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December 8, 2011

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Danger Lurks in the Shadows

Posted: 08 Dec 2011 12:42 AM PST

I've also complained about this off and on over the last year or so, and I'll feel better about the security of financial markets when the problem is finally addressed:

The Price of a Haircut, by Steve Landsburg: Yesterday I had the pleasure of attending a very good talk by Yale's Gary Gorton on the origins of the financial crisis.
Gorton's story is that this was a bank run, not substantially different from the bank runs that have always plagued capitalist economies. In this case, the run took place in the repo market, which is an unregulated (and largely unmonitored)... The repo market serves large institutions (e.g. Fidelity Investments or state governments) with a lot of cash on hand that they want to stash in an interest-bearing account for a day or two. So Fidelity deposits, say, a half-billion dollars at, say, Bear Stearns, just as you might deposit five hundred dollars at your local bank. One difference, though, is that your account at your local bank is insured, whereas Fidelity's account at Bear Stearns is not — so Fidelity, unlike you, demands collateral for its deposit. Bear Stearns complies by handing over a half-billion dollars worth of bonds, of which Fidelity takes physical possession. The next morning, Fidelity withdraws its money and returns the bonds.
The problem comes in when rumors begin to spread that some bonds might be riskier than they appear, and Fidelity starts to worry that maybe Bear Stearns is picking particularly risky bonds to hand over. Therefore Fidelity demands more than a half-billion in bonds to guarantee its half-billion dollar deposit. If there's, say, a 10% discrepancy between the deposit and the collateral, we say that Bear Stearns has taken a half-billion dollar haircut.
Because Bear Stearns has a fixed quantity of bonds on hand, and because all of its depositors are demanding haircuts, Bear Stearns can now accept fewer deposits than before. This means that Bear Stearns has less cash on hand. This makes depositors even more worried about the security of their deposits, which means they demand larger haircuts. The effects snowball until Bear Stearns collapses. ...
So what should we do about all this? Gorton, along with his colleague Andrew Metrick, argues that the repo market, like any banking market, is inherently susceptible to runs and therefore ought to be regulated. In this case, the regulations should focus on insuring the availability of sufficient high-quality collateral to keep depositors calm. Gorton observes that the existing policy responses to the crisis (e.g. the Dodd-Frank bill) do pretty much nothing to address this fundamental need. The Gordon/Metrick paper contains some specific proposals, which unfortunately Gorton never got to in yesterday's talk. ...

Insuring the availability of high-quality collateral is not the only solution. For example, the shadow banking system could also be regulated much like the traditional banking system where limits on risk taking behavior and insurance fees are traded for deposit insurance (see here for an email from Metrick on this, the limits on risk-taking and the fees are intended to counter the moral hazard that arises with the deposit insurance). Regulators are supposedly working on this, and a solution involving collateral restrictions is the likely outcome, but so far the vulnerability persists.

The US is Almost Last in Relative Labor Market Policy Spending

Posted: 08 Dec 2011 12:33 AM PST


More here.

"A Bluesy Road-Novel with a Lot of Economic Theory and Analysis"

Posted: 08 Dec 2011 12:24 AM PST

I would have never thought to do this, or had the courage to do it if somehow it did occur to me:

Microeconomics using "The Grapes of Wrath", INET: Stephen Ziliak, Trustee and Professor of Economics at Roosevelt University-Chicago and a member of the INET Curriculum Committee Task Force, teaches introductory microeconomics using The Grapes of Wrath (1939). Here is the syllabus
The Grapes of Wrath was published by its author, John Steinbeck, in 1939, during the worst economic crisis in American and world history. Set in and written during the Great Depression, The Grapes of Wrath is a bluesy road-novel with a lot of social and economic theory and analysis. It follows a family of homeless and landless tenant farmers from Oklahoma—the Joads—who've been forced on account of foreclosure to leave the farm and land which they labored and lived on for several generations.
Forced by a large bank and absentee owners to leave their home, the Midwestern farmers with little education and no income join other displaced workers on the road to California, in search of jobs, food, and housing—a piece of the American Dream.
Steinbeck's Pulitzer Prize-winning novel was for many years censored and banned by governments and school boards made uncomfortable by the novel's detailed portrayal of economic inequality, hardship, and oppression.
We asked Stephen Ziliak to share his experience teaching The Grapes of Wrath, which he has used since 1996 to form the basis of his intro economics course.
Q: Why, Professor Ziliak, way back in 1996, did you begin to teach to introductory economics students The Grapes of Wrath?
A: I guess my first response is that I eschewed in my own research the one-voiced, monological approach of conventional neoclassical economics. Trained as an economic historian, I'm an amateur poet who had also worked as a welfare and food stamp caseworker in the county welfare department, going door-to-door in the poorest neighborhoods of Indianapolis. When I became an Assistant Professor of Economics, in 1996, I was searching for a teaching method that would open up the conversation to a wider, more realistic set of issues. It only seemed fair to me: given that I myself had philosophical objections to the conventional approach to teaching utilitarian economics, it hardly seemed right to force-feed my students. Plus, many of my students came from working class families but they'd never experienced a recession. I wanted them to know that growth and bubbles do not last forever.
Q: Why teach The Grapes of Wrath and not some other novel?
A: Good question. First and foremost, it's an incredibly moving novel that—I openly admit—continues to make me laugh and cry. Now laughing and crying are not necessary for good pedagogy. But it seems to me that if a fact-based story about economic history can make a grown man and professor of economics cry, it must have something important to say. The visible hand of class conflict needs to be aired and this novel does it.
Q: You said fact-based. What do you mean—it's a novel, it's fiction, yes?
A: Yes, but it's historical fiction—meaning that Steinbeck, like Hugo, Zola, and others before him, was deliberately depicting real and felt experiences. There are exaggerations and omissions of fact, true—as economic historians and English professors know full well. But in fact, Steinbeck himself spent a year or more working and studying inside of the same temporary labor camps that the fictional Joad family experienced in California.
Q: How do students react? Can you share some insights from the teacher perspective?
A: Really well, eventually. Some are defensive at first, being trained to believe that stories are for novelists and theory for scientists. Still others have been so deeply entrenched with what I call the banking approach to learning—regurgitating facts and equations—they're afraid of dialogue and a plurality of voices and interpretation. But students tell me it's one of those life-changing courses.
Q: What about the "quants"? Do quants survive the course?
A: Again, it's not for everyone. But yes, absolutely. An example is a student who studied with me at Roosevelt University. He came to Roosevelt as a freshman from Puerto Rico on a violin scholarship. He was preparing for a career in violin at our conservatory and, at the same time, he had a passion for advanced mathematics. On a lark he enrolled in my Grapes of Wrath course. Half-way through the term he told me that something was happening to him. The evolution of the protagonist, Tom Joad, from self-interested ex-con to benevolent labor leader, he found fascinating. He thought that he might have to switch from violin and math to economics. I told him no, if he really wanted to switch he could study math and economics—he wouldn't have to give up the math. By the time he was a junior (a third year student) he landed a job with the Federal Reserve Bank of Chicago. At graduation he was promoted to Associate Research Economist. Now he's a master's student in economics and statistics at Duke University but he is not at all bamboozled by the utility maximization-only school.
Q: Do you supplement the novel with other literature or media?
A: Yeah. For example, a particularly fun day of class is when we play music by Woody Guthrie, Bruce Springsteen, and Rage Against the Machine—who've recorded songs about Tom Joad. Springsteen himself recorded an entire CD on the central themes.

From the syllabus linked above:

In 1776 three astonishing works of genius were given to the world. One was the Declaration of Independence. A second was Edward Gibbon's Decline and Fall of the Roman Empire. For many students these two great works of 1776 require little or no introduction. The third work does. Yet some say it is the most important and influential of all. I am speaking of The Wealth of Nations, a lengthy and learned book written by a humble professor of philosophy living in Scotland. Adam Smith's The Wealth of Nations supplied an intellectual justification for a free and commercial society. It gave new life to a field of inquiry called "economics" and it continues to challenge and to shape the values of economists, presidents, and ministers of finance all over the world.
Smith's book is central to the economic conversation, true, but it is not the end-all, be-all of economic truth. It would not be wrong to think of our course as a conversation about "How the economists Adam Smith, Karl Marx, John Maynard Keynes, Joan Robinson, Milton Friedman, and others have responded to Mercantilism, Romanticism, and the rise and fall of Communism and Fascism."
Mostly, however, the course is an introduction to microeconomic ways of thinking. Our course introduces a new grammar, if you will – an economic grammar of scarcity, competition, relative price, opportunity cost, supply and demand, efficiency, and equilibrium, to name a few. At minimum our course will help you to become an informed voter and a sophisticated reader of The Wall Street Journal. It will certainly invite you to engage in a lifetime of learning.
But microeconomics cannot be learned just by reading The Wall Street Journal or Atlas Shrugged, nor by listening to Green Day or Rage Against the Machine. These will help you care about economics. But to learn how to speak economics you'll have to solve homework problems, read the books, and participate in class.
Still, the economic conversation is shaped by many different texts and experiences, from novels to music and media. It's important for economists to learn how to speak to the humanistic sides of the conversation, and, likewise, it's crucial that humanists speak intelligently about economic theory and facts, and not be bamboozed. To this end and others, we'll read and analyze the most famous protest novel in American literature, John Steinbeck's The Grapes of Wrath. Set in and written during the Great Depression, The Grapes of Wrath is a bluesy road-novel with a lot of economic theory and analysis. It follows homeless and landless tenant farmers from Oklahoma, who've been pushed off of foreclosed farms. Forced by large and foreign banks to leave their rented shacks and lean-tos, the Midwestern farmers with little education and no income join other displaced on the road to California, in search of jobs, food, and housing—a piece of the American Dream.
We'll read this highly relevant novel using in part the lens of economic theory and facts, and likewise we'll critically analyze economic theory and facts, using concepts and insights we discover in The Grapes of Wrath. Attached to the back of this syllabus is an example of a homework assignment from a previous semester, indicating how we'll put Steinbeck's Depression-era novel together with supply and demand.
Finally, throughout the semester, we'll occasionally read and discuss parts of Tim Harford's popular book, The Undercover Economist, which supplies many useful, real-world applications of the microeconomic way of thinking. Harford's book is a great help, especially to those who do not naturally think of price and incentive when analyzing the human condition. ...

Required Texts: Microeconomics, by David Colander, 7th edition...; The Grapes of Wrath, by John Steinbeck; The Undercover Economist, by Tim Harford. ...

Links for 2011-12-08

Posted: 08 Dec 2011 12:06 AM PST

"The Futility Of Bipartisan Outreach"

Posted: 07 Dec 2011 03:33 PM PST

In light of this latest bit of stupidity from the administration, this comment from Paul Krugman seems appropriate:

The Futility Of Bipartisan Outreach, by Paul Krugman: President Obama has tried — desperately, and far beyond the point at which it made any kind of sense — to reach out across the partisan divide. He has bent over backwards to be nice to bankers. He has clearly been uncomfortable with any kind of populist rhetoric, although that may finally be changing.

And his reward for all that is that Mitt Romney describes him as a full-on Marxist, from each according to his ability to each according to his needs:

[Obama] seeks to replace our merit-based society with an entitlement society. In an entitlement society, everyone receives the same or similar rewards, regardless of education, effort and willingness to take risk. That which is earned by some is redistributed to the others. And the only people to enjoy truly disproportionate rewards are the people who do the redistributing — the government.

Reality just doesn't matter here — which is why Obama might as well reach out to his base instead of the unreachable right.

Lucy and the football. The fake handshake trick. True colors shining through. Whatever. Ken Houghton has had it:

...the Obama Administration has been making it Really Effing Easy for Its Base to Mobilize since around the time Tim Geithner was appointed. That mobilization is just away from the voting booth and onto the streets. ...

There are two ways to get votes. You can take votes from the other side by appealing to the middle, or you can increase the turnout on your side by mobilizing the base or bringing in new voters (many policies involve a tradeoff between these margins, but the best policies appeal to both groups). It seems to me that Obama is losing far more in terms of enthusiasm and turnout than he is gaining by moving the middle (though it may be incorrect to describe him as having to move to the middle, unless it's from the right).

Whatever gains the administration made yesterday with the speech intended to bring back memories of FDR, it gave away today.

"Who Would Pay a 73 Percent Income Tax?"

Posted: 07 Dec 2011 10:35 AM PST

Richard Green:

Who would pay a 73 percent income tax? Not necessarily the rich., by Richard Green: A paper which is receiving considerable attention (see here, here and here) is Diamond and Saez's Journal of Economic Perspectives piece on optimal marginal tax rates. They put the rate at 73 percent, and declare it an optimum because it would maximize revenue that could then be used for other things. In particular, they argue that the utility lost to the rich would be much less than the utility gained by lower income people via government programs. I do believe that many government programs leave people better off, but I am skeptical about whether the optimal size of government is that which is supported by a revenue maximizing income tax.
In any event, one aspect of the paper bothers me: if one searches for the word "incidence," it is not found. Incidence reflects who really bears the burden of a tax. If one taxes a person or a business, they might absorb it, or they might pass it on to someone else.
The formula for the incidence of a tax on those who demand a taxed good is (Supply Elasticity)/(Supply Elasticity - Demand Elasticity). (I apologize for having elegant formulas--I don't know how to paste them into Blogger). Because demand curves are generally downward sloping, demand elasticity has a negative sign, so in a sense, the incidence reflects how relatively elastic supply is relative to the sum of the absolute values of the elasticities of demand and supply.
Now let's think about supply elasticity at the revenue maximizing point. It is exactly one, in that the reduction in labor offered exactly offsets any increase in the rate. To illustrate, let us just assume for a moment that demand elasticity is -1. Then half the incidence of the tax is on the supplier of labor or capital (a.k.a. the rich) and half the incidence is on the demander. This means that the burden on the rich person is 36.5 percent, not 73 percent.
What we do know is that as tax rates fall, the supply elasticity of the wealthy falls. Why? Because we know at lower tax rates, raising rates raises revenue-the supply response to an increase in taxes is smaller. Let's assume that at a 50 percent marginal tax rate, the elasticity of labor supply for the rich is .25. Now the incidence on demanders is .25/1.25, or 20 percent of the tax burden; it is 80 percent on the rich. hence with a 50 percent tax rate, the effective tax on the rich is 40 percent, or higher than it would be with a 73 percent rate!
These arguments all depend on assumed elasticity parameters, and so it is important to estimate them as best as possible. I should also note that I am all for raising taxes, including on myself, to pay for the many government services that I do support. Somedays I think that if I could change the tax code, I would just raise my own taxes by ten percent and then have policy that assured that everyone with income greater than mine would pay an effective tax rate no lower than mine.

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