Why I Am Not a Neoliberal

Link to the article above

Link to the article above

Without looking at the details, I would have thought that I was a Neoliberal. Indeed, I have a Storify story "The Time Miles was Called a "Neoliberal Sellout" by Matt Yglesias and was Glad for the Compliment in the End." But digging deeper, I am now not at all sure I am a Neoliberal. Let me consider point by point where I agree with Neoliberalism and where I disagree.

Whole books have been written on Neoliberalism, but I haven't read them. So let me take Mike Konczal's take on Neoliberalism in his excellent Vox essay "'Neoliberalism' isn’t an empty epithet. It’s a real, powerful set of ideas" as a rough-and-ready definition of Neoliberalism. My discussion of whether I am a Neoliberal or not will only be relative to Mike Konczal's description of Neoliberalism there. If Neoliberalism moves in the direction of Supply-Side Liberalism as laid out in all of the posts in this blog, so much the better. But historically, Neoliberalism seems to have many differences from my version of Supply-Side Liberalism. 

Early on in his essay, Mike Konczal cautions:

The difficulty of the term ["Neoliberalism"] is that it’s used to described three overlapping but very distinct intellectual developments.

                                                      Moving to the Political Center

The first of these three intellectual developments was political:

In political circles, ["Neoliberalism" is] most commonly used to refer to a successful attempt to move the Democratic Party to the center in the aftermath of conservative victories in the 1980s. [One] can look to Bill Galston and Elaine Kamarck’s influential 1989 The Politics of Evasion, in which the authors argued that Democratic “programs must be shaped and defended within an inhospitable ideological climate, and they cannot by themselves remedy the electorate's broader antipathy to contemporary liberalism.”

To me, this is just democracy in action—when political entrepreneurs don't get blinded by their own personal ideology. Ignoring the views of close to half the electorate can be politically dangerous. You can see some of my views about the partisan divide abroad and in the US in

Personally, I have a great deal of sympathy for many (but by no means all) "Conservative" arguments. 

                                                         The Washington Consensus

Mike Konczal continues: 

In economic circles, however, “neoliberalism” is most identified with an elite response to the economic crises of the 1970s: stagflation, the energy crisis, the near bankruptcy of New York. The response to these crises was conservative in nature, pushing back against the economic management of the midcentury period. It is sometimes known as the “Washington Consensus,” a set of 10 policies that became the new economic common sense.

It is this “Washington Consensus” that I most want to put under the microscope. John Williamson's 1990 Peterson Institute of International Economics paper "What Washington Means by Policy Reform" is the touchstone Mike Konczal refers to for the "Washington Consensus." Looking at this document, one can see that, to this day, when policy folks talk about "structural reform," they are often talking about reform in line with the  "Washington Consensus." 

1. Fiscal Discipline

Fiscal discipline is the first tenet of the Washington Consensus. (All of this about the Washington consensus is "according to John Williamson in 1990.") I am a fiscal hawk in the sense that I worry quite a bit about the national debt. You can see this in my early post "Avoiding Fiscal Armageddon." Yichuan Wang and I interpreted the data as providing no support for the idea that national debt lowers GDP growth in "After Crunching Reinhart and Rogoff's Data, We Found No Evidence High Debt Slows Growth," but there we write:

We don’t want anyone to take away the message that high levels of national debt are a matter of no concern. As discussed in "Why Austerity Budgets Won't Save Your Economy," the big problem with debt is that the only ways to avoid paying it back or paying interest on it forever are national bankruptcy or hyper-inflation. And unless the borrowed money is spent in ways that foster economic growth in a big way, paying it back or paying interest on it forever will mean future pain in the form of higher taxes or lower spending.

What I said in "Why Austerity Budgets Won't Save Your Economy" is: 

To understand the other costs of debt, think of an individual going into debt. There are many appropriate reasons to take on debt, despite the burden of paying off the debt:

  • To deal with an emergency—such as unexpected medical expenses—when it was impossible to be prepared by saving in advance.

  • To invest in an education or tools needed for a better job.

  • To buy an affordable house or car that will provide benefits for many years.

There is one more logically coherent reason to take on debt—logically coherent but seldom seen in the real world:

  • To be able to say with contentment and satisfaction in one’s impoverished old age, “What fun I had when I was young!”

In theory, this could happen if when young, one had a unique opportunity for a wonderful experience—an opportunity that is very rare, worth sacrificing for later on. Another way it could happen is if one simply cared more in general about what happened in one’s youth than about what happened in one’s old age.

Tax increases and government spending cuts are painful. Running up the national debt concentrates and intensifies that pain in the future. Since our budget deficits are not giving us a uniquely wonderful experience now, to justify running up debt, that debt should be either (i) necessary to avoid great pain now, or (ii) necessary to make the future better in a big enough way to make up for the extra debt burden. 

My worries about the national debt are also an important impetus behind my arguing for a public contribution program, as introduced in "No Tax Increase Without Recompense" and developed in other posts linked in my bibliographic post "How and Why to Expand the Nonprofit Sector as a Partial Alternative to Government: A Reader’s Guide."  

But what about fiscal stimulus? I am firmly of the view that, other than automatic stabilizers (such as taxes that go up with income and benefits that increase with low income), monetary policy should take on the primary stabilization role. One of my signature efforts has been to figure out the most practical and acceptable possible ways to eliminate the zero lower bound. My organized bibliography for that effort is "How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide." Once a central bank's target interest rate can go as low as necessary, aggregate demand is no longer scarce. So there is no excuse for a government to then run deficits beyond those induced by automatic stabilizers to stimulate the economy.

    There are three exceptions to this generalization. First, as part of the monetary policy transmission mechanism, the fiscal arm of the government should spend most of the windfall from reduced interest expenses when interest rates go down and cut back spending to compensate for higher interest expenses when interest rates go up. (See "Negative Rates and the Fiscal Theory of the Price Level.") Most governments will do this without extra prompting. Ideally, the government should also do some intertemporal substitution in spending that responds to high or low interest rates in the way that would be optimal for a private corporation. Governments have been surprisingly slow to do this.

    Second, in a monetary union such as the euro zone, where countries in disparate economic situations share monetary policy, an individual nation might need to use some sort of fiscal stimulus. For that I recommend the kind of credit policy I discuss in my paper "Getting the Biggest Bang for the Buck in Fiscal Policy," which is introduced in my blog post of the same name. The abstract for the paper clarifies the key issue for fiscal hawks who see the need for some stimulus:

    In ranking fiscal stimulus programs, it is useful to focus on the ratio of extra aggregate demand to extra national debt that results. This note argues that (because of repayment after the end of a recession) “national lines of credit”--that is, government-issued credit cards with countercyclical credit limits and favorable interest rates—would generate a higher ratio of extra aggregate demand to extra national debt than tax rebates. Because it involves government loans that are anticipated in advance to involve some losses and therefore involve a fiscal cost even after efforts to minimize losses, such a policy lies between traditional monetary policy and traditional fiscal policy.

    Third, because monetary policy has a lag of 9 months or so in its effects, the same kind of credit policies can be of some value in the first few quarters after an unexpected shock.

    Other than these exceptions, I come down decisively in favoring monetary policy over fiscal policy for economic stabilization. See for example:

    On the other hand, I do not always look like a fiscal hawk. In "What Should the Historical Pattern of Slow Recoveries after Financial Crises Mean for Our Judgment of Barack Obama's Economic Stewardship?" I strongly criticize Barack Obama for not politically prioritizing and pushing through a larger fiscal expansion in 2009. At that time, the fact that interest rates could go as far negative as needed with easy-to-implement policies was not well understood, so Barack Obama should have done at least three times the amount of fiscal stimulus that he did historically. Because he didn't, a big part of the harm of the Great Recession in the US was his fault. The political prioritization necessary to get a bigger fiscal stimulus package through could easily have meant not getting the Obamacare legislation in anything close to the actual "Patient Protection and Affordable Care Act" through. But to me, avoiding a significant part of the harm of the Great Recession at the cost of being forced to proceed with health care reform on a more bipartisan basis seems the better choice.  

    On a more technical issue, I believe strongly that there should be a separate capital budget for national governments. Noah Smith and I argue this in "One of the Biggest Threats to America's Future Has the Easiest Fix" and I have thought hard about technical details of how to make a capital budget work well by keeping incentives to game the system mostly in check: see my powerpoint file "The Applied Theory of Capital Budgeting," which I presented at the Congressional Budget Office in May 2014. My post and the associated Powerpoint file "Discounting Government Projects" addresses another technical issue in capital budgeting. 

    2. The Composition of Public Expenditures

    The second tenet of the Washington Consensus is that health, education and infrastructure spending are especially good types of public expenditure and that indiscriminate subsidies are especially bad types of public expenditure. Here I am in total agreement. 

    3. Tax Reform

    For the most part, I don't want to talk about the current Republican tax reform plans being hatched in the House and Senate today. Those plans are a mix of very bad measures with some good technocratic measures. But I am sympathetic to widely agreed-upon principles of tax reform. John Williamson writes:

    .. there is a very wide consensus about the most desirable method of raising whatever level of tax revenue is judged to be needed. The principle is that the tax base should be broad and marginal tax rates should be moderate.

    I favor the more transparent approach of taxing the rich people who (for the most part) own corporations rather than the opaque approach of taxing the corporations themselves. And I favor consumption taxation, as you can see in "Scrooge and the Ethical Case for Consumption Taxation" and "VAT: Help the Poor and Strengthen the Economy by Changing the Way the US Collects Tax." 

    I do not depart from the Washington Consensus here. 

    4. Real Interest Rates Market-Determined and Positive

    According to John Williamson, a fourth tenet of the Washington Consensus is that real interest rates should be market-determined, positive and moderate. Distinguishing between the short-run, medium-run and long-run as I do in "The Medium-Run Natural Interest Rate and the Short-Run Natural Interest Rate," in the medium-run and long-run, I certainly agree that interest rates should be market-determined. But a market-determined medium-run or long-run rate may or may not be positive. As John Williamson himself wrote in 1990:

    The question obviously arises as to whether these two principles are mutually consistent. Under noncrisis conditions, I see little reason to anticipate a contradiction.

    With policy heavy-weights such as Larry Summers and Olivier Blanchard talking about secular stagnation, I think the Washington Consensus may be moving toward realizing that situations where real interest rates need to be negative in the long-run are quite possible. 

    I fully agree that there are many bad market interventions that push some interest rates down. A good example is the low interest rates given by state-owned banks to state-owned enterprises in current Chinese policy. These divert funds away from the non-state sector, raising the rates in the non-state sector, thereby making it harder for households and private businesses to borrow. 

    In the short-run, the idea that interest rates should be market-determined and positive is not helpful. First, I see it as inevitable that some sort of monetary policy be central to interest-rate determination. There is no neutral "free-market" monetary policy. The gold standard is not a neutral monetary policy. The closest it is possible to come to a free-market monetary policy is for the central bank to do its best to get the economy quickly back to the natural level of output, the natural level of unemployment and the natural interest rate. I advocate that strongly, as you can see in my paper "Next Generation Monetary Policy." 

    Second, I believe negative rates—both real and nominal—are crucial for cutting short recessions and enabling a lower inflation target. See "How Subordinating Paper Currency to Electronic Money Can End Recessions and End Inflation."

    5. Free Capital Flows

    Here I think the "Washington Consensus" shifted between when John Williamson was writing and now. I feel there has been more and more emphasis not just on competitive exchange rates, but also free capital flows. Here I favor a more managed version of international capital flows than the current consensus. See "Alexander Trentin Interviews Miles Kimball about Establishing an International Capital Flow Framework." 

    6. Free Trade

    I am in favor of free trade. Here I am in agreement with the Washington Consensus. But, in something the Washington Consensus did not push, I think the benefits are much greater for freer immigration than from freer trade. See ""The Hunger Games" Is Hardly Our Future--It's Already Here." But as I mentioned above, I think international capital flows should be better managed in order to get more balanced trade:

    7. Foreign Direct Investment

    I agree that encouraging foreign direct investment is a good thing. For many countries it is a very good thing. Looking at things from the standpoint of countries doing foreign direct investment, one of my favorite essays is "Nicholas Kristof: "Where Sweatshops are a Dream." 

    8. Privatization

    I agree that many enterprises are better run privately than by the government. But privatization of core government functions such as prisons has often led to very poor quality. For a country like the US, if further privatization took place, my guess is that it would be more likely to move in the wrong direction than in the right direction. 

    Part of the problem with privatization of core government functions is the great danger of corruption in government contracting. Suppose I define: 

    • core government function = something where if it isn't done by the government itself, the the government needs to contract with a private firm for the service.

    Then one needs to consider whether any inefficiency of having the government do the job itself is outweighed by the likely corruption in the contracting relationship. 

    In what might seem, but isn't, a view antithetical to a pro-privatization view,  I think the US government should take a much bigger role in bringing down the risk premium with a sovereign wealth fund, which would involve it owning, at least indirectly, a large amount of stock. See:

    The reason a sovereign wealth fund wouldn't violate the principle of avoiding undue government meddling is that it would be required to hold only ETFs that had no voting rights. 

    9. Deregulaton

    Regulation is one of the areas where I most strongly disagree with the Washington Consensus. I think capital requirements/leverage limits are much too loose. I have said this strongly many times.  "Martin Wolf: Why Bankers are Intellectually Naked" is a good post to start with. I have also cheered on the efforts of the Consumer Financial Protection Bureau under Richard Cordray. I give the philosophical justification for the type of regulation done by the CFPB in "On the Consumer Financial Protection Bureau." I also think there are many types of wealth that are ill-gotten, even though they are legal. See "Odious Wealth: The Outrage is Not So Much Over Inequality but All the Dubious Ways the Rich Got Richer."

    On the other hand, at the state and local level, regulation is often used as a tool to keep the poor from living next door or competing with middle-class jobs. That is, state and local regulation is often effectively a tool of oppression. I write about the common impulse behind immigration restrictions at the national level and land-use and occupational licensing restrictions at the state and local level in "Keep the Riffraff Out!"

    Affordable housing in desirable cities for all the people who want it requires an adequate total amount of housing. That in turn requires allowing needed construction. In "Building Up With Grace," I call for every substantial city to have some district with no height limits that has excellent bus service to the rest of the city. This is for the sake of those of modest means who want to live and work in the city. (Genuine earthquake dangers might lead to some height limits, but these should not be used as an excuse beyond genuine safety needs.)

    In relation to regulatory restrictions on construction, I find myself in sympathy with the great bulk of posts on the excellent Facebook group "Market Urbanism." I highly recommend it. 

    I should note that allowing more construction has financial stability benefits as well as benefitting social justice. See "With a Regulatory Regime That Freely Accomodates Housing Construction, Lower Interest Rates Drive Down Rents Instead of Driving Up the Price of Homes." 

    Occupational licensing requirements often keep those at the bottom of the heap out of jobs, as I discuss in my post “When the Government Says “You May Not Have a Job.” The extent to which this is done in practice is unconscionable. Fortunately, occupational licensing reform efforts are afoot. But these efforts could easily stall out. This is an important area to focus on. 

    For those who haven't thought much about occupational licensing, there are two key related points to take away. First, occupational certification and occupational licensing are not the same thing. In "John Stuart Mill: Certification, Not Licensing" I write:

    As for licensing itself, although they are often spoken of in the same breath, there is a world of difference between certification and licensing. Certification requirements say that you have to inform customers of your level of qualifications or lack of qualifications in unmistakable ways, according to a well-defined terminology established by the government. They are based on the principle of telling the truth and not deceiving, but do entail some details to make sure no one misunderstands. 

    By contrast, licensing requirements say you can be fined or thrown in jail for getting paid for something that someone with an absolutely crystal clear idea of your lack of qualifications is perfectly happy to pay you to do. For example, I would run afoul of the law in Michigan if I cut someone else’s hair for pay–a law ultimately backed up by the threat of throwing me in jail, even if the initial penalty is only a fine. The real reason for that stipulation is that barbers want that barrier to entry in place (I think at least a year and a half of training), not any danger that I will seriously harm someone with a basic haircut. I express some of how wrong I think the overgrowth of licensing requirements is in my post “When the Government Says “You May Not Have a Job'."

    I have no problem with certification—it simply makes things clear. But I do have a problem with licensing, which says to people "You may not have a job" unless they devote time and money to training they may not be able to afford.

    (Update: See also my December 5, 2017 post "Against Occupational Licensing.")

    For practical reform efforts, the second key point to make about occupational licensing is that establishing a low-hurdle licensing category in each general type of job has many of the good effects of having a certification regime instead of a licensing regime. It isn't too harmful to require that "barbers" have a year and a half of training if there is also an occupational licensing category of "haircutter" that requires only a week of training, and haircutters are legally allowed to do everything that barbers are allowed to do. In that case "barber" would indicate someone highly trained, which is useful, but barbers and haircutters would still compete. 

    My post "Against Anticompetitive Regulation" discusses other regulatory issues as well. The title of that post indicates the very first question you should ask about any regulation: "Is the regulation about keeping everyone honest, or is it about keeping down the competition?"

    Crucially, "keeping everyone honest" doesn't mean "ensuring high quality." If someone honestly signals that what they are selling is low-quality but inexpensive, they should be allowed to sell their honestly low-quality goods and services.

    Overall, more regulation is needed of the financial industry; less regulation is needed for service jobs and housing construction. And it is important to watch out for firms running to the government to get the government to put an obstacle in the way of a potential competitor. Finally, regulations that make corporate deception illegal are almost always a good thing. After all, the key welfare theorems suggesting that a free market will do a good job all rely on people knowing and understanding the truth! (General anti-fraud principles in the legal code are helpful, but often don't do enough.)

    10. Property Rights

    There are many virtues to property rights as they exist in the United States. But I think we have gone much too far with intellectual property rights. See:

    One of the bad aspects of trade negotiations in the last few years has been the emphasis by the United States on imposing its dysfunctional intellectual property system on the rest of the world. (See Dani Rodrik on one aspect of that here.) The United States should get its own house in order on intellectual property, and only then recommend its intellectual property system to other nations. 

    On property rights more generally, I think if, by a high standard of proof, an action can be shown to be a bad action that should have been prohibited in the past, then taxing away the wealth resulting from that action is appropriate. If done right, this has good incentives: companies and people will try to avoid doing things that people in the future will realize were wrong. However, there may need to be some statute of limitations on this.

    And where uncertainty about future legal treatment stands in the way of important investments, the government may need to provide better guarantees of future legal treatment. I am thinking here of the development of self-driving cars, that could be seriously hindered if there were too much legal uncertainty. Fortunately, that seems to have been avoided. 

                                                Markets Defining More and More of Our Lives

    Leaving the Washington Consensus, the last of the three meanings of "Neoliberalism" Mike Konczal writes of is markets defining more and more of our lives:

    The third meaning of “neoliberalism,” most often used in academic circles, encompasses market supremacy — or the extension of markets or market-like logic to more and more spheres of life. This, in turn, has a significant influence on our subjectivity: how we view ourselves, our society, and our roles in it. One insight here is that markets don’t occur naturally but are instead constructed through law and practices, and those practices can be extended into realms well beyond traditional markets.

    Another insight is that market exchanges can create an ethos that ends up shaping more and more human behavior; we can increasingly view ourselves as little more than human capital maximizing our market values.

    Here let me break out as a distinct problem the idea that companies should only be concerned about maximizing shareholder value. Even if "obeying the law" is added as a constraint on that goal, it still leads to serious problems, as corporations look for every possible loophole to maximize shareholder value even at the expense of social welfare. Although it isn't perfect, a much better goal for big companies, quite consistent with economic theory, would be to maximize the overall welfare of those people who hold index funds covering all the public companies in the nation or in the world.  

    In his book Finance and the Good Society, Robert Shiller speaks approvingly of legal structures for corporations that stipulate that a given corporation should pursue goals beyond shareholder value maximization. This is likely to be helpful where it is used.

    But what is most needed is for business school professors to quit teaching that maximizing shareholder value is the be-all and end-all duty of those who run public corporations—perhaps with obeying the law as an added duty. I am not at all satisfied with the alternatives proposed by most of those who want companies to pursue something other than shareholder value maximization. In the immediate future, I think what I mentioned above—"maximizing the overall welfare of those people who hold index funds covering all the public companies in the nation"—would be a good alternative to shareholder value maximization in business school instruction. With thought, I have no doubt that careful thinkers can come up with an even better alternative that still has some of the hard edge of economic theory but that is even more conducive to social welfare. 

    More specifically on the issue of markets defining more and more of our lives, I think economists need to appreciate more all of the non-monetary motives that drive people. I wrote about this in "Scott Adams's Finest Hour: How to Tax the Rich." In addition to affecting taxation and being a big part of the argument for the public contribution program I have proposed in order to expand the non-profit sector, non-monetary motives are a key reason why current copyright law is off-track, as discussed in my post "Copyright." 

    Religious motives are good examples of non-monetary motives though far from the only non-monetary motives. Personally, I know well how powerful non-monetary motives can be from my forty years as a Mormon. (See "Five Books That Have Changed My Life.") The posts I noted there can help you appreciate how big a difference non-monetary motives can make:

    Also see this Bloomberg View article by Megan McArdle:

    The biggest share of my research time is currently being devoted to collecting and analyzing data in order to write a paper with the working title of "What Do People Want?" with Dan Benjamin, Kristen Cooper and Ori Heffetz, supported by a brilliant and capable team of research assistants: Becky Royer, Tuan Nguyen, Tushar Kundu, Rosie Li and (early on) Samantha Cunningham, and by heavy-duty coding support from Robbie Strom and Itay Zandbank. That exercise demonstrates well how many things people care about—of which only some can be purchased in the market. I hope to share some of our latest results in a few months. But for now, take a look at the results from an earlier round of data collection that I discuss in "Judging the Nations: Wealth and Happiness Are Not Enough."

    It is a big mistake to think that people only care about things that can be bought and sold. Acting as if people do care only about things that can be bought and sold impoverishes our interactions with one another. 

    Markets are useful tools, but they have downsides as well as the many upsides that we teach in economics courses. 


    There are many areas where I agree with Neoliberalism. But I disagree with Neoliberalism in important areas:

    • the need for more financial regulation (particularly the need for stricter capital requirements and leverage limits and more regulation in the domain of the Consumer Financial Protection Bureau)
    • the need for negative interest rates
    • the need for international capital flow policies that lead to more balanced trade
    • the need for less restrictive intellectual property law
    • the perils of corporate decision-makers believing their job is "shareholder value maximization"
    • the downsides of excessive marketization—and even more the downsides of having a view of human beings as motivated almost entirely by the things money can buy
    • the prevalence of ill-gotten legal wealth in countries like the US
    • the virtues of (possibly debt-financed) sovereign wealth funds as a policy tool for countries such as the US, Japan, the UK and many other European countries 

    These differences seem important enough that I do not consider myself a Neoliberal. Supply-Side Liberalism is not Neoliberalism. It is a different animal. 





    Why I Am Now a Bear

    image source

    image source

    On August 1, 2012, I wrote "Why My Retirement Savings Accounts are Currently 100% in the Stock Market." (This was the post that Mitra Kalita noticed and motivated her to invite me to write for Quartz when it started up.) Today's post is an update on "Why My Retirement Savings Accounts are Currently 100% in the Stock Market."

    John Hussman had the office next to me at the University of Michigan in the 1990's. By at least 1998, he was saying that the stock market was quite overvalued. Thanks to him, I was out of the market in 2000. I pulled out of the market a couple of years before the 2000 peak. The techniques John is using can't time market peaks exactly, they simply tell if the market is overvalued or undervalued.

    On March 6, 2017, John put up a blog post entitled "The Most Broadly Overvalued Moment in Market History." Take a look at his first graph, of the expected 12-year stock-market return his equation predicts. In the graph, you can see the low expected stock returns that caused me to pull out of the stock market in about 1998. You can also see the low expected stock returns in the 12-year period beginning now. Of course, those returns need to be compared to what one could get in the bond market or other available investments.  For clarity in thinking, I like John's approach of first determining expected return on stocks, then comparing with bonds.

    I read John's post last Wednesday morning (March 8), and found it convincing. So I changed my main account (my University of Michigan defined contribution pension)


    • 58.07% US Index Fund (FID TOT MKT IDX INS)
    • 26.65% International Index Fund (FID INTL INDEX INS)
    •  9.05% Real Estate Investment Trust Fund (VANG REIT IDX INST)
    •  6.24% Emerging Market Index Fund (VAN EM MKT ST IDX IST)


    • 50% Money Market Fund (VANG TREASURY MM)
    • 50% Real Estate Investment Trust Fund (VANG REIT IDX INST)

    (I was careful to choose a money market fund with a low expense ratio. There were high-expense money market funds available from Fidelity that I avoided.) For me, this was a very conservative portfolio. I didn't have time that morning to change a couple of smaller accounts (my NBER defined contribution pension and my new University of Colorado Boulder defined contribution pension) that combined would only be a fraction as large. 

    I reported the action I had taken with that retirement account on Facebook and received some useful feedback. Reminding everyone that everything on my Facebook page is totally public, let me share some of that feedback with you. The best advice was from Einer Richard Elhauge, who wrote:

    Terrific article and great analysis of the problem. But a few questions on the remedy. Vanguard Reit PE is 26. Isn't that just as overvalued and likely to collapse? The yield for Vanguard Treasury MM is 0.5% -- even less than the 1% yield this article predicts for US stock market. Why isn't a better remedy switching to foreign stocks?

    I replied:

    I am worried that border adjustment will cause the dollar to appreciate and hurt the dollar value of foreign stocks. Long-run Treasuries I am worried will come down when QE is unwound. Obviously, I need the market to come down in a lot less than 12 years for having money in T-bills to make any sense. Does anything have a below normal P/E?

    I am very much a devotee of international diversification, as you can see in "Why My Retirement Savings Accounts are Currently 100% in the Stock Market." But I figure I don't need to take on the risk of whether border adjustment goes through or not—a risk that should be resolved within a 6 months time, I hope. You can see more of my thinking about border adjustment in my post "Border Adjustment vs. Dollar Depreciation." (Also see Olivier Blanchard and Jason Furman's post  "Who Pays for Border Adjustment? Sooner or Later, Americans Do," which addresses a question I have been thinking about in a way similar to my thinking:)

    Many people scolded me for trying to do market timing. My response to that is a bit subtle. As I wrote in "Robert Shiller: Against the Efficient Markets Theory":

    Can You Succeed at Contrarian Market Timing? The one thing I would add here to what Bob says is this about market timing. Some of Bob’s work, some of it joint with John Campbell, suggests that contrarian market-timing can be a good idea. In particular, their work suggests increasing one’s stock holdings when the price/dividend ratio is low and reducing one’s stock holdings when the price/dividend ratio is high. (Bob has also used the ratio of price to cyclically adjusted earnings or smoothed earnings as a way of gauging if the market is high and likely to fall or low and likely to rise.) I believe this works and try to do it myself. But it is hard to do without a contrarian personality. What makes the market too high is that some story is making people optimistic about the market–a story that is likely to infect you as well; what makes the market too low is that some story is making people pessimistic about the market–again a story likely to infect you as well. So doing any market timing subjects you to the danger of succumbing to the stories out there that, because most other people are succumbing to them at the same time, will make you likely to buy high and sell low. It is only if you naturally like stories other people don’t like and dislike stories that they like that you can be a contrarian investor without great intellectual and emotional self-discipline.

    In other words, if the market is not fully efficient, it is because a mass of traders—whom I will call "noise traders"—are pushing it away from efficiency in a way that necessarily involves them buying high and selling low. So if the market is not efficient a lot of money has to be doing things exactly wrong. Therefore, anyone who is going to follow the herd will lose by trying to time the market. And unavoidably, most people who time the market must be following the herd—otherwise there wouldn't be a herd generally going one way. So it is absolutely right that it is generally good advice not to time the market. However, if one has a contrarian personality and finds it easy to go against the herd, then it should be a good idea for one to do some market timing, at least to go against serious mispricing. I consider myself to have a contrarian personality that finds it easy to go against the herd, so I am not worried in general about doing some market timing.

    Consciously in response to Einer's arguments, and perhaps unconsciously in response to some of the scolding about market timing (which I don't rationally agree with), I decided I had overreacted and changed my portfolio allocation in my main account to

    • 35% Real Estate Investment Trust (VANG REIT IDX INST)
    • 33% Money Market Fund (VANG TREASURY MM)
    • 30% US Index Fund (FID TOT MKT IDX INS)
    • 1% International Index Fund (FID INTL INDEX INS)
    •  1% Emerging Market Index Fund (VAN EM MKT ST IDX IST)

    (Revising my real estate investment holdings again so soon got me a scolding from the Fidelity computer for making a "roundtrip" on those real estate investment trusts.) My other much smaller accounts are mostly in that emerging market index fund. Despite the danger of a loss there because of border adjustment pushing the dollar up, I have always liked to have some in emerging market funds for diversification, and that fund has been flat for so long, it seems less likely to be overvalued. The 1% holdings are to help me remember the names of the funds I want to get back into once the uncertainty about border adjustment is resolved. 

    I don't want to stay in Treasury bills very long (the money market fund), but these early months of the Trump administration seem like a time of yuge policy uncertainty. (People talked a lot about policy uncertainty under Barack Obama, but get real—isn't there more policy uncertainty right now?) So I am willing to accept a very low return on almost 1/3 of my visible portfolio until we see a little better what the Trump administration will do in economic policy. And the Fed will raise rates enough that the insurance premium I am implicitly paying will go down somewhat. 

    Despite its relatively high valuation, I am still hoping that a diversified real estate investment trust will act a bit like a bond that hasn't been pushed up as much in price as the bonds the Fed has been buying in QE. Indeed, I expect a real estate investment trust to owe some money in the form of long-term bonds, so I hope there is an aspect that is a little like shorting long-term bonds. I could be doing my analysis wrong, but that is where I am coming from.

    Also, I have some hopes that (a) real estate investment trusts are a bit safer than most stocks and so deserve a higher valuation than most stocks and (b) that the lingering psychological after-effects of the end of the house price bubble are still pulling down real estate investment trust valuations somewhat, so that I am not overpaying too much compared to other available investments. In any case, some substantial holdings of real estate seem sensible from the point of view of diversification.  

    In any case, things in general are at high enough valuations that it is not easy finding investments with the expected real rate of return that I would like to find. As usual in life, nothing is perfect. But you can see how I am muddling along in my portfolio decisions. 

    I would be glad for more feedback, especially from those who have gotten this far in reading this post. 

    Presidential Q&A: Is a Strong Dollar or a Weak Dollar Good for the Economy?

    Link to Angelo Young's February 14, 2017 Salon explainer "  Should the U.S. dollar be weak or strong? President Trump allegedly wants to know." 

    Link to Angelo Young's February 14, 2017 Salon explainer "Should the U.S. dollar be weak or strong? President Trump allegedly wants to know." 

    In his Salon article shown above, "Should the U.S. dollar be weak or strong? President Trump allegedly wants to know," Angelo Young reports: 

    According to two anonymous White House insiders, Trump recently called National Security Adviser retired Lt. Gen. Mike Flynn at around 3 a.m. to ask whether a strong or weak dollar is good for the economy.

    Angelo invited me to answer the President's question. Here is the answer I gave in full, an answer you can see reflected in several ways in Angelo's article:

    It is not right to say in an unqualified way that a "strong" dollar is good or to say that a "weak" dollar is good. It depends on why the dollar is strong or weak. The dollar tends to be stronger

    a. if opportunities for investing in the US are good

    b. if demand for US products is high

    c. if US saving is low

    d. if trade barriers make it hard to import things into the US

    Simplifying a bit, the first two (a & b) are good. The last two (c & d) are bad. 

    The best way to "improve" the US trade balance (that is, to reduce the trade deficit) is to encourage additional saving. (This will lead to a weaker dollar in a good way.) Encouraging more saving is surprisingly easy to do. And the extra saving has an especially big effect on the trade balance if people are encouraged to be diversified by including international mutual funds among their investments. I explain all of that in my Quartz column "How Increasing Retirement Saving Could Give America More Balanced Trade." (This column gives my recommendation to the President. I am explicit about that in my more recent post "Border Adjustment vs. Dollar Depreciation.")

    By the way, one of the reasons a strong dollar caused by trade barriers against imports is bad is that it defeats the intended benefit of improving the trade balance, but leaves the harms of the trade barriers. (There are other effects of trade barriers that create some winners among American citizens and some losers. Making some Americans lose to benefit other Americans may sometimes be part of the purpose of trade barriers. Trade barriers can rob Peter to pay Paul in this way despite the strengthening of the dollar.)

    On who benefits and who is hurt, again it depends on why. The strengthening of the dollar defeats most of the effect of trade barriers and border adjustment on the dollar. By contrast, increasing the saving rate works through the fundamental forces affecting the value of the dollar, and so succeeds. Such a policy would benefit most Americans--some by enhancing retirement security, others by increasing net exports and therefore the number of attractive jobs, others by the increase in the dollar value of their foreign investments. However, imports would become somewhat more expensive, hurting those who import foreign goods for a living and those who consume a lot of foreign goods. 

    (Trade barriers, unlike border adjustment, significantly hurts exporters and helps those who compete with imports.) 


    On the Consumer Financial Protection Bureau

    Link to James Freeman’s November 27, 2016 Wall Street Journal Article “Consumer Financial Protection Rewrite: The rogue bureau needs to be reined in if it can’t be killed.”

    Election results have created great uncertainty about the future of the Consumer Financial Protection Bureau (CFPB). Having paid close attention to relevant articles, I can say that the editorial board of the Wall Street Journal has displayed a venomous hatred of the CFPB. Below, I will address some genuine constitutional questions about the CFPB, but the Wall Street Journal is wrong about the policy value and policy appropriateness of the CFPB’s actions. 

    The Philosophical Basis for Consumer Financial Protection as Part of Limited Government

    I can see three principles that can justify consumer financial protection beyond simple contract enforcement: 

    Duping people is fraud even if they wouldn’t have been duped had they had infinite time and infinite intelligence. First let me argue that misleading people to their detriment by taking advantage of difficult-to-avoid finite cognition is a form of fraud. (See my post and paper “Cognitive Economics” on the argument that cognition is, in fact, finite and scarce.) Punishing fraud is viewed as a legitimate activity of limited government even in quite libertarian worldviews. For example, I recently read Robert Nozick’s Anarchy, State and Utopia. There, punishing fraud is viewed as something that careful vigilantes can legitimately do (see “Vigilantes in the State of Nature” on Robert Nozick’s views on vigilantes in general), and therefore something that the state can legitimately do. And I don’t think it is ultimately a winning argument to claim that something is not fraud because someone would have realized in advance all the flaws in the product that the seller knew if she or he had spent a wastefully large amount of time investigating something, or had had the acumen of Sherlock Holmes.

    Facilitating gain for oneself and harm to others by taking advantage of preexisting confusion is predation of those who are especially vulnerable. A more difficult case than duping people by taking advantage of their finite intelligence and finite time is taking advantage of people who show up already confused. Here the issue is the mental competence of someone to make a particular decision. It is important that people have a decisive way to demonstrate their mental competence so that declaring someone confused doesn’t become a way to sneak in blanket paternalism. Fortunately, economic models identify in their common assumptions what knowledge is crucial for making key decisions. It should be possible to develop online tests of that knowledge that regular people can take (and have a good chance of passing if they are determined to pass) to demonstrate their competence to make complex financial decisions. 

    It is legitimate to protect time-slices of people from serious injury by other time-slices of people. In blogging through John Stuart Mill’s On Liberty, I put forward the view that time-slices of individual’s can be viewed as relevant moral units, so that people can be legitimately protected from serious injury by their past selves: 

    The analogy I made was to the rules we have for children. Because most parents care deeply about the welfare of their children, the state should ordinarily show great deference to decisions parents make that affect their own children. But occasionally, a parent demonstrates so little concern for her or his own child that the child must be protected from the parent. Similarly, most people care deeply about their future selves, so the state should ordinarily show great deference to decisions people make that affect their future selves. But occasionally, someone is willing to sell her or his future self down the river. The future self, which is not around to defend her or himself, has a right to get help in trying to deter such an injury.

    Refuting Specific Allegations by Wall Street Journal Editorialist James Freeman

    On November 27, 2016, James Freeman wrote this about the CFPB:

    This lack of accountability has led to outrageous abuses, such as its attempts to regulate car dealers though Dodd-Frank expressly said that wasn’t a job for the bureau. Last year Rep. David Scott (D., Ga.) ripped the bureau’s “deceitful” attack on auto lenders for alleged racial bias based on “shamefully flawed” information. The bureau sued banks for discrimination after guessing the race of borrowers based on their last names and addresses. Internal documents reveal that the bureau gang knew their guesses were wildly inaccurate. So they discussed how to keep defendants they were smearing as racists from learning the truth.

    Then there is its attack on payday lenders though government research showed borrowers want such services and suffer when they aren’t available. 

    Racial discrimination by car dealers. As I understand it, the CFPB was put in an almost impossible spot by its originating legislation. (1) A legislative carve-out with no principled justification said it had no authority to prevent car dealers from duping people or taking advantage of their preexisting confusion, except that (2) the CFPB was supposed to investigate and work to prevent racial discrimination by car dealers. Finally, (3) the CFPB was prohibited from collecting information on the race of car buyers. What would you do if you had the job of investigating discrimination by car dealers without being able to ask about the race of car buyers is a very difficult task? You would have to use some kind of proxy for race. Using names and addresses could easily be close to the best you could do. (I have a hard time believing that the CFPB would only use last names, though. First names could be quite helpful in guessing race to provide evidence on racial discrimination.) I may be mistaken in my understanding, but if not, the fact that over quite a few editorials I have read in the Wall Street Journal on exactly this topic (of CFPB investigations of racial discrimination in car-buying), the Wall Street Journal never provided the background above is unconscionable. It make the editorials into hatchet jobs, not serious journalism. 

    Payday lending. Many who do payday borrowing are not well-informed about the high frequency of people making their financial situation worse by payday-borrowing. This counts as a preexisting confusion that makes the borrower less than fully competent to undertake the contract. Sometimes payday-lenders have key contract provisions that make a lot of money for them to the detriment of the borrower that they try to get the borrower not to pay attention to. That counts as duping the borrower. And sometimes, a payday borrower is, in all knowledge, selling her or his future self out. In all of these three cases, the borrower might well express a desire for a payday loan. So the fact that people say they “want such services” is only the beginning of the argument. It functions only as a reminder of the gravity of making the decision to regulate the purchase of something.  

    Indeed, if people are buying something without a gun to their heads, one already knows that they “want such services” in some sense. So there wouldn’t have been any discussion of regulation in the first place unless there was some reason to think regulation was appropriate even if, in some sense, people “want such services.” To put it even more bluntly, is even the most avid regulator ever even tempted to talk about regulating something that no one wants at all, so that even in the absence of regulation none is purchased? 

    Constitutional Issues

    Other than the possible issue of almost unfireable regional Fed Presidents who have not been confirmed by the Senate voting on monetary policy, the Fed has passed US constitutional muster. So it seems possible that the CFPB could be governed in a similar way without being unconstitutional. The court case against the CFPB in the article linked at the top suggests that if only the Chair of the Fed could vote, the Fed would be unconstitutional too. If that is, so, there could be more people appointed to govern the CFPB, just like the Fed. But in practice, the way the Fed is governed seems quite different in practice from the usual bipartisan board for government agencies. There is a real danger that with more governors the CFPB would become more like other agencies run by a “bipartisan” board rather than like the Fed. “Bipartisan boards” often seem in practice overly politicized, yet without real political accountability to the public because the party generating a result is obscured by the “bipartisan” nature of the boards. 

    To me, the constitutional case should involve a close examination of how well bipartisan boards for government agencies actually function. And it should take into account the value of political accountability in that whatever Richard Cordray, current head of the CFPB does, is something that a Democratic president–Barack Obama–is to an important extent accountable for by virtue of appointing Richard Cordray. 

    If there is a change to the CFPB’s governance in order to pass constitutional muster, I think it is better to make the head of the CFPB fireable by the President than to go to a bipartisan board or to put it under some other agency that has some other mission. Then the head or acting head of the CFPB still has some capacity for decisive action in an area that I believe still often needs decisive action and at least the measure of independence that comes from a president’s reluctance to have to go through an additional Senate confirmation process for a replacement.  

    Update: An In-Depth Reaction from a Reader

    Here’s another way to put your point about “infinite time and intelligence”: Pitting an ordinary consumer against a large financial firm that can hire the smartest graduates of Harvard or MIT to design their contracts and web interfaces, is like asking an ordinary tennis player to go up against Roger Federer (worse, actually, because unlike playing tennis, participating in financial transactions is unavoidable). Even if both consumer and firm have to abide by the same laws (“the rules of tennis are the same for Federer and his opponent”), it’s still not a fair contest.  Federer starts with enormous talent and then spends all of his time improving that skill (but, if he’s a bank, he can play a hundred million opponents at once). If there were an argument that enormous benefits accrued to society from having the financial firm (Federer) wipe the floor with the consumer, that would be one thing, but if it’s just a transfer from consumer to firm then it’s closer to theft than to commerce. There’s an interaction between this point and your second point about preexisting confusion. What the clever financial firm can do is to construct a “choice architecture” (otherwise known as a website) that deliberately leads people into making decisions that they don’t really need to make, but that are most likely to exploit areas of “preexisting confusion.” Or, even more perniciously, design their websites in ways that make it difficult for consumers to use tools that could help clear up their confusions or enlighten them about alternatives. In this last category, over the last year there has been a big push by many financial firms to make it hard or impossible for their clients to subscribe to services like Mint.com or Yodlee or Check.me; the banks say it is cybersecurity, but it’s very hard not to suspect that the real reason banks don’t want you to use Mint.com is because Mint.com sends you messages saying things like “hey, your bank just charged you a big fat fee that lots of other banks don’t charge.” In my view, this is one of the biggest consumer protection issues out there, but the press coverage of it has been mostly focused on terrifying people about “here’s another cyberthreat for you to worry about – your kindly bank is generously cutting you off from Mint.com so that the Russians won’t steal all your money.” The truth is that there are straightforward technological fixes to the security problems, but those fixes seem to have been deliberately blocked by specific firms who believe that it would hurt their bottom line to fix the security problems.
    Finally, on the supposed constitutional issues. For the reasons you mention and others, making the CFPB head fireable by the President is better than a “bipartisan commission” in which the Democrats appoint commissioners from Goldman Sachs and Citibank while the Republicans appoint commissioners from Merrill Lynch and Goldman Sachs (see: Securities and Exchange Commission).  CFPB has been a pioneer in “evidence based” policymaking and in bringing rigorous analysis to its rulemaking and other processes. The really radical proposal would be to say that if there must be a commission, it should require a PhD in some relevant field and a record of relevant publications in academic journals, and a meaningful scholarly reputation.  Work on consumers’ cognitive processes relevant to financial decisions (e.g., risk aversion) has begun to be published not just in economics and finance journals but in Science and Nature, and the increasing availability of big data in consumer finance means it is increasingly possible to do pretty much unimpeachable empirical research. It’s hard to imagine the constitutional argument against requiring commissioners have relevant expertise.  And there are precedents in other branches of government: the National Science Foundation and the National Institutes of Health and the US Geological Survey are not mostly led by former industry lobbyists or congressional staffers or big campaign contributors.  Certainly, the CFPB should not be dominated by commissioners whose prior careers were entirely in the financial industry, or in politics, which is what would likely happen if some of the “reform” proposals currently circulating were to be adopted.

    Tyler Cowen: The Rise and Fall of the Chinese Economy

    The Chinese economy is not easy to understand. So I am always on the lookout for things that can help make it more understandable. This 12 and a half minute segment by Tyler Cowen is excellent. 

    I have one disagreement and one thing to add. The disagreement is that I don’t think “capital flight” has to be a big problem for the Chinese economy. The Chinese Yuan may need to depreciate; they have been using up reserves at a rapid clip to try to prop it up, which has to stop at some point, despite the large reserves they start with. But because China’s government and Chinese firms owe relatively little debt in any foreign currency, such a depreciation due to outward capital flows shouldn’t cause any huge problems. Indeed, it will help increase net exports, in line with the principles I discuss in my post “International Finance: A Primer.” 

    Nevertheless, the Chinese economy would be more balanced if Chinese households start doing more consumption spending. Many economists and foreign observers have recommended that China shore up its social safety net to reduce precautionary saving and thereby foster consumption. The additional point I wanted to make is that allowing higher interest rates on savings accounts might spur consumption in the Chinese case, where the marginal propensity to spend of the banks and their owners on the other side of that particular borrower/lender relationship might be lower than the households doing the saving–especially if the Chinese government tells those banks to keep doing a given quantity of lending, or if the rate at which Chinese banks lend is disconnected from the rate at which they pay interest to depositors. (In general, to see the effects of an interest rate change, try the kind of analysis I illustrate in “Even Central Bankers Need Lessons on the Transmission Mechanism for Negative Interest Rates.” This Chinese case is unusual. For almost all borrower-lender relationships, a cut in interest rates is stimulative and an increase in rates is contractionary.)

    David Pagnucco: The Eurozone and the Impossible Trinity

    Link to David Pagnucco’s Linked In homepage

    I am pleased to host another student guest post, this time by David Pagnucco. This is the 13th student guest post this semester, rounding out the semester. You can see all the student guest posts from my “Monetary and Financial Theory” class at this link.

    European Union countries considering to join the Eurozone must evaluate the major risk of forgoing their sovereign monetary policy before adopting the euro.

    Joining the Eurozone poses numerous risks and benefits for European Union countries outside the zone. In Rick Lyman’s article, leaders from non-Eurozone countries evaluate the risks they face in joining the Eurozone. Some of the major recent factors countries are assessing include political attitudes, the Greek crisis, and domestic fiscal set backs. In order to weigh these risks and benefits, the impossible trinity can be used to describe them. The impossible trinity illustrates that a nation cannot have free capital flows, a sovereign monetary policy, and a fixed exchange rate at the same time. They must choose a position and sacrifice one of the policies.

    For example, Eurozone members are at position a in which their single currency allows them to have free capital flows and a fixed exchange rate. On the other hand, European Union members not in the Eurozone are at position b, in which their differing domestic currencies allow them to have free capital flows and a sovereign monetary policy. One of the main goals in creating the European Union was to create a single unified market with free capital flows, and all European Union members share this aspect. However, with the creation of the euro, Eurozone members lose control of their domestic monetary policies. This is the greatest risk facing non-Eurozone members, as they no longer can change their money supply to stimulate or slow down their economies’ growth according to their own preferences.

    The European Central Bank creates the central monetary policy for Eurozone members, and a governing council member, Philip Lane, stated that the ECB will continue to increase its government bond purchases. This will ultimately increase the supply of the euro and decrease interest rates, resulting in lower borrowing costs for households and firms that will help stimulate the economy. If the ECB sets the monetary policy for all Eurozone members, what happens if a country within the Eurozone does not want the ECB’s particular policy? This is a major dilemma for countries considering to join the Eurozone. Countries outside the Eurozone may have differing preferences on interest rates, inflation, and unemployment than the ECB’s established policy. For example, consider if Poland were to adopt the euro. If the ECB is using the expansionary monetary policy described by Philip Lane, Poland will be required to partake in it. If Poland does not want this policy, they will ultimately need to counter the ECB’s policy in a more complex way such as increasing taxes to deter economic growth.

    Non-Eurozone countries, besides Britain, must adopt the euro at some point in the future, and the timing of the decision is critical because these countries’ economies must be stable and have basic economic convergence to have a successful change over to the euro. They need convergence in areas such as debt levels, GDP, and unemployment to ensure that the ECB’s policies are effective. Overall, the decision to switch to the euro is a major change, and new members must be sure their economies are ready for the switch.

    Q&A: Evidence that Financial Flows Determine the Overall Balance of Trade, Not Tariffs

    I am grateful to Greg Mankiw and Doug Irwin for permission to share this email exchange with you on the impotence of tariffs to affect the balance of trade. 

    Miles to Greg Mankiw: 

    Dear Greg, 

    I have always really liked your model of international finance in your Principles and your Intermediate books. You may not know this, but I wrote a blog post to try to explain it,I have always really liked the the model of international finance in your Principles and Intermediate books. I wrote a blog post, “International Finance: A Primer,” to try to explain it. I use those principles all the time in blog posts as well as in class.

    My undergraduate student, August Klatt (copied above) asked this excellent question: “Is there any empirical evidence to back up the prediction that a change in tariffs has no effect on net exports under flexible exchange rates (other things being equal)?”

    Greg to Miles:

    Thanks, Miles, for your note and kind words.

    I do not know of a relevant study to cite off the top of my head.  But when I return from spring break, I will look around and let you know if I find anything.


    Greg to Doug Irwin:

    Hi Doug,

    I was wondering if you could help me find a relevant paper or two.  You seem like you might be the right person to ask (in light of your great book, Free Trade Under Fire).

    A lot of standard models predict that, under flexible exchange rates, trade restrictions do not affect the trade balance (because NX=S-I and the restrictions do not directly affect S or I).  Instead, the exchange rate moves so that a trade restriction reduces both imports and exports.

    Do you know of any empirical studies that confirm or refute this?  Obviously, this topic is relevant for Mr Trump’s proposed policies regarding China.

    Doug Irwin: 

    Hi Greg,

    I don’t know of any particular studies or papers to point you to, but theory and experience confirm it. The theory is the Lerner Symmetry Theorem, that a tax on imports is a tax on exports, so that imposing a tax on imports (to reduce imports) means that necessarily that exports will be taxed as well (resulting in a reduction in exports). The question is the mechanism by which this happens, which is obviously different under fixed and floating exchange rates.

    In terms of experience, the US trade balance did not change appreciably after the imposition of the Smoot-Hawley tariff. In more recent decades, countries that have rapidly dismantled import restrictions (Chile, New Zealand) did not start running large trade deficits (although they often had fixed exchange rates and devalued or floated when they introduced their trade reforms). I don’t think China ran a large trade deficit when it unilaterally opened up its economy in the 1980s and 1990s, although as your know their current account began to balloon when you were at CEA (no causality suggested!). Another experience: I think Japan had a rough current account balance until they deregulated private capital outflows in 1980 at which point their CA surplus began to grow.

    Regarding China - we do know that they retaliate immediately. Whenever Commerce and the ITC rule affirmatively on an antidumping case involving China, it is almost miraculous how China immediately finds that the United States has been dumping in their market as well.

    I hope this helps a little. Let me know if you would like some elaboration.

    Crush Cuckoo CoCo Coddling

    Link to “The Trouble With CoCos” on Bloomberg View

    Let me reprise part of what I wrote in the preface to “Cetier the First: Convertible Capital Hurdles” and augment it with the wise words of the Bloomberg View editorial board on the topic of debt that are converted into equity (stock) upon a certain trigger  (“contingent convertibles” or “CoCos”).

    The Problem with Convertible Debt

    Here is what I wrote back in August 2013:

    …the basic problem with convertible capital, bail-ins, and so on is that they all require a decision–either drawn out an painful, or sudden and painful–to force those who have theoretically accepted a risk to actually take a loss. By contrast, equity holders take losses and make gains continually, without everything hingeing on a decision to make some group take the loss. The automatic nature of taking equity losses and getting equity gains is both an advantage in itself and tends to make these capital gains and losses more continuous and less sudden than for convertible capital and “debt” in bail-ins.

    Another way of putting the problem is that the moment when conversion threatens is typically seen as a crisis, even if the approach to that moment was gradual, while a simple decline in the price of common stock is seldom seen as a crisis unless it is a very large and sudden decline. This crisis atmosphere is both damaging to confidence in and of itself and a temptation for government to do a bailout–a bailout they would be much less tempted to do after a simple decline in stock price.

    And here is the Bloomberg View Editorial Board on February 12, 2016:

    The incident serves to reinforce concerns, expressed by various financial economists, that CoCo bonds may make investors in banks and their debt more apt to take flight when trouble looms. After all, if CoCos protect taxpayers, they do so at the expense of bank shareholders and bondholders. Moreover, CoCos are complicated instruments. In a time of stress, uncertainty over the conditions that trigger conversions may add to the sense of alarm.

    Paradoxically, a panic of that kind might eventually call forth a government bailout – the very thing that CoCos are intended to prevent. …

    These flaws underscore the case for simply requiring banks to finance themselves with more equity, which has the advantage of absorbing losses without any special triggers or added anxiety.

    The Problem with Debt in General

    The problem with debt is that it is a bit of a pretense that there is not risk for the debt-holder. Given this pretense, debt-holders get alarmed when they are forced to face the reality of risk. Convertible debt does not escape this problem. The great virtue of common stock equity is that every day it goes up and down in price in a way that reminds its holders of the risk they face. Moreover, there is no obvious angle from which one can view common stock equity as risk-free. So stock-holders are made to face the reality of risk every day. They still may freak out at very large movements in price, but they become accustomed to substantial movements on a regular basis. Although in principle, one can think of bonds as just one more type of risky asset–one that is a bit more complex than stocks because of the complexity of default (and economists in their models often do imagine bonds in exactly that way), this is not always the way bond-holders view it. It is not good to set up a large group of asset-holders for freaking out because of a mismatch between the safety they think they are getting and the risk they are actually bearing. 

    Avoiding CoCo Coddling

    It is much better to have truth in labeling by requiring that half of all the liabilities of a firm be labeled and treated as common stock, and only pretending (now a more nearly accurate pretense) that the other half of the liabilities are safe. That is what a 50% common stock equity does. That is the single most important policy to avoid financial crises. 

    As far the convertible bonds that are already in place, government authorities should act very much as if these convertible bonds were already converted in equity. It is no crisis for them to convert into common stock equity–that is what they should have been from the beginning. And anyone who thought their CoCo’s would be bailed out should be taught the reality of risk. 

    Not how different this is from sending a bank into bankruptcy–the bank’s operations are fine and continue to function. It is only those who made a bet that the bank was safer than it really was that pay the price, not the customers and commercial counterparties of the bank. 

    And if CoCo conversion makes it harder for banks to sell CoCo’s in the future, so much the better–it will make them more likely satisfy existing regulatory requirements by selling common stock equity, even if the regulators are sadly slow to insist on that as the way to satisfy capital requirements.

    Remittances in International Finance

    Link to the Economist article “Like manna from heaven: How a torrent of money from workers abroad reshapes an economy”

    The recycling of currency to its home currency area is crucial to understanding international finance and trade balances. As I laid out in “International Finance: A Primer,” unless someone abroad–outside the US dollar zone–intends to accumulate a pile of dollar-denominated assets, then once dollars are abroad, the only way those dollars can get back home is by being used to buy exports from the US. And imports in the US send dollars back abroad, so it is only net exports that can get them back home to stay. So sending unwanted dollars abroad inevitably leads to more net exports from the US, with US dollar exchange rates doing whatever it takes to make that happen. 

    It is theoretically possible that changes in the exchange rate might change what people want to do with their investments. But it seems much likely to me that exchange rates mainly cause the adjustment of dollar flows from net exports to balance out other dollar flows, while exchange rate movements cause relatively little adjustment of capital flows or other dollar flows. 

    That currency tends to make its way back to its home currency area–and any exception is treated as a capital flow–is often expressed through the equation NCO = NX: net capital outflows equal net exports. But remittances–relatives sending money home from their work abroad–and to a lesser extent foreign aid, cause currency flows as well. The graph at the top, from the very interesting Economist article “Like manna from heaven,” shows the importance of remittances. 

    Consider currency flows in and out of India. One could track the flow of rupees, but an alternative is to track the flow of all other currencies in and out of India. Except when Indians want to accumulate or decumulate piles of foreign-currency-denominated assets, foreign currency that comes in will go out to buy foreign goods as imports–or actually as net imports if some round trips from balanced bits of trade are ignored. For this, it doesn’t matter how the foreign currency comes in (unless it is from intentional selling foreign assets, which we are leaving aside). Whether the dollars or other foreign currency arrives from foreign direct investment in India (minus FDI going out of India), foreign portfolio investment (minus intentional portfolio investment going out of India), remittances or foreign aid, those dollars or other foreign currency will make their way back out buying net imports.  

    Don’t assume that raising net imports is a bad thing. As “Like manna from heaven” indicates, the resources from remittances in particular allow many families to have nicer houses, buy more refrigerators and other appliances, and give them enough financial leeway that they are willing to let their daughters stay in school longer. Most of the money from abroad is spent on things that I personally applaud.

    Luke Kawa: How Central Banks Gained More Control Over the World's Major Currencies


    Link to the article on Bloomberg Business

    It was a very pleasant surprise when I received an email from Luke Kawa just a day after I put out “Why a Weaker Effect of Exchange Rates on Net Exports Doesn’t Weaken the Power of Monetary Policy” on Medium (the day before I posted it here) asking for clarification since he wanted to quote it in a Bloomberg Business article. He understood the point perfectly in his excellent article “How Central Banks Gained More Control Over the World’s Major Currencies.” You should read the whole thing, but here is a key graph, a key passage, and Luke’s quotation from my post: 

    The foreign exchange team determined that an expected change in interest rate differentials between two countries from the Group of 10 nations is now accompanied by a much bigger move in the exchange rate:

    … The rising import content in exports, however, does not imply that the efficacy of monetary policy has deteriorated.  In fact, it’s compatible with the increased responsiveness of currencies to expected interest rate differentials described by HSBC.

    “If net exports are relatively insensitive to the exchange rate, the exchange rate will simply move more,” wrote Miles Kimball, professor of economics at the University of Michigan. “Large fluctuations in the exchange rate are exactly what one should expect if net exports are relatively insensitive to movements in the exchange rate.”

    Why a Weaker Effect of Exchange Rates on Net Exports Doesn’t Weaken the Power of Monetary Policy


    Link to this post on Medium

    On New Year’s Day, 2016, I tweeted what you see above.

    Let me explain at greater length. Paul Hannon is right in his Wall Street Journal article “Why Weak Currencies Have a Smaller Effect on Exports” in writing:

    When a country loosens its monetary policy, interest rates fall and investors tend to pull their money out in search of higher yields elsewhere, pushing down the currency’s value.

    And the article goes on to make a very interesting point about how global supply chains might be blunting the effect of a given change in the exchange rate on net exports:

    Measuring the impact of global supply chains on trade flows is the task of a project undertaken by the Organization for Economic Cooperation and Development and the World Trade Organization. …
    Economists at the International Monetary Fund and the World Bank have used those measures to assess whether currency movements have the same impact they once did on exports and imports. They found that the effect has in fact reduced over time, by as much as 30% in some countries.

    But Paul Hannon’s overall subtext that this weakens the power of monetary policy is wrong. Start with the basic accounting identity of international finance that Paul alludes to and that I discuss in detail in my post “International Finance: A Primer”: the provision of domestic currency to those outside one’s currency zone through net capital outflows NCO (and through other channels as remittances of foreigners sending money to their families back home) must lead to an increase in net exports NX of equal magnitude. (Also see my column “How Increasing Retirement Saving Could Give America More Balanced Trade.”) The only wiggle room in this statement is that for whatever period of time someone abroad are willing to temporarily hold a growing pile of our domestic currency provided byintentional purchases of foreign assets that counts as an unintentional capital flow in the reverse direction. As soon as they want to unload our currency, our currency will make its way back home one way or another. (If people abroad decided to hold a pile of our currency more permanently, that rightly counts as an intentional capital flow in the reverse direction, canceling out all or part of the initial capital flow.)

    Of course, the way the price system guarantees the return home of domestic currency that is unwanted abroad is through exchange rate movements. But the logic here means that exchange rates move as much as it takes to bring about the return of domestic currency that is unwanted abroad. So an increase in intentional capital outflow of $1 creates a $1 increase in net exports over whatever horizon it takes for domestic currency that is unwanted abroad to make its way back home. The relevant horizon is not instantaneous, but foreigners are unlikely to be willing to hold piles of unwanted domestic currency for very long. (Of course, governments sometimes choose to override this part of the prices system by imposing fixed exchange rates. Fixed exchange rates work by having the government equal and opposite capital flows to neutralize the effect of changes in intentional private capital flows on exchange rates.)

    When the central bank cuts interest rates, the initial step in affecting international finance is in generating net capital flows of a certain size as domestic investors search for higher returns abroad, and potential foreign investors think better of sending their funds to a low-interest-rate country. These capital flows then have a 1-for-1 effect on net exports after the recycling of currency described above, regardless of the elasticity of net exports with respect to the exchange rate.

    If net exports are relatively insensitive to the exchange rate, the exchange rate will simply move more. Indeed, many casual observers are struck by the large fluctuations often seen in the exchange rate. Large fluctuations in the exchange rate are exactly what one should expect if net exports are relatively insensitive to movements in the exchange rate, as I wrote about in“The J Curve.”

    What would affect the potency of monetary policy is if the effect of a given movement in interest rates on international capital flows went down. But I don’t know of anyone claiming that is the case. (What I do hear a lot of is the speculation that cutting interest rates into the negative region would be especially salient to investors and so might have a particularly large effect on international capital flows — which would then increase the potency of monetary policy.)

    One particular area where the discussion above matters is in assessing Japanese monetary policy. How much stimulus the Bank of Japan has achieved through the international finance channel is much better measured by the size of the international capital flows generated than by the size of the exchange rate movements that result. Because overall Japanese investors have a particularly strong home-bias, the effect of monetary policy on international capital flows may be weaker than in most other countries. But it is factors such as home-bias that matter for the contribution of international finance to the potency of monetary policy, not the elasticity of net exports with respect to the exchange rate. (On Japanese monetary policy, also see “Is the Bank of Japan Succeeding in Its Goal of Raising Inflation?”, “Japan Should Be Trying Out a Next Generation Monetary Policy” and “QE May or May Not Work for Japan; Deep Negative Interest Rates Are the Surefire Way for Japan to Escape Secular Stagnation.”)

    To repeat: Weak effects of a given size of exchange rate movement on net exports does not blunt the effects of monetary policy because exchange rates do whatever it takes to make net exports equal to net international capital flows.

    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.”

    Discounting Government Projects

    Image source: February 4, 2014 speech on “The outlook for the New Zealand economy,” by Graeme Wheeler, Governor of the Reserve Bank of New Zealan

    Image source: February 4, 2014 speech on “The outlook for the New Zealand economy,” by Graeme Wheeler, Governor of the Reserve Bank of New Zealan

    During my three weeks in New Zealand as a Visiting Research Fellow of the New Zealand Treasury helping New Zealand get closer to developing national well-being indices (see 1,2,3), I learned of the New Zealand Treasury’s current custom of using an 8% per year real discount rate for evaluating government projects (including “social projects”). That custom makes no sense to me; I wrote a series of emails to New Zealand Treasury officials explaining why. They took me up on my offer to give a presentation on this issue. You can see the Powerpoint file I used here, though I didn’t have time to cover the abridged version of the presentation I had given a year ago at the US Congressional Budget Office on capital budgeting that I appended after the discussion about discounting. 

    Below, I have copied out the text of the emails I wrote, after subtracting some identifying information at the beginning of the first email. As usual when I talk to officials of government agencies, I am telling you what I told them and what I recommended, but–to maintain a certain degree of confidentiality–remarking only in the most general terms about their reactions. The distinct emails are marked by Roman numerals. To understand these emails, you need to know that New Zealand has a sovereign wealth fund called the Superfund. Also, it is good to have a sense of the yield on New Zealand government bond: I have a graph showing the nominal yield above, and a graph comparing the nominal to the real yield below. 

    I. There is an extremely strong argument against using an 8% real discount rate in evaluating government projects. I think the argument below can be sharpened to become institutionally relevant.

    Basically, an 8% real discount rate makes no sense to use unless the New Zealand government is actually getting an 8% real return on funds that it saves. It is not enough for someone to claim that the New Zealand government theoretically could get an 8% real return on funds it saves when that is not true or is only theoretical because the New Zealand government would never actually do that with funds saved by not doing a project.

    The argument here also dovetails nicely with a presentation I gave at the Congressional Budget Office a little over a year ago on capital budgeting, that I would be happy to give here next week some time in addition to my other talk if there is interest. (I attached the Powerpoint file.)

    Here is the argument against the 8% real discount rate used for assessing government projects in more detail:

    (1) On the face of it, such a high discount rate is hard to square with the much lower government borrowing rate, which in simple cases clearly implies a benefit from borrowing to fund the project if the project has a net present value that is positive given that government borrowing rate. What is going on?

    (2) Historically (perhaps back in the 1970s) the 8% per year real discount rate was motivated by the expected return on the stock market, and the idea that government projects are risky investments. But it is important to look beyond this superficially plausible set of words to the underlying logic, which doesn’t hold up.

    (3) The underlying logic of the 8% per year real discount has to be that the opportunity cost of a project is that the money could be put into the stock market (say a diversified international fund) if it weren’t used for the project. This logic requires (a) that if funds weren’t used for the project that it is in fact realistic the funds would be added to the Superfund and (b) that the extra funds in the superfund would be earning an 8% per year real return.

    (4) To the extent that there is a great reluctance on the part of the government to invest extra funds in the Superfund, that tends to indicate some combination of either (a) for various political or institutional reasons it is not realistic that the extra funds will be added to the Superfund or (b) the risk-adjusted return that is expected if the extra funds were added to the Superfund is much less than 8% per year in real terms. In either case, an 8% per year real return is not a relevant rate at which to discount government projects. This is easy to show in two models: (a) where the flows of funds into the Superfund (the government’s sovereign wealth fund) are fixed in a way that is exogenous to projects undertaken among the projects now being discounted at 8%; (b) where the government is rationally indifferent on the margin between investing more in the Superfund and paying off some of the debt, which then makes the interest rate on the debt the relevant one because it is in this model equivalent to a risk-adjusted return on money in the Superfund.

    (5) Some might argue that the riskiness of government projects hasn’t been adequately included in the discussion above. That is true, but the risk in government projects is quite different from regular stock market risk, so the risk adjustment must be done in another way. A good method of risk adjustment for projects is to think seriously of the real dollar value they will have dependent on the level of real consumption in the economy. One virtue of thinking about the adjustment this way is also that it provides a reminder that the dollar value of the flow of benefits from many projects will tend to increase in the future simply because trend increases in per capita income will raise the willingness to pay for those benefits.

    II. Just to be clear, my view is that (a) all projects that are better than putting the money in the Superfund should be done, and (b) if someone claims that a project is worse than putting money in the Superfund, then money should be put in the Superfund instead, and © if a project looks better than paying off some of the debt by buying bonds–or, almost equivalently, good enough that borrowing at the bond rate to do it looks like a positive present value–it should also be undertaken UNLESS the government is willing to issue additional bonds to put more money in the Superfund invested in risky assets.

    Like Roger Farmer, I have argued that many, many governments should in fact be expanding their sovereign wealth funds (like the Superfund) by borrowing at the quite low interest rates that are possible for financially sound governments these days. Borrowing at favorable rates to better fund the Superfund (which I am assuming would invest the extra funds in a diversified international portfolio of risky assets) is indeed quite a good “project” in its own right and so should set a substantial hurdle for other projects to meet but

    (1) certainly not as high as an 8% real return, assessed almost as if that were a safe return and

    (2) if borrowing or using other available funds to better fund the Superfund is ruled out of court for any reason, that “project” of better funding the Superfund (and thereby implicitly investing in a diversified international portfolio of risky assets) cannot rationally be used as a comparison to set a high hurdle rate for other projects.

    To argue that borrowing to better fund the Superfund should in fact be taken seriously, let me point out several other advantages to it, beyond the fact that it is a relatively high return “project”:

    (i) If the accounting separates the Superfund from the rest of the government debt, then better funding the superfund makes it possible to point to the amount of bonds the government has issued to remind people of the liability the government has taken on to pay pensions in the future out of the Superfund (and whatever else the Superfund is committed to in the future). This reminder of the liability the government has taken on can be quite helpful.

    (ii) Because it makes sense for a small open economy such as New Zealand’s to be investing in an internationally diversified portfolio of risky assets, better funding the Superfund will generate capital outflows that are likely to cause some depreciation in the New Zealand dollar. Some opinions suggest the New Zealand dollar is to strong to begin with, so that might be a good thing.

    (iii) The issuance of additional government bonds could raise safe interest rates. As long as this is taken into account in calculating the returns to the “project” of borrowing to invest in an internationally diversified portfolio of risky asset, that “project” is still a good idea in terms of the overall government budget. For the private economy, it will lead to a safe interest rate that better reflects the the costs and benefits of various actions that New Zealand actually faces vis a vis the rest of the world. One interesting side effect of a higher safe interest rate is that land prices are likely to fall somewhat.

    (iv) The choice between investing only in broadly based ETF’s and doing more actively managed diversified international investments is a hard one. However, on one end, even simply by its choice of ETF’s New Zealand could have a good effect on corporate governance around the world. On the other end, if the dangers of rent-seeking and corruption can be avoided, there may be a way to, say, use more actively managed international diversified investments as a way for New Zealanders to learn more about technologies in the companies they invest in, for example.

    Note in all of this that other projects that are actually better than investing internationally are being undertaken, after a full assessment of all the costs and benefits of those projects, including how those costs and benefits are correlated with high levels of per capita consumption or low levels of per capita consumption.  

    III. Note that all these arguments boil down to saying that one can argue quite sincerely that if someone claims that despite meeting the present value test according to the government borrowing rate that a project is less good than investing internationally in risky assets, it implies that one should be investing internationally in risky assets, NOT necessarily that the project should not be undertaken (though one would have to reassess after investing internationally in risky assets as appropriate). If investing internationally in risky assets is ruled out, then the simpler present value test relative to the borrowing rate is the right one.  

    IV. Thoughts on how to frame a rule for the evaluation of projects in relation to their intertemporal dimension–and in relation to their interpossibility dimension given that outcomes are uncertain:

    A. It is appropriate to use the government borrowing rate to evaluate the intertemporal dimension of projects …

    B. PROVIDED that the ever-present option of adding more funds to the Superfund is enrolled in the list of possible projects to be evaluated. Actually, this option of adding more funds to the Superfund is a number of different projects, since adding the first $1 billion dollars is a different proposition from adding the 101st additional $1 billion; if adding the first $1 billion is actually undertaken, then adding the 2d $1 billion must be added to the list of projects to be evaluated and compared with other projects.

    C. The simplest application of the (real) government borrowing rate as a discount rate is when the (real) dollar value of of benefits and costs is certain. But this is uncommon. How should one deal with uncertainty? Here is my suggestion:

    1. The strong assumptions needed to use a market risky rate to adjust for risk definitely do not hold. This is for many reasons, but the simplest is to say that the kinds and details of risks entailed by government projects tend to be different from the kinds and details of risks entailed by private projects. Hence, market risky rates should not be referred to at this stage. Provision B expresses well the primary and big way in which market risky rates are relevant.

    2. Any adjustment for the risk in the cost and benefits of a government project in real dollars needs to be serious about asking “How will the costs and benefits change depending on how high the level of per capita consumption is?” Sometimes the answer to this question may depend on why per capita consumption is high or low in a future situation, but often a reasonable answer can be given simply by considering the likely benefits and costs in more or less prosperous possible futures.

    A simple example of variation in the real dollar value of a project is that the willingness to pay for most non-market goods goes up when people have more money from which to pay.

    3. It is also essential for good project evaluation that the overall upward trend in per capita GDP be realistically taken into account. For example, since on average the future is likely to be more prosperous than the present, we can anticipate that on average, the willingness to pay in real dollars for then current non-market goods is likely to be higher in the future than in the present.

    4. Projects that provide benefits that are just as high in real dollar terms in bad financial situations where dollars are more precious as in good situations where dollars are less precious (which can be discounted quite simply at the government borrowing rate) are more valuable than otherwise similar projects that provide benefits that are high in real dollar terms primarily when dollars are also less precious and provide benefits that are lower when dollars are very precious. This should be assessed.

    5. In assessing the extent to which the typical project which evinces benefits with higher willingnesses to pay in good financial situations than bad should be marked down in attractiveness relative to a simple discounting of its expected real dollar benefits by the government borrowing rate, there is a serious discussion to be had about what level of risk aversion should be applied. As someone who has devoted a significant part of my career to studying and thinking about risk aversion, I want to insist that much is unknown here and that a simplistic application of the level of risk aversion that seems to be implicit in some particular financial market (without regard to all of the conflicting evidence about risk aversion in other markets and other decisions) is inappropriate. I think it is best for the government to make its own, separate determination of an appropriate level of risk aversion to apply based on a vigorous internal debate about this very issue, which should involve philosophical considerations and a wide range of survey data on people’s preferences as a counterpoint to market data. I would be delighted to be involved in such a debate. (I have a presentation or two in my back pocket on this, but consider presenting them less urgent than the one on capital budgeting that is a strong complement to the series government discount-rate memos I have been sending by email.) Based on what I know, I would apply a risk aversion curvature in per capita consumption of not more than 2.

    Answering Adam Ozimek’s Skepticism about a US Sovereign Wealth Fund

    image source  (2013)

    image source (2013)

    In many blog posts and Quartz columns, I have argued that major economies such as the US should establish sovereign wealth funds even when issuing bonds is required to capitalize the funds. Sovereign wealth funds are already standard for countries that have positive net liquid assets. The new idea is to say that major countries that have negative net liquid assets should also have sovereign wealth funds as stabilization tools. A good post to turn to first for this is “Roger Farmer and Miles Kimball on the Value of Sovereign Wealth Funds for Economic Stabilization.”

    In my tour of central banks to advocate eliminating the zero lower bound, I point out that even if monetary policy is someday done well enough to essentially keep the economy at the natural level of output all the time, there could still be a financial cycle. This possibility becomes clear if one writes down an entirely real general equilibrium noise trader model (as I have done in some very early stage research with Jing Zhang that might involve other coauthors before we are through). Even if the business cycle is entirely conquered in the sense of a zero output gap from sticky prices at all times, the financial cycle can cause welfare losses. Welfare losses can occur even when high enough equity requirements have taken away the implicit bailout subsidy for leverage. A contrarian sovereign wealth fund can help counteract the messed-up price signals caused by the noise traders.

    In a July 19, 2015 post, “Skepticism About A U.S. Sovereign Wealth Fund,” Adam Ozimek worries about implementation difficulties for a sovereign wealth fund or other major economy. The first thing to say is that in general, institutions tend to be better in countries that–apart from natural resources–would be the richer ones, and so the right benchmark for the likely quality of a US sovereign wealth fund is Norway’s sovereign wealth fund rather than, say Saudi Arabia’s.

    The second thing to say is that both Roger Farmer and I recommend a rule that the sovereign wealth fund is only allowed to invest in (low-fee) exchange traded funds. The importance of this is to keep the government from (a) micromanaging the investments and to keep the government from (b) voting the shares and micromanaging the behavior of the firms that way. In the US at least, if a sovereign wealth fund such as I recommend could ever be established, such aspects of the initial design of the fund can be maintained by the difficulty of getting changes opposed by one party through both Congress and a potential presidential veto. An initial bipartisan agreement on principles could not easily be broken.

    The third thing to say is that I know in practice how to get the fund started off with a contrarian philosophy: I would recommend appointing John Campbell as the first head of the US Sovereign Wealth Fund.

    On the objective of a sovereign wealth fund, the more I think about it, the more I realize that calculating the optimal policy for a large country’s sovereign wealth fund given a concern with overall social welfare in the usual way is a very interesting research problem. Basically, there is a technical answer to this question in the same sense that there is a technical answer for optimal monetary policy, after what I think is easier math than for optimal monetary policy.

    The small country problem is, of course, even easier: a small country faces something much more akin to the standard portfolio problem, with the issue of what level of risk aversion to use when investing on behalf of a nation’s citizens. And of course, just as an individual household needs to integrate human capital into its portfolio decision, a small country sovereign wealth fund needs to integrate a wide variety of assets the country’s citizens and government already hold into its portfolio decision.