Is Israel’s war with Lebanon going to end differently from past attempts to secure Israel’s northern border? Journalist Matti Friedman, who recounted his experience as a soldier in Lebanon in his book Pumpkinflowers, reflects on that experience in light of current events and looks to the future in this conversation with EconTalk’s Russ Roberts. The post Is This War With Lebanon Different? (with Matti Friedman) appeared first on Econlib.

Tyler Cowen recent asked o1 Pro this question: What is the biggest problem with the idea of the Fed subsidizing an NGDP futures market, as economist Scott Sumner has proposed? Feel free to give an answer relying on theoretical macroeconomics, agency problems, finance theory, and the like. Here’s part of the response: One of the most serious challenges with the proposal to have the Federal Reserve subsidize an NGDP (Nominal Gross Domestic Product) futures market is the inherent vulnerability to market manipulation and distorted incentives. While the idea is elegant in theory—using a market for NGDP futures as a direct feedback loop into monetary policy—several interrelated issues arise: Market Manipulation and Gaming the System:If the Fed stands ready to adjust monetary policy based on the NGDP futures price, then traders have strong incentives to move that price in directions favorable to their own portfolios. Because the central bank would be compelled to respond to the signal emanating from the futures market, well-capitalized or strategically coordinated groups of traders might manipulate the quotes to influence policy actions. For instance, if participants believe the Fed will ease policy in response to lower NGDP expectations, they could short the NGDP futures contract to force the Fed’s hand, benefiting from subsequent asset price responses. The subsidization of the market, meant to improve liquidity, ironically lowers the cost of such manipulation by making the trading environment more attractive to those with non-informational motives. Information Asymmetry and Noise Trading:The existence of a subsidy may attract traders who are motivated less by fundamental views on future NGDP and more by the possibility of collecting the subsidy or exploiting the Fed’s reaction function. Under normal circumstances, futures markets aggregate dispersed information and reflect genuine expectations about future economic conditions. However, if the market is dominated by participants responding to the Fed’s predictable policy feedback loop, the price signal becomes less about true economic fundamentals and more about speculators front-running the central bank. Consequently, the quality of the informational content in the NGDP futures price can be severely degraded. Due to the Efficient Markets Hypothesis, I don’t think that this would be a serious problem.  If market manipulation were possible, then competition among market manipulators would drive the rate of excess return down close to zero.  If someone manipulating monetary policy the “wrong way” could make $X in profit, someone reverse manipulating in the opposite direction could make even larger profits.   Long ago, I realized that this was a losing battle.  Thus for the past decade I have been advocating an NGDP futures targeting approach that is clearly not subject to the risk of market manipulation.  I call it the “guardrails approach”, and it is explained in chapter 5 on my free online book.  Once again, I feel I need to explain this idea so that critics of my policy respond to what I am actually proposing. Suppose the Fed has a 4% target for NGDP growth over the next year.  (During Covid, I would have recommended temporarily switching to 2-year forward contracts.) The Fed could simply announce a willingness to take unlimited long positions on NGDP futures contracts based on 3% growth, and unlimited short positions on NGDP futures contracts based on 5% growth.  In that case, the Fed would profit any time the actual growth rate was within these two guardrails, between 3% and 5%.  That’s it.  That’s the entire proposal.  Aren’t I also suggesting the Fed must respond to the futures market?  No, they can completely ignore it when setting monetary policy, if they wish.  No subsidy is required. So let’s consider some objections: 1. What if no one trades the contracts?  I don’t care.  To quote Bob Dylan, “There’s no success like failure”.  If no one trades the contract, it’s likely because traders expect NGDP growth to fall within the 3% to 5% range. 2. What if no one trades the contracts at a time when policy is far off course, like 2008, or 2022?  In that case, I would trade the contracts, and I’d get really, really rich.  To anyone with half a brain it was obvious in late 2008 that NGDP would soon undershoot the Fed’s desired NGDP growth rate.  It was obvious in 2022 that NGDP growth would overshoot the Fed’s desired growth rate.  So I’d get rich.   But didn’t I previously argue that the EMH suggests that it’s actually very hard to get rich?  Yes I did.  But think about the implication of that fact.  If it’s obvious that the Fed is far off course, and no one is trading NGDP contracts, that would mean that it’s easy to get rich.  And that implies that in reality lots and lots of people would be trading those contracts if the Fed were obviously far off course. And we’re not done yet.  The Fed clearly doesn’t wish to lose vast amount of money on dumb NGDP futures trades.  Imagine having to explain to Congress that they lost a fortune on trades that anyone could see were foolish.  To prevent that from happening, the Fed would likely adjust policy until the market expectation of NGDP growth was within the 3% to 5% range. So why isn’t this guardrails approach subject to market manipulation?  It will be helpful to consider two scenarios: Case A.  Trading is fairly quiet for a time, and then a large number of traders begin to line up on one side of the futures market.   Case B.  Trading is fairly quiet, and then George Soros suddenly makes a billion dollar bet in the market. If you were a Fed official, which of these two scenarios would make you more likely to shift your policy stance?  The answer is obvious—the whole point of NGDP targeting is to leverage the “wisdom of crowds”, the idea is to expand the FOMC voting members from 12 to as many as 8.2 billion members.  George Soros is rich, but he’s still just one opinion. There are two ways of thinking about this proposal: 1.  It gives the Fed useful information. 2. It adds constraints on policy that make policy more credible. It actually does both, but I believe that the credibility aspect is far more important than the information aspect.  Even the Fed knew that NGDP in 2009 was going to be too low.  Even the Fed knew that NGDP in 2022 was going to be too high.  Guardrails force the Fed to “do the right thing”. In this respect, NGDP futures targeting is a lot like level targeting without NGDP futures contracts.  Under level targeting, markets also strongly pressure the Fed to “do the right thing”.  If we had had a level targeting regime in place in late 2021, then once markets saw that NGDP growth was going to be too high, they would have pushed market interest rates higher, in anticipation of the tighter future monetary policy required to bring NGDP back down.  But those higher interest rates would have quickly reduced nominal spending.  Under level targeting, whenever the Fed is asleep at the wheel, the markets move the wheel (market interest rates) for the Fed.  Guardrails and level targeting—two ways for markets to force the Fed to do the right thing. Perhaps some day I’ll have people respond to my actual proposal.  Until then, I feel like this guy (painted by Titian): (0 COMMENTS)

Friday Feature: SEA Homeschoolers by Colleen Hroncich, Cato at Liberty, December 6, 2024. Excerpt: Conservative Christians probably aren’t generally seen as trailblazers, but they were at the forefront of homeschooling in the 1960s and 1970s. So it’s not surprising that curricula and resources for homeschoolers are often Christian in nature. When Blair Lee, a college professor with a background in chemistry and biology, began homeschooling her son in the early 2000s, she struggled to find quality secular science resources. What started as an effort to fill that gap eventually became Secular Eclectic Academic (SEA) Homeschoolers. “Homeschooling wasn’t really on my radar,” Blair says. “My son was a very early reader. No Child Left Behind left all of those advanced kids behind. His teacher prompted me to make the decision to homeschool. She told me that with the current system, my child would get lots of test prep, and they would always want to test him because he would make the school look good.” But he wouldn’t be given work that would challenge him and help him grow. The teacher predicted he would eventually wonder why he bothered trying so hard. He’d still be “advanced,” but he’d be achieving well below his capabilities. Blair listened to the teacher and homeschooled her son from first grade through high school. DRH comment: The way the teacher treated the kid was awful. I’m not necessarily blaming the teacher; it was the higher-level people in government who screwed it up. It reminds me of what was one of the last two straws that motivated us to take our daughter out of the government school in Pacific Grove at the end of 4th grade. We went to parents’ night and said to the teacher, “Our daughter is getting all A’s, but we’re wondering what an A means.” The teacher answered, “Oh, Karen is one of the ones I don’t have to worry about.” In context, it was clear that “worry” meant “think.”   Argentina’s Economic Challenge in Context by Timothy Taylor, Conversable Economist, December 9, 2024. Excerpts: When those outside Argentina discuss Javier Milei, who took office as President of Argentina in December 2023, I sometimes feel as if they are actually saying how they would feel if Milei was elected in their own country. For example, Milei has in a year cut Argentina’s government spending by 30% in real terms. So US-based commenters have a tendency to evaluate him by whether they would favor a 30% cut in US government spending. They do not ask such a policy might make sense specifically in Argentina–or what facts in Argentina’s history might make a majority of voters willing to give such a policy a try. To understand why Argentinians would turn to Milei, it’s useful to ask the question: What if growth in your country’s standard of living had been lagging for decades. Moreover, what if you had had some experience with reforms that seemed to work in the 1990s and early 2000s, but now it felt as if the country was back on the same old treadmill of very sluggish growth and high inflation? Tobias Martinez Gonzalez and Juan Pablo Nicolini provide context for Argentina’s economic experience in history in “Argentina at a Crossroads”(Quarterly Review: Federal Reserve Bank of Minneapolis, November 13, 2024). Both are affiliated with the Universidad Torcuato Di Tella in Buenos Aires, and thus have a close-up view of Argentina’s economy and the arrival of Milei as president. Their point is not to dissect the merits what Milei has done in his first year as president, but to convey the economic situation in Argentina to which Milei is the elected response. And: The authors summarize Argentinian economic experience in the last half-century with a table and a figure. The table shows that when Argentina’s government was able to keep inflation under control, in the 1990s and for a time in the early 2000s, growth was strong. But when inflation climbed, growth dropped.   Itinerant Baseball Team May “Need” More Taxpayer Funds by Marc Joffe, Cato at Liberty, December 9, 2024. Excerpts: The baseball club formerly known as the Oakland A’s has begun an odyssey that should ultimately take it to Las Vegas in the late 2020s. But the team may need to shake down Nevada taxpayers for even more money before finishing its journey. Professional sports, in which wealthy owners employ well-compensated players to compete in front of disproportionately affluent crowds, may seem like the least eligible business for taxpayer-funded government largesse, but somehow the subsidies keep coming. Until the early 20th century, US stadiums were normally funded privately. But in 1928, Cleveland, Ohio voters approved a $2.5 million bond measure to fund the construction of Cleveland Municipal Stadium, kicking off the Depression-era trendtoward publicly funded construction. Although the stadium was part of a failed effort to attract the 1932 Olympics, it soon became the home of the MLB Cleveland Indians and later the NFL Cleveland Browns. The facility was demolished in 1995, only 64 years after it opened, a fact that throws cold water on the notion that big municipal infrastructure projects are generational investments benefiting residents far into the future. Instead, stadiums rapidly become obsolete, necessitating either replacement or costly makeovers. Such was the case with the Oakland Coliseum, which opened in 1966, became the home of the A’s in 1968, and was considered obsolescent long before the A’s finally left in 2024. The Coliseum and adjacent Oakland Arena have been encumbered by municipal bond debt throughout their entire existence.   Phil A. McBride: Canada Post’s workers might have killed the cheque by Phil A. McBride, The Line, December 10, 2024. Excerpt: For more than a century, Canadian businesses have been using cheques and the post office to send and receive money across the country and the world. It’s easy: you write a cheque, you put it in the mail, the recipient deposits the cheque at their bank, you wait five business days for it to clear and voila — you’ve got the money. Except, right now, of course, that’s not happening, due to the ongoing postal strike. In fact, a great number of cheques that are in the mail are stuck there, leaving businesses and Canadians with money stranded in transit. I am increasingly convinced that this strike will be remembered in the future as the death of cheques in Canada, at least as a major medium of business exchange.   The People Cheering Brian Thompson’s Murder Can’t Have the Medical Utopia That They Want by J.D. Tuccille, Reason, December 11, 2024. Excerpts: Evoking a collective scream of despair from socialists and anti-corporate types, police in Pennsylvania arrested Luigi Mangione, a suspect in the murder of UnitedHealthcare CEO Brian Thompson. Thompson, they insist, stood in the way of the sort of health care they think they deserve and shooting him down on the street was some sort of bloody-minded strike for justice. The assassin’s fans—and the legal system has yet to convict anybody for the crime—are moral degenerates. But they’re also dreaming, if they think insurance executives like Thompson are all that stands between them and their visions of a single-payer medical system that satisfies every desire. While there is a lot wrong with the main way health care is paid for and delivered in the U.S., what the haters want is probably not achievable, and the means many of them prefer would make things worse. And: And Canada’s single-payer system famously relies heavily on long wait times to ration care. “In 2023, physicians report a median wait time of 27.7 weeks between a referral from a general practitioner and receipt of treatment,” the Fraser Institute found last year. “This represents the longest delay in the survey’s history and is 198% longer than the 9.3 weeks Canadian patients could expect to wait in 1993.” You have to wonder what those so furious at Brian Thompson that they would applaud his murder would say about the officials managing systems elsewhere. None of them deliver “unlimited care, from the doctor of their choice, with no wait, free of charge.” Some lack the minimal discipline imposed by what competition exists among insurers in the U.S.   State Pension Contributions and Their Impact on State Education Budgets by Joshua D. Rauh and Gregory Kearney, Hoover Institution, November 2024. Excerpt: However, most states are severely underestimating their expenses by assuming that high investment returns will make up a great deal of their shortfalls, often using rates as high as 7.5 percent. For example, using an assumed investment rate of return of 7.5 percent, a state can say that a $100,000 payment due in about ten years is “fully funded” even though only $50,000 is set aside today. Using more realistic assumptions tied to the Treasury yield curve, the authors of the above study find that a more accurate approximation of the underfunding level is $5.12 trillion. Due to these concerns, states have largely ignored the possibility of making major shifs away from DB [Defined Benefit] plans, instead attempting to ofset some of the DB costs by increasing the contribution rates assigned to employees, school districts, and to a lesser extent, the state governments themselves. For example, in California, the employee contribution rate increased from 8 percent of pay to 10.25 percent of pay from 2014 to 2024. During this same time frame, the employer contribution rate increased from 8.25 percent of pay to 19.1 percent of pay. The state government’s own contribution rate sits at 8.328 percent, and this may only increase by, at most, 0.5 percent year-to-year. Without such contribution increases, which are largely passed along to school districts, the unfunded liability will continue to grow even faster.     (0 COMMENTS)

My wife and I recently returned from our first trip to Greece.  Between a busy schedule of espresso, sailing, hiking, pilgrimages to historical sights, and just generally eating our way across the Hellenistic Empire, I noticed one thing in particular: cats.  Cats everywhere.  In the street, on our feet, in the bar, on the car.  Our friends in Athens had mentioned this; the cats are very much residents of the town.  It’s an arrangement that goes back millenia: cats were seen as good luck as well as protectors against evil spirits; the goddesses Artemis, Aphrodite, and Athena were often seen in the company of cats and, if Greek mythology has taught me anything, it’s that you don’t mess with the gods or local wildlife (lookin’ at you, Zeus).  There was a practical aspect as well: cats helped keep rodents out of granaries and control other pests while the winding, narrow alleys that serve as streets provide shelter and a stable food source. But what stood out to me was the organization of the felines.  Regardless if you were in Athens, or Nafplion, or Ithaca, or Meteora, or Mount Olympus, the cats generally behaved the same.  Sometimes they were solitary or sometimes in small groups, but their manners were always exquisite.  You’d always find a cat curled up at your feet, preferably in a sunny spot, patiently eyeing you and your meal waiting for you to make the right decision to drop some of your dish on the ground.  They’d never climb on the table or scratch at your leg impatiently; frankly, my cats could take a lesson from them.  If anyone, either a cat or a person, broke the code, they were quick to be corrected. One day as we were enjoying an afternoon coffee in Ithaca, we were discussing this phenomenon with a local friend of ours, another tourist remarked uninvited, “Best not to feed the cats.  They’re a plague, really.”  I honestly could not imagine a more asinine statement!  Besides being a childless cat guy, we were witnessing a social order that evolved spontaneously through the self-interest of each party.  F.A. Hayek argued that many constructs were examples of spontaneous orders, and witnessing this development of cross-species law and moral code, I’m inclined to agree.  In essence, this posh tourist’s view was that humans were better situated to allocate the resources.  Strays are an inefficient use of limited resources that could better be spent in other ways. Had I not been occupied with accidentally dropping part of a sardine on the ground in the vicinity of my feline shadow, I might have retorted.  No one person, or planning body, has all the knowledge to effectively allocate resources.  We are best suited to allocate our resources based on each of our needs, values, perceptions, and conditions.  We are able to influence each others’ behavior to develop a societal norm that fosters mutual prosperity and evolutionary survival.   But maybe I’m thinking too much about the interaction of communal cats and their adopted people.  Maybe all that there is here is a bit of fish, a gentle “thank you” purr, and then we part ways, on to other parts of our lives.  But even if all my waxing philosophical about spontaneous order is nothing but a bunch of hooey, with a velvety espresso in my hand, warm sun on my face, and a soft cat keeping me company, I am perfectly ok with that.     Dennis Murphy is a professional airline pilot with a background in aviation safety, accident investigation, and causality. When he’s not flying 737s, he enjoys the company of his wife, their dogs, cats, and bees. (0 COMMENTS)

It is possible to spend $100,000 on a luxury car. Most people don’t do so, and not just because they cannot “afford” one. Even among Americans with over $100,000 in wealth, only a tiny fraction would choose to spend $100,000 on a luxury car.You can also spend $35,000 on a luxury car, something like a Toyota Camry. You might object that a Camry is not a luxury car. Actually, it is. Car manufacturers have basically perfected the art of building a high quality car. Today, the quality difference between something like a Camry and a $100,000 car is so slight as to be hardly worth commenting on. What would get me to buy a $100,000 car? Perhaps if the government paid 95% of the cost of my new car. In that case, I might prefer to spend $5000 (out of pocket) on a fancy Mercedes rather than $1750 on a new Camry.It would be extraordinarily wasteful if price distortions caused our economy to switch from producing $35,000 cars to producing $100,000 cars. In other sectors, however, we’ve done something very much like that—because of subsidies.What would get me to spend $100,000 on a medical procedure rather than $35,000 on an almost as good procedure? Subsidies. If I only had to pay a small percentage of the cost out-of-pocket, then the highest quality procedure would become much more attractive. That’s one reason why America spends 17% of GDP on medical care.This Bloomberg story caught my eye: Trump’s economic advisers are considering doubling the state and local tax deduction, a popular — but expensive — tax break that could deliver big savings to many residents of New York, New Jersey, and California. Economist Stephen Moore, a member of President-elect Donald Trump’s economic advisory transition team, told Bloomberg Thursday that the group has discussed expanding the tax write-off limit from $10,000 to $20,000. In my view, the decision to cap the SALT deduction at $10,000 was the single most successful economic policy initiative of the past decade.  It had two important benefits: 1. The deduction greatly simplified tax preparation for many taxpayers (including me.)  Now you could simply take the standard deduction, avoiding lots of time-consuming paperwork. 2. The SALT cap took away a major subsidy to spending at the state government level.  For people in the 40% federal tax bracket, the SALT deduction meant that the federal government effectively paid 40% of their state income tax bill, at least in those states that have an income tax.  In the period since the change, a number of states have begun reducing their state income tax rates, which is exactly what I would have expected.  If the cap goes up to $20,000, then states will have a strong incentive to do additional wasteful spending. PS.  Of course, the claim “single most successful economic policy of the past decade” is a very low bar, as the past decade has been one of almost unrelenting policy mistakes. (0 COMMENTS)

We’ve heard a lot about misinformation in the news of late…but how do we know when we encounter it? What’s the difference between misinformation and disinformation, and is there any space for truth anymore? If too many people believe things that aren’t true, shouldn’t we try to fix that??? Not necessarily, says this episode’s guest Arnold Kling. Kling holds little stock in a monolithic notion of truth, but rather sees truth as the result of a process , a process of searching for truth. Through such a process, Kling argues, many things ultimately turn out to be wrong. Because of this, he thinks that people who claim to have found “the truth” are the most dangerous- in part because such claims allow them to think they have a right to censor what is not “true.” Roberts regards disagreements about what is “true” as a conflict between people who favor process versus people who favor outcomes; he draws an analogy to economic policy- the disagreement over rules versus discretion. So what’s the best way to seek truth- and perhaps more importantly, how might one be best able to identify what is NOT true? Consider the prompts below, and share your thoughts with us online, or start your own real-world conversation. Let’s keep the conversation flowing!     1- Both Kling and Roberts (obviously!) appreciate competition in economics- trial and error, profit and loss- and seem to wish there were a similar process in the market for ideas.  Roberts wonders why feedback loops in this sort of [market] competition work, while perhaps less so with regard to information? Put simply, why can’t bad information “go out of business?” Or can it? Consider Kling’s assertion, “We decide what to believe by deciding who to believe.” What does he mean by this, and to what extent do you agree? How do brokers in information build up credibility?   2- Roberts brings up his disenchantment with social media and the issue of censorship. Should there be standards for what can be posted on social media? If so, what might such standards look like? What are Roberts’ biggest issues with social media censorship? When asked about regulation social media, Kling states he’d prefer a softer, more bottom-up approach to regulation.  Again, what might this look like? How does this compare with the answer Reason’s Katherine Mangu-Ward gives when asked a similar question by Mitch Daniels (~15:00)? What’s YOUR answer to this thorny question? (And a follow-up question, to what extent ought we regard social media as today’s “public square?”)   3- The conversation turns to the COVID pandemic as an example of misinformation and information suppression. Roberts describes three possible reasons for withholding truths- one of which he finds reasonable, and another which he thought was driving the public health establishment. What are these three reasons? Which do you find reasonable, and why? (In answering this question, it might be useful to ask yourself who were the Baptists and who were the Bootleggers in this situation?)   4- What role does the science establishment and the academy play in determining and disseminating truth? What does Kling mean when he says, “you get what you select for” in an organization, and what’s the difference between prestige and dominance hierarchies? Does the academy have more or less credibility than in the past? Why?   5- Toward the end of the conversation, Roberts and Kling return to Kling’s Three Languages of Politics. How do these three languages (conservative, progressive, libertarian) become political blind spots, according to Roberts? Roberts and Kling describe this process with regard to police brutality and the war in Israel. What other issues can you apply this framework to? Explain. (0 COMMENTS)

Here’s a multiple-choice question I’ll be placing on an upcoming quiz in my monetary economics class: The Federal Reserve is like which of the following: A failed 1980s Savings & Loan 2023 failure Silicon Valley Bank 2001 mega bankruptcy Enron All of the above Answer: All of the above.  The Fed compares to S&Ls because it’s banking backwards: borrow high, lend low. Old time S&L bankers lived by the “3-6-3” rule: pay 3% interest on short terms deposits, lend at 6% on 30 year mortgages, and be on the golf course by 3 pm. This business model worked well with low, stable inflation, which kept  interest rates steady. S&Ls began losing money when inflation—and the Fed’s belated response to it—pushed short-term interest rates up well above 6% (remember Paul Volcker?), but a large portion of their loan books was locked-in at those 6% mortgages. A multitude of regulatory blunders led to compounding losses of $175 billion by the time the dust settled on the S&L crisis.  The Fed compares to Silicon Valley Bank because it “invested” in highly interest rate sensitive assets (US Treasuries) which saw a massive decline in market value as interest rates began to rise. As finance students know, “bond prices are inversely related to interest rates.” When interest rates rise, existing bonds, with relatively low “coupons” (annual interest payments) become less attractive to own in comparison with new bonds, issued at the new, higher coupon rates. Investors unload those older bonds, forcing their prices (capital value) down until their risk-adjusted yields match the new, higher rates. SVB invested very heavily in a seemingly “safe” portfolio of Treasury bonds, but their managers apparently never took a basic bank management class, in which they could have learned about interest rate sensitivity, asset-liability management, portfolio diversification, and risk hedging tools like options and swaps. When rising interest rates, combined with its bond-heavy investment book, revealed looming capital losses in early 2023, SVBs depositors began to run on the bank, which forced SVB to fire-sale its devalued bonds, perpetuating even more losses. The bank was liquidated by the FDIC in March 2023 at a loss to the insurance fund of about $20 billion. The Fed compares to Enron because its financial reporting uses “non-standard” (non-GAAP) accounting to hide losses on its income statement. Enron’s accounting trickery—abetted by auditor Arthur Anderson— was sophisticated and multifaceted, but among their biggest tricks were overstating prospective future income streams and using “off-balance sheet” entities to mask the company’s true debt levels. Enron’s financial chicanery, combined with an audacious rent-seeking grift by way of regulatory arbitrage, made its earnings growth appear unbelievably strong, and made its stock one of the biggest flyers of the dot-com era. The exposure of Enron’s fraud in late 2001 led to the largest bankruptcy in US history to that date. To be fair, the Federal Reserve is neither a commercial bank, nor a for-profit corporation subject to GAAP, so my comparisons are in one sense purely academic. However, these parallels are fascinating and reveal some troubling aspects of our current monetary and fiscal situation.  To understand how the Fed pulled off this bad-finance trifecta—negative yield spread, capital losses on interest-sensitive “safe” assets, and massive accounting fraud—we need to review some recent history and track how the Fed’s monetary policy operating procedures have changed in response to major events.  Here’s a thumbnail sketch of how the Fed used to operate, pre-2008 (I don’t necessarily endorse any of this, but this is how it was generally presented in textbooks): When the Fed wants to “stimulate” the economy, it looks to cut interest rates. The Fed reduces interest rates by way of “open market purchases” of Treasury securities. The Fed creates new money (in the form of bank reserves) and uses it to fund these purchases of T-bills from banks. Banks swap T-bills for cash, which positions them to increase their lending. The increased supply of “loanable funds,” if large enough, can push interest rates down—at least in the short run. This can cause inflation to heat up, as the increased bank lending leads to more bank deposits and a larger measured money supply. Moreover, lower interest rates combined with Fed purchases of T-bills enables greater deficit spending by Congress. This can really have an inflationary kick, as we witnessed with Covid stimulus checks puts spendable funds directly in the hands of consumers. To cool down inflationary pressures, the Fed raises interest rates to put a damper on bank lending, and hence business and consumer spending. The mechanism here involved “open market sales” of Treasury securities. The Fed would sell T-bills to banks (at attractive prices) and this would draw bank reserves out of the banking system, as banks hand over reserves to the Fed in payment for their newly acquired T-bills. The Fed would then “extinguish” those bank reserves, and with fewer reserves on hand, bank lending would taper off, leading to smaller rates of growth in the money supply and overall spending, ostensibly putting downward pressure on inflation.  Because the Fed decided to undertake “quantitative easing” in their response to the Great Financial Crisis of 2008, we’ve arrived at a situation where good old “open market operations” are no longer feasible. In its bid to suppress long-term interest rates and boost total spending, the Fed purchased an absolutely huge amount of Treasury and mortgage-backed securities, something on the order of $8 trillion cumulatively through 2022. The relatively small open market operations that the Fed used to rely on to manipulate interest rates and lending are no longer adequate to the task. To effect a noticeable interest rate hike, for instance, the Fed would have to transact multi-trillion dollar open market sales. Dumping this volume of T-bills on the market all at once would risk massive market disruptions and potentially wild interest rate swings. Treasury prices would plummet (and their yields spike), negatively impacting not only the US government’s ongoing funding operations, but the balance sheets of all manner of businesses which hold significant amounts of Treasuries. Thus today, rather than sell securities in a potentially disruptive fashion, the Fed has found a new mechanism to move short term interest rates around: the so-called “floor mechanism” with the policy tool known as interest on reserve balances (IORB). The way it works is very simple: the Fed pays banks interest on the reserves they keep on deposit with the Fed. This sets a reliable price floor on market interest rates, as banks will refuse to lend to commercial clients at any rate below what the Fed will reliably pay them to just sit on reserves with zero credit risk. So nowadays, when the Fed needs to fight inflation, it simply ups this IORB rate, raising banks’ opportunity cost of lending and thereby pushing all market interest rates upward.  However a significant problem has inevitably emerged, given the combination of QE, IORB, and inflation. QE meant that the Fed issued trillions of dollars in new reserves, a large chunk of which banks have opted to just sit on, rather than lend. IORB, especially after the recent rate-hiking cycle, has meant banks earn a tidy return by not lending this large chunk of reserves. Inflation means the Fed has to raise interest rates (and IORB), which means even more easy, passive income for banks via their un-lent reserve balances. So here’s where it gets weird, sad, and fraudulent: we have arrived at a situation where the Federal Reserve is paying more money for the deposits it holds (via IORB) than it earns on its portfolio of investments in Treasurys and MBS that it acquired through all that QE. In other words, the Fed has gone full 1980s S&L: borrow high, lend (invest) low. This also means the Fed has turned over a new leaf: for the first time ever, America’s central bank is losing money. In its 2023 operating year, the Fed system amassed total operating losses of $114 billion—this in addition to unrealized capital losses on its Treasury/MBS portfolio that began with rate hikes in 2022. However, if you look at the Fed’s consolidated income statement for 2023, you’ll see “comprehensive income” (net income) reported at a positive $1.5 billion. Did the Fed have non-operating income to offset the fact that it paid $281 billion in interest, but only earned $175 billion on its bond portfolio? Nope. The Fed indeed lost money outright, S&L style. But in a move that would impress the most creative accountants, the Fed simply engaged in “non-standard accounting practices” to hide that loss on its income statement. In truly Enron-esque style, the Fed listed the loss as, get this, a “deferred asset,” and magically waved it away. Here’s the fine print from the Fed’s 2023 financial statements: The Reserve Banks remitted excess earnings to the Treasury on a weekly basis during most of 2022 and periodically during 2023. In the fall of 2022, the Reserve Banks first suspended weekly remittances to the Treasury because earnings shifted from excess to less than the costs of operations, payment of dividends, and reservation of surplus. The Reserve Banks’ deferred asset represents the net accumulation of costs in excess of earnings, and is reported as “Deferred asset – remittances to the Treasury” in the Combined Statements of Condition. The deferred asset represents the amount of net excess earnings the Reserve Banks will need to realize in the future before remittances to the Treasury resume. No impairment existed as of December 31, 2023, as net excess earnings of the Reserve Banks in future periods are expected to exceed the balance of the deferred asset. In other words, the Fed admits it lost money last year, but it will definitely earn that money back later, and therefore it can just kick that loss down the road, repackage it as a “deferred asset” and add it back on the income statement. It’s recorded as a negative, but it’s subtracted: a negative plus a negative equals a positive. If only Kenneth Lay had lived to see it!  The irony of Fed losses is rich. The Fed was created as a “lender of last resort” for the US financial system. It’s job was to centralize the reserves of the entire financial system (then: gold; now: Fed-issued base money) and be ready, willing, and able to lend freely to member banks during times of financial crisis. The Fed acquired the reserves it held largely by regulatory mandate for member banks to keep a certain amount of money on deposit—”required reserves.” Thus, the Fed would force banks to deposit money with it at zero interest, and in turn the Fed would lend that reserve, as needed, to banks at a positive interest rate. While the Fed was not seeking to earn constant profits on its reserve fund, it at least covered its operating expenses and acted as a bank normally does: “borrow low, lend high”—albeit with a limited, crisis-oriented lending role. Today, things are bass-ackwards for the Fed: it is borrowing high and lending low. It’s so backwards that the Fed is losing hundreds of billions of dollars annually. If this were a Fortune 500 company, stock values would have tanked, bankruptcy proceedings would be ongoing, lawsuits would be flying, executives and auditors would be facing jail time.   The difference with the Federal Reserve, of course, is that it’s a government-chartered central bank with a monopoly on issuing base money, so none of this matters, at least legally speaking. Unlike the badly-managed and/or fraudulent corporations I compared it to, the Fed won’t go out of business. The Fed can endlessly create new money to paper over its problems and continue operating as if everything’s hunky-dory. And in a sense, everything is fine for the Fed, at least for now. The Fed is special, it’s a central bank, it’s the government. It can excuse itself from standard accounting practices and it doesn’t have to turn a profit. Maybe you’re okay with that, but let me leave you with a deeper note of worry. It appears we have arrived at a moment in time where the solution to any and every potential problem is to print more money. After all, printing money—via QE to “stimulate” the moribund US economy—is what got the Fed into this situation of needing to create a price floor on short-term interest rates (the IORB mechanism). Printing money to finance massive government deficits and stimulus checks is what triggered the biggest inflation in 40 years. And now, to raise rates and cool the inflation it created, the Fed finds itself… printing more money. But this time, on account of the new floor mechanism and IORB, the Fed finds itself in a position where it must pay out more interest (on reserves) than it’s earning (on its Treasury and mortgage bonds). The Fed has painted itself into a corner where the solution to every scenario involves just printing money. Unless drastic steps are taken to either reduce bank reserves and/or slash interest rates, the Fed seems to be stuck with the losses and the money printing. This does not bode well for the future of the US economy.  Perhaps I’ll add a follow-up question on that upcoming quiz: The Federal Reserve is most likely to enact which policy in the near- to medium-term future:  Print money to “stimulate” the economy via QE Print money to “fight inflation” via IORB-induced rate hikes Print money to finance $2 trillion US government deficits All of the above   (0 COMMENTS)

Public choice is often called by the shorthand “politics without romance.” In the Concise Encyclopedia of Economics entry, we summarize this romance to overcome as,  The wishful thinking…that participants in the political sphere aspire to promote the common good. In the conventional “public interest” view, public officials are portrayed as benevolent “public servants” who faithfully carry out the “will of the people.” In tending to the public’s business, voters, politicians, and policymakers are supposed somehow to rise above their own parochial concerns. Public choice helps explain why, instead of selfless, elevated public servants pursuing only the public good, we see problems like log-rolling, rent seeking, and the concentration of power. But there is another kind of romantic politics—one to which fans of public choice are much more susceptible. It’s the romantic notion that we can, in response to the problems with politics revealed by public choice, do away with politics altogether.  The theory is that if we can set the institutions and incentives, we can take the reins of politics off those areas of life. There are two problems with this theory. First, we don’t get to start from scratch, but from the world we’re in. That means the problems of public choice apply to the process that would have to bring about these changes. The second is related: it ignores that people do things through politics in the first place for a reason.  We’re stuck with each other. Adam Smith got this. One of his most famous phrases is about the “man of system.” The man of system “seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess-board. He does not consider that the pieces upon the chess-board have no other principle of motion besides that which the hand impresses upon them”.(TMS VI.ii.2.17) Market liberals often use this quotation to illustrate the flawed idea at the heart of comprehensive economic planning. But that’s not what Smith was talking about. Smith was talking about political change.  For example, Smith didn’t think that completely free trade was politically possible. It could only ever be brought about by a man of system. [1] Only a man of system could sweep aside political interests and organizations that would stand in the way of free trade. Only a man of system would try to order what remained to make that change last.  Instead, Smith acknowledges the importance of existing political structures, interests, and groups. Someone “whose public spirit is prompted altogether by humanity and beneficence” has to compromise and act politically. “He will accommodate, as well as he can, his public arrangements to the confirmed habits and prejudices of the people; and will remedy, as well as he can, the inconveniencies which may flow from the want of those regulations which the people are averse to submit to. When he cannot establish the right, he will not disdain to ameliorate the wrong; but like Solon, when he cannot establish the best system of laws, he will try to establish the best that the people can bear.” (TMS VI.ii.2.16) Like it or not, some principles of motion are political.  Exchange and change James Buchanan, who coined the term “politics without romance,” thought that modelling politicians and bureaucrats as economic actors is “not enough. If you start thinking about politics that way then you have a very empty type of theory…The thing that must be added to that must be the notion that at some ultimate level, people must enter into political arrangements for mutual gain.” (Buchanan Intellectual Portrait Series, 8:50) The implicit hope for limits on politics that will solve the problems of politics is that the small-government policies frustrated by democratic politics can be imposed, one time, some other way. Then, things will simply run themselves. The new rules will become the background conditions for ordering society. Over-emphasis of emergent institutions might be partially to blame for the temptation to treat institutions as background conditions that can be taken for granted. In reality, institutions and rules are also in the realm of politics. Institutions that can be improved don’t automatically fade into the background. They can also be changed back, or made worse from the status quo. Those who want to depoliticize society hope for a lasting restriction on government action. There are two ways that action can be restricted. The first is to prohibit politics from breaking out again. This requires concentrating the power to set the limits on politics into some institutions not subject to democratic pressure. The libertarian warning that we shouldn’t create power we wouldn’t hand to our political opponents comes to mind. The second way toward lasting change is to do the persuasive work that would have brought them about—or the best approximation that the people can bear—through democratic politics. This method does not save anyone from the problems in politics that public choice so usefully identifies. But unlike a solution that prevents politics from breaking out, democratic persuasion keeps power dispersed and treats people as equals, with principles of motion of their own.  It’s not as neat and tidy. It’s not as romantic. But it’s democratic. It’s liberal. That should be enough.     [1] Thanks to Jacob T. Levy for this observation. [2] Thanks to Mike Munger for making me aware of this quotation. [3] In the interview, Buchanan rejects the view that any single theory, even public choice, explains politics. (0 COMMENTS)

Every year in December, The Economist finds a “word of the year” that summarizes a major event or trend and has gained popularity in its wake. It is useful to know that the magazine has been opposed to populism as it rose in the United States and elsewhere in the world but, I would say, not always in a consistent way. The real problem is not the right and the left, but the preference for collective choices over individual choices that characterizes both sides. (There have been some encouraging signs, however, that the prestigious magazine is evolving toward its 19th-century classical liberal roots.) The Economist‘s word for 2024 is “kakistocracy,” the rule by the worst, from the ancient Greek kakistos (κάκιστος) for “the worst” and, of course, kratia (κρατία) for “rule” or “power.” Contrary to the case of, say, “aristocracy,” the derivative “kakistocrat” for those worst people who govern has not taken root, but we can hope it will. The 2024 word of the year would remain very relevant even if Ms. Harris had been elected in place of Mr. Trump. It is also relevant in many other countries. In his 1944 book The Road to Serfdom, Fredrich Hayek, the future economics Nobel laureate, foresaw that as the state gains power, the worst people would become rulers, whether it be a single dictator adored by the majority or an omnipotent democratic majority. The regime would be supported by people with the lowest moral and intellectual standards and by the most gullible. They would embrace the principle that the end justifies the means and unite against scapegoats. People would lose any “respect for the individual qua man instead of merely as a member of an organized group.” Cynicism and disregard for truth would spread. Tribal emotions and government propaganda would displace rational arguments. Hayek would not have been surprised if foreigners, immigrants, and pet-eating Haitians were among the scapegoats. Kakistocracy is etymologically a very pejorative term. Kakistos is the superlative of kakos (κακός), which means bad or evil. Cacophony, for example, means unpleasant sounds. The plural neutral of kakos is kaka (κακά) and means bad things. The French baby-talk word “caca,” meaning “pou-pou,” came from that Greek word or a Latin derivative. It has been part of the French language since the 16th century. I understand that, in American English (“****”) and in Spanish, the word has the same meaning. From a political-economy viewpoint, which is what interests us here, kakistocracy is bad for everybody except the kakistocrats. ****************************** Behind the scenes: I instructed DALL-E to create an image “representing three members of a democratic kakistocracy.” The bot refused, saying that this concept “didn’t align with our content policy.”  He would only agree to represent a democratic kakistocracy that would, as I told him, “makes your content policy illegal”! The second image below is one of the two he produced for that case. But the least bad image I finally obtained to illustrate this post was when I asked him for one “representing three members of a populist kakistocracy.” Changing “democratic” for “populist” also worked for his content policy! This is the first one just below. DALL-E explained, “Here is the generated image representing three members of a fictional populist kakistocracy.” AI bots are not Einsteins nor great social theorists. “Three members of a fictional populist kakistocracy,” by DALL-E DALL-E’s view of a democratic kakistocracy that would outlaw his “content policy”     (0 COMMENTS)

Over the years, I’ve done a number of posts reacting to Paul Krugman’s columns and blog posts. Now that Krugman is retiring from his NYT column (but not from academia), I thought I’d share a few observations about his career as a pundit. What made Krugman such an influential economic pundit, perhaps the most influential?Some pundits are especially good at showing how a seemingly simple problem might actually be quite complex. I’ve seen blog posts by people like Tyler Cowen and Scott Alexander that discuss an issue about which I can only think of 2 or 3 relevant factors. They somehow come up with 10 or 12 important perspectives, most of which I’d never considered. My mind tends to move along a narrow track.Other pundits are especially good at showing that a seemingly complex problem actually has a fairly simple underlying cause. They are good at getting to the heart of an issue that seems very messy at first glance. Paul Krugman is one of the most talented at that sort of analysis.  (He also has excellent writing skills.) Many of my readers have views closer to mine than Krugman on questions such as size of government, deregulation, and fiscal stimulus.  They are often surprised to find that I have a very high opinion of Krugman as an economist, despite important policy differences in some areas. Although my policy views are closer to those of people like Tyler Cowen, my analytical approach is often closer to Krugman’s.  Indeed, some would argue that I oversimplify things.  Thus I argued that the Great Recession of 2008 was caused by overly tight money that depressed NGDP, and the other things we observed (such as financial distress) were mostly symptoms of that decline in aggregate demand.  In a recent post, I argued that the Great Depression was more complicated than many people assume, but even in that case I believe the underlying cause was pretty simple: the hoarding of gold by central banks and the hoarding of currency by the public.  The increased demand for those two media of account caused NGDP to fall in half between late 1929 and early 1933.  Because of sticky wages, the sharply lower NGDP greatly reduced employment and output. I’ve argued that Krugman’s 1998 Brookings paper entitled “It’s Baaack . . .” was the last example of an innovative paper that fundamentally changed how we think about money/macro.  Of course there are lots of excellent research papers being done all the time, but we now seem to be running out of truly transformative ideas, or at least transformative ideas that are broadly accepted.   In that paper, Krugman developed a new way of thinking about the zero lower bound problem, also known as the “liquidity trap”, which occurs when nominal interest rates fall to zero.  I won’t do an in depth discussion here; interested readers can look at my (fairly long) paper on the Princeton School of Macroeconomics.  Most importantly, Krugman showed that underlying a liquidity trap is a deeper problem of an “expectations trap”, the challenge of shaping expectations of the future path of monetary policy.  In my Princeton School paper, I used the analogy of the Coase Theorem to explain this insight. Coase had showed that underlying the issue of external cost, there’s a deeper problem associated with transactions costs. Coase is another economist that was good at seeing beyond all the surface complexity, and getting to the essence of a problem.   Congratulations to Paul Krugman on a distinguished career as a NYT columnist.   (0 COMMENTS)