to look beyond inflation—and to consider targeting nominal GDP (NGDP) instead.

… an NGDP target would free central banks from the confusion caused by the broken inflation gauge. To set policy today central banks must work out how they think inflation will respond to falling unemployment, and markets must guess at their thinking. An NGDP target would not require the distinction between forecasts for growth (and hence employment) and forecasts for inflation.

Mentioning the Zero Lower Bound in a Way that Indicates It Is a Policy Choice, Not a Law of Nature:

Interest rates cannot be cut far below zero without radical changes in the nature of money (the Bank of England’s chief economist recently suggested eliminating cash).

Harris Schlesinger

Link to Harris Schlesinger’s University of Alabama homepage

I am sad at the passing of Harris Schlesinger, a leading light in the economics of risk that I have done some work in. Here are passages from two emails I received about his life, work and untimely death:

With great sadness the board of EGRIE [European Group of Risk and Insurance Economists] learned of the death of Harris Schlesinger on September 29 after a long illness.  His intellectual contributions to the field of risk and insurance economics were substantial.  A friend of many; his dedication, enthusiasm, humor and kindness will be greatly missed.  His loss will be deeply felt, particularly at our annual meeting that he enjoyed so much.

– Mark Browne, Christophe Courbage, Alexander Mürmann, Andreas Richter, Hato Schmeiser, and Nicolas Treich

We have just heard that Harris Schlesinger passed away this week. He was only 63, and had visited CESifo as a guest scholar as recently as last November. To say that the news was a shock is a huge understatement.

Harris was a Professor of Economics and Finance at the University of Alabama, as well as the holder of the Frank Park Samford Chair of Insurance. He was also an Adjunct Professor of Finance at the University of Konstanz, a Research Fellow at the Center of Finance and Econometrics, and a CESifo Research Network Fellow. He had affiliations as a Research Associate with the Munich Risk & Insurance Center and with the Institute for Insurance Economics at the University of St. Gallen.

With a BA and MA from SUNY College at Potsdam, New York, and an MS and PhD from the University of Illinois, he was past president of both the American Risk and Insurance Association and the European Group of Risk and Insurance Economists. He was the founding editor of the Geneva Papers in Risk and Insurance Theory and an associate editor for five academic journals. He published articles in more than two dozen journals, including the American Economic Review,Journal of Finance, Econometrica, Quarterly Journal of Economics and Journal of Political Economy.

But that was only the professional side. As a person he was endowed with a terrific sense of humour, generosity and a warm personality that will be sorely missed.

– Hans-Werner Sinn

Mackenzie Wolfgram: Why the $15 Minimum Wage is Bad for the Poor

New York Governor Andrew Cuomo has already issued official recommendation for all fast food chains in New York City to raise the minimum wage for employees to $15 per hour, and he doesn’t intend to stop there. On Thursday the Democrat unveiled plans to hike the statewide minimum wage for all workers to a hefty $15 per hour. On the surface, these wage hikes seem like a benevolent plan. One that is only fair to the people who work low paying jobs only to live in relative poverty; after all, paying poor people more money should lead them out of poverty. Again, that is on the surface. In reality, this wage hike is one of the worst things that legislators can do to these lower class workers. Raising the minimum wage this drastically will have huge negative effects on employment, the profitability of thousands of businesses, and the condition of the lower class.

The arguments against this movement are laid out fantastically in Tim Worstall’s, “Yes, New York’s $15 Fast Food Minimum Wage Will Be A Failure–Why Do You Ask?” In this article, Worstall effectively dismisses any good that the $15 minimum wage is rumored to do.  Cuomo claims that his plan will benefit the people of New York in the following ways:

  1. Ending government welfare as a means of subsidies to employees of large corporations
  2. Saving taxpayer money at the sole expense of multimillion dollar corporations
  3. Having minimal effects on employment

Effectually, these benefits are meant to raise low wage workers out of poverty. Unfortunately, not one of them is fundamentally sound.

Governor Cuomo attacked fast food corporations, namely Burger King and McDonald’s, for paying such low wages that their employees were required to live with the aid of state funded subsidies, costing the state millions of dollars annually. However, as Worstall points out, welfare is by no means a subsidy program. This can be clearly proven.

A subsidy to the workers of a fast food franchise would lead to the employer paying lower wages. Since part of the reserve wage would be met by the government subsidy, the employer would only have to make up the difference between the subsidy and reserve wage. So, a true subsidy would cause businesses to pay lower wages, since the government would step in and pay a portion of their workers salaries.

With exception made for the Earned Income Tax Credit (EITC), which is pretty clearly effectively a subsidy (and which I will ignore due to its making up only a small percentage of welfare) most forms of government welfare offered today do not allow companies to pay lower wages, and therefore cannot be considered subsidies. In fact, welfare is cause for a higher reserve wage. When a person is unemployed with no welfare, they are willing to work for a lower wage. So without welfare, companies can attract people to jobs that offer lower wages. When a person is unemployed, but has welfare, it will take a higher wage to get them to accept a position. This is because welfare will theoretically give them a bargaining point, and a means of holding out for higher paying positions to come along, as they no longer need the money as desperately as they did when there was no welfare. Since welfare does not lower wages, it cannot be considered a subsidy.

Although Cuomo’s point about subsidies was not exactly correct, I find it immoral to take the stand that we should force people to take the lowest paying jobs for fear of homelessness and starvation. In addition to immorality, the subsidy argument is mainly a semantic one. Yes, Cuomo is wrong to claim that he is subsidizing fast food workers, but the fact remains that these workers are not making a living wage, and require welfare to live. Semantics aside, there is still a problem. However, I maintain that this wage hike is only going to hurt both the employees and employers.

Cuomo’s next point was that this higher wage will save millions of dollars of taxpayer money at the sole expense of big businesses. For the sake of argument, we will give Cuomo an advantage, put on rose colored glasses, and say that companies will not lay off a single employee as a result of this wage hike. (Unlikely, and these newly laid off employees will require even more welfare than they already require.) However, even with these unrealistic expectations, Cuomo is still wrong to claim that he is only hurting McDonald’s and Burger King type businesses. Just because a store says McDonald’s on the outside does not mean that the McDonald’s corporation owns it. In fact, the vast majority of these businesses are owned by franchisees. This wage hike would double the cost of labor for these franchisees and cause many to go out of business, since they cannot afford to staff their restaurants. This plan only attacks these small franchisees. In a way Cuomo is right, he will be hurting these big brands, but indirectly, and only by shutting down their franchised locations, ending the livelihood of hundreds of franchisees, and causing mass layoffs of low wage employees. Again, this is not good for the people his plan “helps.”

Cuomo’s last point is that, empirically, wage increases have not caused widespread changes in employment levels, so this one shouldn’t either. He is wrong. This wage hike is magnitudes bigger than any that we’ve ever seen. The new price floor on labor will be binding for many work positions, unlike prior wage bumps where only a small percentage of workers were forced below the new minimum wage. In this case, a huge percentage of workers would have to be given substantial raises, many nearly doubling their salaries. Businesses cannot afford this hit. We will see vast layoffs, as well as robotics and new computer tech taking over low skilled, formerly manned jobs. Currently, these low skill low pay laborers have jobs, once they become low skill high pay laborers, they will no longer be employable. Again, this plan hurts everybody.

Tony Yates’s Worries about Breaking Through the Zero Lower Bound Are Unfounded for a System Built around Electronic Money that Keeps Paper Currency in a Subsidiary Role

Tony Yates’s Twitter homepage

I wanted to reply to Tony Yates’s post “Haldane on coping with the zero lower bound.” Tony was reacting to this passage from Bank of England Chief Economist Andrew Haldane’s recent speech, discussing the basic options for eliminating the zero lower bound that Willem Buiter detailed in the first decade of this millenium:

Over a century ago, Silvio Gesell proposed levying a stamp tax on currency to generate a negative interest rate (Gesell (1916)).  Keynes discussed this scheme, approvingly, in the General Theory.  More recently, a number of modern-day variants of the stamp tax on currency have been proposed – for example, by randomly invalidating banknotes by serial number (Mankiw (2009), Goodfriend (2000)).

A more radical proposal still would be to remove the ZLB constraint entirely by abolishing paper currency.  This, too, has recently had its supporters (for example, Rogoff (2014)).  As well as solving the ZLB problem, it has the added advantage of taxing illicit activities undertaken using paper currency, such as drug-dealing, at source.

A third option is to set an explicit exchange rate between paper currency and electronic (or bank) money.  Having paper currency steadily depreciate relative to digital money effectively generates a negative interest rate on currency, provided electronic money is accepted by the public as the unit of account rather than currency.  This again is an old idea (Eisler (1932)), recently revitalised and updated (for example, Kimball (2015)).

Tony responds:

Andy points out that inflation is costly, and so an extra 2 percentage points of it is proportionately more costly.  Yet it seems to me that allowing negative interest rates on digital cash increases the cost of 2 per cent inflation somewhat.  Formerly, consumers get zero interest on their notes and coins holdings, while they depreciate at an average of 2 per cent a year.  With occasionally negative rates, these ‘shoe-leather costs’ of inflation increase a bit, proportional to the time spent below zero, and just how negative they go.  A reminder:  during the dark days of the previous crisis it was commonly thought that rates would ideally have gone down to about negative 7% or 8%.

Second, I query the judgement that eliminating cash and using negative rates would be less damaging to the credibility of monetary institutions than bumping up the inflation target.  Ultimately, in the absence of good models of how reputations are won and lost, this argument is really about trading hunches.  But mine is that there is a risk of a serious WTF moment when the no-cash system is explained, or people find out that they actually have to pay large sums of money simply for the privilege of having it.  Anecdotally, we know from many models of money that equilibria where money is valued are quite fragile – specifically, it’s quite easy to write down models in which it is not.

I am not going to defend Silvio Gesell’s direct taxation of paper currency or the total abolition of paper currency. But I will defend my own recommendation, which builds on Robert Eisler’s idea of having an exchange rate between paper currency and bank money (which in modern times can be called “electronic money” since it is encoded in the memory banks of computers). 

Tony has two worries. The first is a worry about “shoe-leather costs”–people being overly discouraged from using paper currency. But shoe-leather costs are all about the spread between the paper currency interest rate and other safe interest rates. My recommendation to central banks is to keep the paper currency interest within 50 basis points of the target rate at all times, except when that would push a paper dollar toward being worth more than an electronic dollar. Consider in particular the baseline case of a paper currency equal to the target rate whenever that doesn’t take paper currency above par. Then there are no shoe-leather costs when paper currency is away from par. 

If a central bank follows this recommendation, paper currency is at par only during periods of time when the target rate is positive, and things are very much as under the current system when the target rate is positive. One might lament the shoe-leather costs during those periods, but it is a lament one could equally have in the current system. And over time, as central banks gain confidence that the zero lower bound is no more, they are likely to lower the target inflation rate, bringing shoe-leather costs during those periods at par down as well. 

Tony’s second worry is that confidence will be shaken by the dramatic change in the system. He is certainly right that the formal models give little guidance on this point because under any fiat money system, the formal models allow the value of money to suddenly drop to zero at any time for no real reason. So any answer must be based solidly on intuitions about the real world rather than on a formal calculation. 

Part of my reply to Tony’s second worry is to note that a straightforward arbitrage argument ensures that how the central bank treats paper currency at the cash window determines the value of paper currency relative to electronic money. (See An Underappreciated Power of a Central Bank: Determining the Relative Prices between the Various Forms of Money Under Its Jurisdiction.) So the danger at issue has to be something about all the forms of money controlled by the central bank put together. 

But the main point I want to make is that the approach I recommend changes everything very gradually. At the moment of introducing the new system, paper currency starts at par, just as it is under the current system. Even at a quite low nominal interest rate of -4% per year, the value of paper currency relative to electronic money would only be changing by about 1.1 basis points per day. For example the exchange rate would go from 1000 electronic dollars per 1000 paper dollars on day zero to 999.89 electronic dollars per 1000 paper dollars the next day–an 11 cent paper currency deposit fee on $1000. The paper currency deposit fee on $1000 would escalate by roughly 11 cents each day, to 22 cents, then 33 cents, etc., until compounding kicked in a little more to make the absolute amount of the addition to the fee each day a little less. (Note that to fully establish the exchange rate, the paper currency deposit fee is levied on net deposits, meaning that on the day a deposit by a private bank at the Fed’s cash window of p$1000 would become e$999.89 in the bank’s reserve account, a withdrawal of p$1000 would only result in a deduction of e$999.89 from the bank’s reserve account. Or if the bank wanted to withdraw e$1000, it would receive something close to p$1000.11.)

Of course, 1.1 basis points per day adds up over time, so this is a big deal. My point is not to minimize the importance of what is being done with the exchange rate between paper currency and electronic money, but to say that the exchange rate is moving very gradually each day. There is plenty of time for people to get used to the new system. And the continuity from one day to the next means that for private agents, behaving more or less as they did yesterday is a viable option until they figure things out. By the time they figure things out, the system already has a track record of day after day looking stable. 

All of the above is to argue that getting paper currency out of the way of negative interest rates will not cause any drastic change in behavior. The electronic negative interest rates themselves can and should cause a significant change in behavior–after all, the point is to stimulate the economy, as was needed in 2009 in the US, and as is needed now in the eurozone and in Japan. But I suspect that central banks will be fairly gradual in going to deeper negative rates as well. If the Swiss National Bank goes to deeper negative rates, for example, I will be surprised if the next step down from -.75% per year is to any lower than -1.25%. (And it is even more unlikely that the next step down would be to lower than -1.5%.) 

Gradualism in going to deeper negative rates, (associated with gradualism in lower the paper currency interest rate to get paper currency out of the way) has costs in the slowness of the extra stimulus, but it tends to allay the kinds of worries that Tony is expressing. If the first step down in the paper currency interest rate is to -.5%, at that rate, after a full quarter, the paper currency deposit fee would only by 1/8 %, meaning that the exchange rate was .99875 electronic dollars per paper dollar after three months. That is nowhere near as disruptive as many other things central banks have done in the past, such as the sudden change in the exchange rate for the Swiss Franc back in January, 2015 (which I wrote of in my column “Swiss Pioneers! The Swiss as the Vanguard for Negative Interest Rates.”)

Patrick Goodney: The Fed Should Raise Its Target Rate Before the End of 2015

Patrick Goodne

Patrick Goodne

I am delighted to be able to start another season of student guest posts with this guest post by Patrick Goodney. The students in my “Monetary and Financial Theory” class are required to do 3 blog posts each weak during the semester. From among the best of these I choose some to be guest posts here. (You can see the class assignment and resource blog here, and links to student guest posts from previous semesters here.)  Patrick’s post below is the first student guest post this semester. 

I have a different take on the current monetary policy situation than Patrick, as you can see from my post “Larry Summers: The Fed Looks Set to Make a Dangerous Mistake by Raising Rates this Year,” but I thought Patrick made the case for raising the Fed’s target fed funds rate sooner rather than later as well as anyone else I have seen. This guest post is a good starting point for the debate. Here is Patrick:

Increasing the federal funds rate before the end of the year would increase the Fed’s credibility and would remove some of the harmful speculation on their plans for the future. It would also be a good start to believing we’re finally out of the shadows of the Great Recession.

In June, the Fed projected to “raise the short-term federal-funds rate from near zero now to 1.625% by the end of 2016 and to 2.875% by the end of 2017,” according to The Wall Street Journal. Many were expecting the Fed to take the first step in hiking rates during their mid-September meeting. However, the near-zero rate persisted. The seemingly apprehensive Fed has many wondering: if the Fed is planning on gradually increasing interest rates, when exactly are they going to actually start?

The common thread through recent media reports on the Fed is a lack of confidence in their ability and willingness to effect change. There is some extreme pessimism about the odds of an increase in the federal funds rate this year. Futures market traders put the probability of a federal funds rate increase before the end of the year at just 35%, according to Jon Hilsenrath and Ben Leubsdorf of The Wall Street Journal. There is some extreme pessimism that an increase now would be good for the economy. Many say that the economy still needs the support of a near-zero interest rate. And there is even pessimism that the Fed isn’t actually able to change the federal funds rate at all.

Matt Phillips argues in Quartz that the Fed’s ability to impact the federal funds rate is uncertain, saying that “in the near decade since [the last time the Fed increased interest rates], pretty much every rule, technique, and guideline the Fed once relied on has been drastically rewritten, revamped, or removed.” Phillips says that the Fed would be working with an entirely new toolbox when it comes to increasing interest rates, and that any outcome resulting from using this toolbox is part of “the greatest monetary experiment in history.”

So there exists significant doubt about the Fed’s power in general, to say the least. The low federal funds rate has persisted so long many are taking it for granted. And the economy is continuing to perform very well—The Wall Street Journal reported yesterday that “The nation’s gross domestic product, the broadest measure of economic output, revved up to a 3.9% seasonally adjusted annual growth rate in the second quarter.” The continued success of the economy is some of the reason why the Fed is planning on increasing rates. The Fed’s policies come with a lag—“If it waits too long, [Federal Reserve Chairwoman] Yellen said, the Fed might end up having to raise rates abruptly to stop the economy from overheating,” write Hilsenrath and Leubsdorf. So surely some change in the interest rate will be inevitable.

One reason why this increase in the federal funds rate should happen sooner rather than later is because, frankly, the Fed needs to show some signs of life in order to gain some credibility and to also prevent speculative forces that lead to “inappropriate risk-taking that might undermine financial stability,” using some more words from Chairwoman Yellen.

The announcement of an increase before the end of the year would be a signal to consumers that we are finally okay again and is a first step to getting the Fed on the path they’re heading towards anyways. The Fed has been taking lashes that they’re unable to change anything, and by announcing that they’re at least going to try, before many are expecting them to, they’ll clear out a lot of the associated negative conceptions about the market. It would be a boon to consumer confidence if there are reports of the Fed believing we do not need the support of a low federal funds rate anymore (perhaps partially mitigating the contractionary effects of the rate hike). The Fed would get more respect as an entity—or maybe less disrespect—by surprising the market with a relatively dynamic decision on their end. And hopefully we would get bogged down by less thinkpieces about how the Fed can’t do anything at all anymore (although that would be unlikely).

So, Fed, silence the critics and let the media write about how America’s finally bounced back, because even if the Fed doesn’t fully believe that to be true, saying it will make it closer to a reality than living in between.