An ongoing review of politics and culture

Re: Apple’s Cash

One of the great things about Karl Smith is that he usually responds to critical comments thoughtfully and collegially. His response to my post on Apple is no exception. Let me take his responses one at a time.

Smith begins his response by writing that:

So, I am not actually making any statement about whether Apple’s stock price is “too high” or “too low.”

Smith wrote in his original post that:

On the one hand you can buy Apple stock for $375 a share and pay $7 to ScottTrade. On the other hand I also have a trash can in which you can deposit your $375, pay me $5 and I will set it on fire for you.

Clearly, I am offering the better deal as in both cases you have approximately zero probability of getting your money back and I am willing to burn it for $5 whereas you have to pay ScottTrade $7.

He wasn’t saying that there is a risk that Apple will never pay out enough cash to shareholders to justify the price of the stock, but that there is “approximately zero probability” of this happening. If a share of Apple stock has the same value as a pile of ashes, then it is not only worth less $375, it’s worth less than $1. That sure sounded to me like he was arguing that Apple’s stock price of $375 is “too high.”

Smith goes on to respond to my observation, based on my experience, that it can be very beneficial to shareholders for a company to hold cash on its balance sheet so that it can act decisively when opportunities arise, by writing that:

In Jim’s scenario he has a lot of cash on his balance sheet and that allows him to make strategic purchases. But, by construction you know who doesn’t have that cash – Jim’s shareholders.

If Jim had paid out the cash to his shareholders then they would have it. And, if Jim could convince them that he really did have all of these great opportunities they could give it back to him. The fact that no one wants to give Jim cash should be taken as evidence that giving Jim cash is not a good idea.

On a blackboard, maybe. If we lived in a world where it was free, instantaneous and riskless to go through the fundraising process, I guess this might work. Actually raising cash from investors can take anywhere from days to months, and you can lose the chance to buy the asset, or lose the chance to get the best price; it is often expensive, especially in the time and attention of senior managers; and, it often results in information about the potential investment or acquisition leaking out to the market while you are raising the money, which can materially increase whatever you have to pay for the asset, and maybe cause you to lose the deal entirely.

In response to my point that maybe Apple is keeping cash on its balance sheet in part to work a tax angle, Smith writes that:

Yeah, this is just akin to saying that I am reading their signals wrong which of course could be true.

This is a very different statement than “a share of Apple stock is worth the same as a pile of ashes.” If Smith is saying that his actual argument is that it is possible that Apple is just never going to deliver cash to shareholders, because of a principal-agent problem or some other issue, then I have misunderstood what he wrote, and we are in agreement. My argument is that Smith has not come close to making the case for what a rational expectation for future cash dividends to shareholders from Apple ought to be.

In response to my point that maybe Apple is using the cash in part to deter potential competitors, Smith writes that:

Again, its clear why this is good for Apple. Its not immediately clear why its good for a diversified shareholder who also own stocks in the companies that Apple is deterring.

Except that an Apple shareholder might not have the opportunity to invest in such a competitor because it is private, or because it is a division of another company that requires making a compound bet on that division plus the rest of the company, or because the investor has finite time and attention to devote to her portfolio, or for any other of a large number of reasons. I don’t think it’s especially bizarre that a shareholder of company X tends to be made better off when company X succeeds versus competition.

Smith concludes with this:

Key in my claims is that under none of these hypotheses is it in the interest of the Management to take these actions. Whether its in the interest of shareholders to take some action different than what they are taking I am not taking a stand on.

What is true – and a puzzle – is that under some variants of my claims it would be in the interest of private equity to take over the firm. The private equity problem is difficult as well though. Because, its clear how given these principle-agent problems one can create discounted present value using private equity.

Its not perfectly clear how one extracts that value.

Smith has argued that a given shareholder will get more free cash flow by paying $380 for a bunch of ashes in a trash can than by paying $382 for a share of Apple stock. The important exception is that she can get cash in pocket by selling this share to some other buyer of the stock. Smith is arguing that any investor who counts on that is counting on a greater fool buying it, because Smith can see what they cannot, which is that Apple will not ever pay dividends. (Once again, if he is really saying that it’s possible they won’t pay dividends, then we have no disagreement.) But exactly this judgment is the contested issue. This is what markets price.

Here’s the most obvious way that you extract the value if you are convinced that a stock’s market price overestimates its true value: you short it. If Smith doesn’t believe that the market will, in any feasible investment horizon, figure out that he’s right and begin to heavily discount Apple’s stock price, then you have just defined an asset that will, with respect to this issue at least, retain its value – otherwise known as “a good investment.”

(Cross-posted to The Corner)

Blogging About Business versus Doing Business

Both Matt Yglesias and Karl Smith have blog pieces that claim businesspeople are doing pretty dumb things. The claims are in some ways mirror images. Yglesias claims that Barnes & Noble is foolishly spending money developing and selling Nook, when instead it should just return the cash to shareholders. Smith is claiming (as far as I can tell) that Apple investors haven’t figured out that Apple can’t really return much of its immense pile of cash to shareholders, because this money is required to run the business.

Yglesias says that it is an obviously bad use of shareholder funds for Barnes & Noble to invest in Nook, because their expertise is in running brick-and-mortar stores. But by this kind if logic, why would movie company Disney invest shareholder funds opening theme parks, why would brick-and-mortar retailers Walmart, Target and Macy’s invest shareholder funds developing web businesses, and why would computer company Apple invest shareholder funds developing phones?

Core competencies and intangible assets are notoriously tricky to define and quantify for a real company, but for Barnes & Noble they almost certainly include the power of their brand name as a place to look for book-related merchandise, their expertise in developing and managing relationships with publishers, and their existing back catalog of titles. I don’t know enough about the specific situation to know whether Barnes & Noble should have developed and sold an e-reader, but based on what is in the piece, Yglesias doesn’t either.

Karl Smith is a very smart guy, but keeps digging himself in deeper and deeper on his criticism of Apple’s shareholders as foolish, in direct contradiction to the fact that Apple shareholders seem to have done very, very well for some time.

Smith argued in an earlier post that because Apple has not paid real cash dividends to shareholders, that it is more valuable to put money in a trash can and burn it than to invest it in Apple shares. I did a long post pointing why I don’t think this is true. Smith has subsequently done several posts on this same topic, amplifying and clarifying his point.

His most recent post on this subject develops an analogy between the workforce of a tech company and the particles in a sub-critical fission reactor. This is meant to be literally (as far as I can tell) a sketch of a mathematical model for why Apple requires a huge amount of cash on hand to retain its employees. At best, it is pure speculation. And based on any practical experience in a tech company, it’s also extremely implausible that Apple would start to shed important engineers, or be at a disadvantage in recruiting, if it had built up, say, $40 billion on the balance sheet instead of $80 billion.

Smith is arguing that Apple shareholders are suckers who depend on greater fools coming along, because there are hidden requirements for cash in the business that mean the true free cash flow available for distribution to shareholders is less than it seems to investors based on accounting statements. This is not a crazy idea (though his argument that specific hidden requirement is that this amount cash is needed to retain employees does strike me as very implausible). It is also not a new question to ask, and in my experience is one that is debated by professional equity investors in relation to many stocks, ranging from technology companies to convenience store chains.

I have no idea whether Apple stock should be a buy, sell or hold, but if Smith is right that the current shareholder base of Apple massively misunderstands the true capital requirements of the business, then he has a huge moneymaking opportunity. If he really believes in his investment thesis, he should borrow a lot of money and short Apple’s stock.

Antitrust as Self Medication

Reihan Salam, in a characteristically excellent post here at NRO, points to a paper by Michael Mandel, who is one of the most interesting blogospheric commentators on innovation from a “New Democrat” perspective. Mandel makes the basic point that progressives should not be so gung ho about antitrust enforcement, because big organizations like AT&T Bell Labs and Apple are the anchors of business eco-systems that drive innovation.

My experiences – my first job out of grad school was at Bell Labs, and I’ve since started and built a global enterprise software company – lead me to agree with the conclusion, but to be a little more jaded about exactly how big firms contribute to innovation in the kinds of industries he discusses.

Just as Mandel indicates, there is some straight-up development of new technologies in big labs that is then deployed by the parent company (I was involved in some). And further, consciously planned eco-systems of the type he cites – for example, developers building apps for the iPhone and iPad – can help to identify and then scale successful new technologies efficiently. Both of these things matter a lot. But here’s what I have seen big companies actually do to drive innovation that I think is most important for overall job creation and long-term growth:

1. Because innovation can only be partially planned, even the best research labs that create enormous value for the parent company also inevitably discover things that cannot be practically exploited by the parent firm. In the more extreme cases, they produce innovations that would threaten the parent company’s business model. Xerox’s comparatively tiny PARC lab invented the laser printer, which Xerox turned into a multibillion-dollar business. It also developed the graphical user interface, Ethernet computer networking, and most of the other elements of the modern personal computer that Steve Jobs famously exploited to make Apple, not Xerox, a leading personal-computer company.

2. Big companies provide a cash exit for successful start-ups, either before or after IPO. In this way they act as informed allocators of capital that intermediate between general investors and the complex technology landscape. Think of most software start-ups and IBM, Oracle, SAP, Microsoft and HP.

3. Big companies also use partnerships and other vehicles to act as marketing arms and integrators for successful technologies developed by start-ups. Think of biotech and big pharma.

What’s critical about these roles for big companies is that they require that you have lots of entrepreneurial firms to compete with the incumbents. And, in fact, if my characterization is correct, you would expect most of the job creation to happen in the successful new entrants as they grow, which is just what we see. According to the National Venture Capital Association, venture capital–funded firms employ a majority of all workers across many of the most productive and growing sectors of the economy, including the software, biotech, semiconductor, electronics, telecommunications and computer industries.

I’m glad to see somebody on the Left arguing for a modernized view of antitrust, but I think that what is essential if we are to do this is to reduce simultaneously the political power of large companies to stifle competition, as manifest in manipulation of patents, financial regulation, safety rules and the endless list of regulations, subsidies and tax breaks that govern the modern economy. This is similar to what Reihan called in his post “completing the neoliberal revolution.”

The market process is imperfect and takes time, but in my view is preferable to one in which we allow large companies (who will always have an advantage in lobbying and compliance) to use the political process to protect their position, which we then counter-balance with antitrust regulation. No real system of political economy is ever pure, so we will always have some amount of political jockeying and counter-jockeying; but in general, the more we get government out of the way of innovation, the better off we will be.

I think that “de-politcizing” the economy would be an important and powerful component of a Republican presidential campaign in 2012.

(Cross-posted to The Corner)

Storytime with Joseph Stiglitz

Arnold Kling points to an article in which famous economist Joseph Stiglitz lays out a theory for a common structure for the causes of the Great Depression and what Stiglitz calls the current Long Slump.

Here is what Stiglitz has to say:

At the beginning of the Depression, more than a fifth of all Americans worked on farms. Between 1929 and 1932, these people saw their incomes cut by somewhere between one-third and two-thirds, compounding problems that farmers had faced for years. Agriculture had been a victim of its own success. In 1900, it took a large portion of the U.S. population to produce enough food for the country as a whole. Then came a revolution in agriculture that would gain pace throughout the century—better seeds, better fertilizer, better farming practices, along with widespread mechanization. Today, 2 percent of Americans produce more food than we can consume.

What this transition meant, however, is that jobs and livelihoods on the farm were being destroyed. Because of accelerating productivity, output was increasing faster than demand, and prices fell sharply. It was this, more than anything else, that led to rapidly declining incomes. Farmers then (like workers now) borrowed heavily to sustain living standards and production. Because neither the farmers nor their bankers anticipated the steepness of the price declines, a credit crunch quickly ensued. Farmers simply couldn’t pay back what they owed. The financial sector was swept into the vortex of declining farm incomes.

He then goes on to describe how this problem propagated through the rest of the economy.

It’s interesting that in the first paragraph Stiglitz specifies that “more than a fifth” of all Americans worked on farms at the beginning of the depression, and that “2 percent” do today, but makes the non-numerical statement that “a large portion” of the population did so in 1900. I assume this would tend to lead most casual readers to think that most workers were on farms at that time. In fact, about 34% of the American labor force was in agriculture in 1900, and about 21% in 1930.

The proportion of Americans working on farms has been in continuous decline since at least 1800, when about three-quarters of the labor force was in agriculture. The decade with the biggest reduction in this proportion appears to have been the 1840s, when the percentage of the workforce in farming went from 67.2% to 59.7% (a reduction of 7.5 points). The rate of reduction from 1900 to 1960 appears to have been between 4 and 5 points per decade. As far as I can tell, this was roughly the rate of reduction from about 1860 – 1960.

The Great Depression occurred around the middle of a century-long, steady decline in the percentage of the labor force on farms. How could this decline have been the special cause of a spectacular economic collapse that occurred in one of these ten decades, but in none of those before or after?

(Cross-posted to The Corner)

How Elite Business Recruiting Really Works

There has been a lot of discussion in the blogosphere about a research paper by Lauren Rivera that describes how elite professional service firms (top investment banks, law firms, and management consulting firms) go about hiring. The argument is that it is basically a self-perpetuating old boys’ network. Reading the reactions of smart, well-intentioned people with no first-hand experience of this process, and who therefore take her paper at face value, this seems to be feeding into a meme of “the capitalist game is all rigged.”

I think that there is an element of truth to Rivera’s description, but it is mostly pretty misleading. I’ll focus my comments on management consulting, where I used to work for about ten years. I participated in every stage of the process from job candidate to new junior consultant to hiring partner.

Start with some quick industry background. You can divide management consulting into “strategy consulting” and “other.” Strategy consulting is the elite end of the consulting business. Most of strategy consulting can be sub-divided into two tribes: McKinsey and “Bruce Henderson’s children.” McKinsey is the industry leader. Bruce Henderson founded the Boston Consulting Group (BCG) in the 1960s. A number of BCG spin-offs have occurred since (e.g., Bain, SPA, LEK, etc.), and some of these have created further spin-offs. By far the largest and most important is Bain. Together, McKinsey, Bain and BCG (“MBB”) are the dominant elite recruiters for consulting, though a swarm of smaller strategy firms can compete successfully for the best talent.

There is a lot wrong with Rivera’s picture of how recruiting works, but I’ll focus on three important issues.

Rivera grossly exaggerates the degree to which access is limited to graduates of 4 super-elite schools.

Rivera says that:

Employers formally restricted competition to students at the nation’s most prestigious campuses and, contrary to common sociological assumptions about the role of institutional prestige in occupational attainment, having attended a highly selective school (e.g., top twenty five) was typically not sufficient for access to elite labor markets.

Here are about 40 schools in America where BCG and/or Bain are doing on-campus recruiting this year (meaning not just that they will accept resumes, but that they are doing things like on-campus presentations to get students interested, and then doing on-campus interviews): Duke University; Amherst College; Brigham Young University; Brown University; California Institute of Technology; Claremont Colleges; Columbia University; Cornell University; Dartmouth College; Harvard University; The University of Virginia; Princeton University; Yale University; UCLA; University of Michigan; Northwestern University; University of Chicago; Massachusetts Institute of Technology; New York University; University of Notre Dame; University of Pennsylvania; Emory University; Rice University; Southern Methodist University; Stanford University; University of California at Berkeley; University of Southern California; University of Texas; Georgia Tech; Morehouse College; UNC Chapel Hill; Washington University, St. Louis; University of California at San Francisco; Vanderbilt University; Baylor University; Texas A&M University; Georgetown University; Davidson College.

They also hire a lot of people from these campuses. Consider MBA hiring into the Associate position, which is the most common starting point for the climb to partner. The top MBA programs are usually considered to be Harvard and Stanford (please save your emails, as the point will hold if you move a couple of schools up or down a notch). In the next tier, MBB hired the following numbers of MBAs by campus this year: Northwestern (88), Wharton (85), Chicago (76), Columbia (60), MIT (55), Michigan (40), Duke (36), Dartmouth (24), Berkeley (23), and UVA (20). That’s over 500 hires, or more MBAs than these firms typically hire in a year from Harvard and Stanford.

This is nothing like a random sample of American universities, but it is a much bigger pool than Rivera implies. It’s not the top 4 schools, but more like 40 or 50 highly competitive schools, and 10 or 15 highly competitive MBA programs, that get you access to these firms. Further, while the odds of getting an offer are higher from the most highly-ranked schools, a large fraction of each incoming class normally comes from schools not ranked 1 – 4.

If you get into, for example, Michigan, UCLA, Emory or the University of Texas, work hard to get good grades in a difficult major, and score very well on standardized tests, you will likely be able to get an interview with one of the leading strategy firms.

Which brings me to the next point…

Rivera grossly overestimates the importance of extracurriculars, and grossly underemphasizes the importance of standardized test scores, and especially, case interviews.

Rivera says of elite employers that:

They restricted competition to students with elite affiliations and attributed superior abilities to candidates who had been admitted to super-elite institutions, regardless of their actual performance once there. However, a super-elite university affiliation was insufficient on its own. Importing the logic of university admissions, firms performed a strong secondary screen on candidates’ extracurricular accomplishments, favoring high status, resource-intensive activities that resonated with white, upper-middle class culture.

There will be exceptions to everything I say, but the way the actual selection process usually works is like this.

Interview slots with the best strategy consulting firms are a scarce commodity. Your resume gets you selected for an interview (though in rare cases, the cover letter and any interaction you may have had with the firm at campus recruiting events can matter a little). Take the example of undergraduate resume screening. Candidates are required to submit resumes, complete transcripts, and SAT scores. As an operational matter, the pile of resumes plus supporting materials submitted for all the candidates for school X is assembled, and each of these candidates is scored independently by three members of a school recruiting team (typically consultants who went to that school). These scores are then combined to create an aggregate rank for all candidates in that school. So, school prestige, which looms large in Rivera’s artificial mock resume screens, matters in selecting target schools, but is not usually relevant in real resume screening because you are screening resumes within a school.

In my experience as a resume screener, the logic normally goes something like this.

If you don’t have at least 750 on the math SAT, you’re out. The most common score is 800. Math plus verbal scores should be well over 1500, and typically over 1550. GRE, GMAT and other scores should be scaled similarly.

Then, your degree should be in something hard: math, physics, electrical engineering, analytical philosophy, computer science and so on. It’s OK to major in history or literature, but you better have some really tough quantitative or analytical classes on your transcript, and have done very well in them. If your GPA is below about 3.5, you’re out unless there is some really compelling rationale for why. The average successful candidate has a GPA above 3.7. Everyone understands how bad grade inflation is, and that it’s worst in the most elite schools. Any reasonably smart person with good instincts about course selection can figure out how to get a decent GPA at one of these schools. A GPA-plus-major screen is not about IQ, as much as it is a quick screen to see who is capable of figuring out how to succeed in a new environment, and of doing at least some sustained work. Screeners and interviewers will typically look at the transcript to make judgments about raw candlepower; for example, checking which calculus sequence the candidate completed, and if it was the most difficult track, what grades were achieved.

Prior summer internships at an MBB firm, Goldman, etc. are a strong positive. The reason is not that this means somebody is “clubbable.” The recruiting process for internships has similar resume screen / interviewing steps, and there are even fewer internship slots available each than there are slots for full-time jobs. Therefore, it means that this candidate has succeeded already in a similar, very difficult, selection process.

Finally, extracurriculars matter; but they are marginal compared to these other factors. They are mostly relevant if they show incredible drive. For example, working your way through school in some crap job where you have to deal with people is a big plus.

If you get an interview slot, there are then typically three rounds of interviews. Rivera’s paper claims directly that these are pretty loosey-goosey affairs which people are trying to get a sense of how polished the candidates are:

Interviews – which followed screens – were reported to be highly subjective assessments, where abstract notions of “fit” and “chemistry” routinely drove hiring decisions

Here’s how interviews really work, in my experience.

Interviews begin with first-rounds on campus. Each candidate is given a 45 minute interview, about 44 minutes of which is devoted to presenting the candidate with analytical challenges, and seeing how he or she works through them. The goal is to understand how the candidate can reason analytically – translating an unrehearsed real world problem to a mathematical representation, doing the math, and then translating this back to a real world solution, with awareness of all the simplifications that were necessary – under pressure. This is an attempt to recreate the most challenging part of the job, and is termed a “case” interview. Based on these, a majority of first-round candidates are cut. Second-rounds normally happen the next day on campus. It is a repeat, except that each candidate is normally interviewed twice that day, and each interview is longer. Based on these, a majority of second-round candidates are cut. The remaining candidates are invited back for third-rounds. This takes place at the company’s offices over a full day. Each candidate is subjected to 10 or more additional interviews, most of which are case format, but some of which are more typical “let’s talk about you and us” discussions.

Each candidate is then considered holistically, but because so few people in this final selection group have anything but extremely strong grades and test scores, the interviews are usually the crucial way to try identify the highest potential performers. A small fraction of those who started the interview process are offered jobs.

Which brings me to my third point…

Firms sell into a competitive marketplace.

Almost everybody would love to live in the cozy club atmosphere that Rivera described, and it is always creeping into hiring, promotion and compensation decisions at these firms, as in any human institution. Discipline is maintained only because you have to sell into a competitive commercial market. Unlike how it works in the movies, it is very rare that the COO of a Fortune 500 company hires your case team to do a six month project at $375K per month so that you can sit around and reminisce about rowing crew together at Old Eli. The more vibrant, competitive and open the overall corporate environment is, the more you will see continued emphasis on finding people who can produce, because the corporations will only pay for what creates commercial value for them. The more the corporate environment becomes dominated by crony capitalism, the more you will see the reverse. And to be more precise, you will see the characteristics that define a competitive consultant become more the kind that Rivera describes: fit, smoothness and familiarity with the ruling class.

In an earlier post, Steve Hsu made a useful distinction between what he calls the “soft” elite firms that Rivera profiles (investment banks, law firms and management consultancies) versus “hard” elite firms such as hedge/venture funds, startups and technology companies. He argues that the hard elite firms produce something more measurable, and therefore rely less on prestige in selecting people. This distinction is a useful starting point, but what has been happening over the past 20 years or so is the increasing migration of value from soft to hard; basically, to math, technology and analytics-intensive work. This is happening within firms and industries – the emphasis on math ability was growing within consulting in the period I worked in it, as it was within banking – and across sectors as technology start-ups and math-intensive finance became the most obvious ways to make real money in America. This isn’t random, but is happening because these are huge opportunities to create value. This is in part why I left consulting to start an analytics software company. It became obvious that this was the way to create value for clients. This won’t last forever, but has been true for some time.

This should emphasize that the people selected for these jobs are in no sense a “meritocracy.” Most obviously, it has nothing to do with moral worth, as people don’t earn their genes or parents. But more broadly, what I have described is not a hunt for the “best and brightest” in some general sense, but rather for people who have an incredibly arcane bent of mind and set of ambitions that fit into an environmental niche that they didn’t create. This is as true of “hard” elite firms as “soft” elite firms. Despite all the chest-pounding, 50 years ago most of these people would have clerks; a couple hundred years ago, not especially successful farmers. 50 years from now, for all we know, these will no longer be especially valuable talents.

Ironically, moving away from the idea that firms are looking for “the best” or “most worthy” in some general sense, and simply recognizing that they should look for predictors of success within a given business model relevant to a specific point in economic history, allows not only more effective hiring decisions, but also a little much-needed humility.

(Cross-posted to The Corner)

Nobody Ever Went Broke with Money in the Bank

That’s something that one of the smartest venture capitalists I ever knew once told me.

Matt Yglesias and Karl Smith find the fact that Apple is holding a huge cash hoard instead of paying dividends to shareholders to be pretty ridiculous. Felix Salmon finds Yglesias’s argument “trivially wrong.” All three are smart observers with interesting things to say, but I don’t think any of them presents this situation very well.

Yglesias says that this cash hoarding has caused Apple’s declining Price / Earnings (P/E) ratio:

The crux of the matter, as I see it, is Apple’s ever-growing cash horde which went from $70 billion in liquid assets at the end of Q2 to $82 billion in liquid assets at the end of Q3. The company is earning huge profits, which is great, but since it seems determined to neither return those profits to shareholders nor to re-invest them in expanded operations it’s hard to see how investors aren’t going to discount the value of the enterprise.

I’ve started and run a pretty successful enterprise software company, and I generally held a lot of cash on the balance sheet. From the perspective of shareholders, there can be many good reasons for this. First, do you know when cash-on-hand is most important? When nobody else has any. You can buy up the best talent, patents and assets when they are cheap; you can make big technology investments when they are cheaper; you can make big marketing pushes for the resulting new products when competition for customer mindshare is lower, and so on. When times are good (or at least not catastrophic) it seems like you could always get your hands on cash when you needed it, but that’s least true when you most want it. Cash is the option to act decisively at the moment when this can create large advantages for the company. Another example is that Apple is apparently holding the cash outside the U.S., and might be playing for time before repatriating it because they think corporate tax rates might come down. They might be playing any one of a million tax angles. Another example is that a massive cash pile can discourage potential competitors from entering important markets, because they know you can retaliate by either crushing their foray into your territory or by going after their cash cows. The U.S. will hopefully never launch its nuclear weapons, but we use them every day.

There are also not-so-good-for-shareholders reasons for it. There is an armchair psychology theory that because Jobs went through so many close calls in business, he had an irrational desire for cash on hand. That is at least plausible. But even if so, it’s not as simple as the shareholders just ordering Jobs to disburse the cash. If you believe that Jobs had this irrational desire, but part of the package required to get Jobs to continue run the company was to allow this kind of cash build-up, and that he increased shareholder value enough versus the next best alternative CEO to more than offset the impact of holding this much cash, then it still might be rational for shareholders to let him do it. In my experience, exactly this kind of dynamic happens in the real world all the time. More generally, sometimes a very large cash balance is an indicator that there is a principal-agent problem between shareholders (who want to maximize risk-adjusted returns on a portfolio of assets that includes this stock) and management (who want an operational cushion). Though sometimes, a large cash balance is an indicator of a disciplined management team that refuses to make poor investments in acquisitions or fanciful projects.

In short, there are tons of reasons – some good and some bad – why Apple might be holding this much cash. Apple’s P/E is being affected by some combination of their growing cash pile, changing overall market conditions, the death of Steve Jobs, projections of market saturation, beliefs about future Apple investment plans, competitive behavior, and many other factors. I don’t know whether or not Apple’s cash balance is too high or not; but based on this post, neither does Yglesias.

Salmon says of Yglesias’s argument:

This is trivially wrong. If Apple’s cash pile is growing, that will increase its p/e ratio, rather than decrease it.

In simplified terms, Salmon’s argument is the following. Consider stylized company X that has: $2 of earnings today; a market projection of present value of cash returned to shareholders of $10; 10 shares of stock outstanding; and no net cash on hand. In theory, the company should be worth its present value of cash flows, or $10. This would produce a share price of $10 / 10 shares = $1 per share. This implies a P/E of $1 / $2 = 0.5. If nothing else changes except the company has $2 of cash on its balance sheet, then in theory the company should be worth $10 + $2 = $12. This would produce a share price of $12 / 10 = $1.2. This implies a P/E of $1.2 / $2 = 0.6. So, Salmon argues, Apple piling up cash should increase P/E.

But, what this ignores is that the fact that Apple management has decided to retain the cash can rationally influence investor beliefs about the present value of future cash returned to shareholders in relation to current earnings. Yglesias illustrates the size and rate of growth of Apple’s cash balance by citing a quarter-to-quarter change, but his argument refers to a chart of Apple’s P/E over nine quarters. On this kind of timescale, the fact that management has decided to retain this much cash – rather than either invest it in the business, or pay dividends, or buy back shares – could be a signal to outside investors that management believes growth prospects are lower than previously believed, or that management has become irresponsible in its use of cash, or any other of many possible positive or negative signals. Different investors almost certainly read it different ways. Yglesias is not “trivially wrong.” He might even be right. I just don’t think either he or Salmon knows.

Smith is even more scathing than Yglesias about the point that Apple isn’t using the cash to pay dividends to shareholders:

I have a theory.

On the one hand you can buy Apple stock for $375 a share and pay $7 to ScottTrade. On the other hand I also have a trash can in which you can deposit your $375, pay me $5 and I will set it on fire for you.

Clearly, I am offering the better deal as in both cases you have approximately zero probability of getting your money back and I am willing to burn it for $5 whereas you have to pay ScottTrade $7.

Now that’s not quite true. Apple’s stock price is sustained by the fact that if it goes low enough someone will buy the whole company and liquidate it. However, current investors shouldn’t be under any delusions that Apple has any plans whatsoever to provide them with a return on their investment.

I think that Smith’s point is that because Apple has not paid dividends, therefore I never get paid back real cash in return for the cash I pay for a share of Apple stock, and the only thing I can do with it is to sell it on to some greater fool. The only exception is if Apple gets to a sufficiently low value that owners band together and sell off the land, buildings, inventories, desks, patents and so on in an auction, and then divide up the proceeds.

Assuming that’s what he means, I don’t think it makes a lot of sense.

First, big tech companies often don’t pay dividends for a long time, until they do. Sometimes, these dividends are massive and continuing. Second, if there are continuing growth prospects for Apple that require cash (sometimes in ways that aren’t obvious, as per the first part of this post), then it makes sense for me as a shareholder to not want dividends for some time. The present value of the anticipated dividend stream is higher by getting more money later. If, at a future date, I have a desire for liquidity, I can sell my share of stock to another investor at that time. That investor may go through the same cycle, and the person he sells to may go through the same cycle, and so on. As long as the profit growth prospects are real, nobody has been a fool. Ultimately, the purpose of equity is to be converted into cash (or more precisely, consumption); but for a company like Apple, this can take a long time, and not every investor wants to go along for the whole ride. Third, the “exception” of shareholders banding together is not an exception, but something that often happens to companies well before their stock price reaches liquidation value. This is called the market for corporate control.

I don’t believe in anything approaching purely efficient markets. But when a journalist or academic makes claims that some company could just obviously create enormous value by taking some simple action, the obvious question to them is “Why aren’t you a billionaire?”

(Cross-posted to The Corner)

In the Long Run, We're All German

I argued last week that the right way to think about what’s going on in Europe is as a game of chicken. The ECB was unwilling to act as a lender of last resort to Italy because it did not want Italy’s chronic indebtedness to drive Europe-wide inflation rates. If it loosened the money spigots and allowed high enough nominal growth for Italy to continue to service and pay down its debts, but there was no European institution capable of enforcing fiscal discipline on Italy, then there was the risk of moral hazard – Italy could operate in a business-as-usual manner, and rely on the ECB to keep it from paying the price, which would instead be paid by northern Europe (preeminently Germany).

Of course, it would be absurd for the ECB to actually destroy the Euro in its efforts to prevent this hypothetical future problem. But it’s not obviously absurd for the ECB to play chicken – to withhold help until the moral hazard problem is resolved, and some mechanism is put in place to, in so many words, give Berlin a veto over Rome’s budget. It’s just a bet that Rome will blink first.

But Ryan Avent makes a good case that the ECB hasn’t just played chicken as the crisis has unfolded, but that the ECB engineered the crisis:

The ECB raised its benchmark interest rate in April of this year. It raised that rate yet again in July. Each move was just 25 basis points, but the signaling power of those moves was significant: the ECB, markets were informed, would not let dormant core inflation, a fragile economy, high unemployment, and an intensifying financial crisis stand in the way of its commitment to low headline inflation. As Paul Krugman and David Beckworth point out, the market impact of the ECB’s actions was dramatic. Inflation expectations tumbled. Nominal output across most of the euro zone switched from expansion to contraction. And as the OECD pointed out today, euro economies are now in recession.

The ECB successfully engineered a collapse in demand (not without assistance from governments, of course). It would be shocking if this didn’t feed into a move from a solvency to an insolvency equilibrium in economies relatively close to the threshold.

The conclusion of his piece points to why the ECB might have wanted to engineer the crisis, and it’s consistent with my views:

Some might argue that responsibility for the crisis must nonetheless sit with the debtors. The Italian economy is a mess, Tyler Cowen says, and though Italy could make a substantial dent in its debts through a large tax on wealth it opts not to. It is broken Italian governance that dooms the euro. Neither Germany or the ECB can be expected to save an Italian economy that won’t take reasonable steps to meet its obligations. But as Mr Cowen is fond of saying in other contexts, the central bank moves last. If the ECB is willing to permit contagion, then no Italian action is a sufficient defence. If the ECB is willing to engineer a recession to wring out inflation, then no Italian reform will generate strong growth.

Some might well argue that responsibility sits with the debtors – more specifically, creditors might argue that. In other words: Germany might argue that. Central banks are generally biased in favor of creditors; the ECB was specifically organized to be biased in favor of Germany. (That was the price for getting Germany to agree to give up the Deutschemark in the first place.) One way of looking at the sequence of events is to say that the ECB was willing to permit contagion in order to wring out inflation. I think a better way of looking at it is to say that the ECB was willing to threaten Italy with insolvency in order to give Germany more formal control over Italy’s finances.

That’s incredibly hard-ball politics, but if you are not accountable to anybody (which the ECB, basically, is not) then you can play really, really hard-ball politics.

And, at a high human cost, the bet seems to be working:

“I will probably be the first Polish foreign minister in history to say this,” he said, “but here it is: I fear German power less than I am beginning to fear its inactivity.”

That’s Radek Sikorski yesterday, calling for new budget procedures that would give European institutions – the Commission, the Council and the Court of Justice – formal veto power over member states’ budgets, and to suspend the voting rights of member states that repeatedly violate the rules. When the Polish foreign minister is begging Germany to turn other European states into quasi-colonies, I’d say you’re getting some traction.

Re: Wealth, Innovation and "Job Creation"

Noah,

Thanks for the, as always, great post. You start by asking:

First, if it’s very uncertain how tax policy is going to affect innovation, why does that imply that taxes on the wealthy should be low?

I did not argue that that premise implies that conclusion. Krugman made an affirmative claim (or, as I went into in the post, he used language that Ozimek showed, I think correctly, could only be interpreted reasonably as implying) that innovators capture materially all of the economic value that they create. Ozimek provided a thought experiment that shows that this seems to violate common sense. Common sense is sometimes wrong, but I think the burden of proof is on those who make an affirmative claim. Krugman doesn’t provide any evidence for his claim beyond waving his hand at “textbook economics,” and Ozimek called him on it. I applauded this.

My only addition was to make an observation. Krugman claimed a contradiction between the belief in free-market principles and the belief that innovators can create material economic value that they do not capture, because the textbook economics that he believes is the foundation for belief in free market principles also claims that workers will capture the economic product of their labor. In fact, at least some people who hold free-market principles (e.g., me) do not ground their beliefs in Krugman’s textbook economics. So I am free to simultaneously hold the beliefs that innovators often cannot capture the full value of their work, and free markets are a good general organizing principle for the economy, without (at least this specific) contradiction.

Wealth, Innovation and "Job Creation"

Jim:.

First, if it’s very uncertain how tax policy is going to affect innovation, why does that imply that taxes on the wealthy should be low? One assumption would be that innovators are very sensitive to the taxes imposed on them, and that if they are taxed too much they will just stop working (and live off their already-accumulated wealth, I suppose). But the opposite assumption – that, to the extent that people are motivated to work for monetary reasons, it’s generally to achieve a certain level of consumption – seems at least as plausible. And it implies that higher taxes would make those motivated to innovate by the promise of financial reward more likely to work harder – because they’d have to work harder to reach that level of consumption. (And those who are motivated just by the desire to innovate, and those who are motivated just by the desire to see their bank balance go up, would be unaffected by their tax rates – innovating is still the only way to innovate, and earning money is still the only way to make the bank balance go up.)

If we knew that, at any given level of taxation, higher taxes would depress innovative activity, I could see how skepticism about our ability to predict how far it would be depressed would militate in favor of low taxes. But if we are uncertain about the sign of the effect at a given level of taxation, how do you conclude that low taxes are always preferable?

It seems to me that the consequences of high taxation that we really need to worry about are uneconomic efforts to recharacterize income as something non-taxable, and the risk of high-earning individuals changing jurisdictions to avoid tax (which is a particular concern for states with high income taxes neighboring states with low ones – Massachusetts versus New Hampshire, for example). But, again, it seems to me that simply declaring that you can’t possibly estimate these effects doesn’t get you anywhere.

Second, Adam Ozimek’s argument is, basically, that there are positive externalities to the efforts of very innovative people that cannot be captured by them because they aren’t part of their product. Thus: even if Steve Jobs captured exactly 100% of the value he added to Apple, he can’t have captured 100% of the value he added to Apple’s employees, whose human capital was upgraded by working at Apple, value they will be able to monetize when they go off to start their own firms. Nor can he have captured 100% of his contribution to the creation of the massive cluster of innovation that is Silicon Valley.

But I’m not clear why Ozimek thinks this should be the case. If we posit a truly efficient market, then Apple employees know that they are getting experience at Apple that they will not get elsewhere – and Apple will know they know this. And Apple will therefore offer lower salaries than other firms that do not provide such experiences. Doctors who want to work in Boston often get paid less than those who are willing to work in Fargo in part because Boston has better weather and sushi restaurants – but largely because Boston is a huge medical hub and Fargo isn’t. That is to say: getting a job in Boston will do more to upgrade your human capital than getting a job in Fargo will.

I’m not saying I believe everyone earns 100% of the value of their marginal product. I’m just saying that I don’t see why Ozimek is so confident that high earners are an exception, and earn less than they contribute, for the reason he gives. And given that it’s pretty easy to find real-world examples of high earners who make more than their marginal product because they have found ways to extract rents, it strikes me as a little peculiar to take this particular tack against Krugman’s argument.

Third, it seems to me that Krugman doesn’t address the real implicit reason why people refer to high-earners as job creators: to whit, because they are good at deploying capital.

It’s not true, after all, that if Steve Jobs, say, earned exactly 100% of his marginal product that therefore nobody else benefited from his innovations. That would be true if he took his earnings with him to Mars, and never recirculated them into the terrestrial economy. But people don’t generally take their accumulated wealth to Mars; they usually spend or invest it.

Assuming no effect whatsoever on incentives, taxing high earners transfers their earnings to other people – either to the government, which then makes the decisions about spending or investment, or to the citizenry at large if the money is simply redistributed. If you do the former, you’re substituting the government’s views on how optimally to spend or invest the money for those of the high-earning individual. If you do the latter, you’re substituting the citizenry’s.

Saying, “these people are job creators” is another way of saying, “I think these people will be good investors, will deploy their wealth in ways that will further increase the productivity of society.” It’s basically saying: these are the right people to bet on if you want to deploy capital optimally.

(I want to stress: I’m not making this case; I’m just stating what I think the case is. I’m not sure what a good empirical test would be of the proposition.)

I think the “textbook economics” answer to this would be: if these individuals are genuinely better at deploying capital, capital – whether they own it or not – will flow into their hands to be deployed. A rich entrepreneur doesn’t actually need his own wealth to start a new business – he’d be able to borrow any money that was taxed away and make the same investments he would otherwise. If the government taxes a bunch of money away from great investors, that doesn’t actually reduce the amount of capital they have to deploy – because the money will flow back to these investors and out of other investors’ hands, and it’s most marginal investors who will lose their access to capital, to be replaced, effectively, by the government.

This question, “who will be a better investor” is not so simple a question to answer. It matters greatly what you mean by “better” – better for whom, and over what time horizon, and under what circumstances. Which is why I keep coming back to the question of what our spending priorities – not just the government’s, but our whole society’s – ought to be. But at this point I think we’re out of the textbook.

In my own opinion, if you want to encourage innovation, I wouldn’t focus on keeping taxes low; I’d focus on keeping them simple, because complexity rewards large firms with the wherewithal to do the financial engineering necessary to optimize their tax position, which in turn gives them an unearned competitive edge. And more generally, I’d focus on what other barriers incumbents have erected to prevent disruptive innovation and to extract rents. The existing patent system, which imposes a huge burden on small, young firms, is one good example of where to look. Most broadly, we should be trying to reduce the friction associated with innovation, rather than focusing on the monetary returns to innovation.

Do Job Creators Matter?

Adam Ozimek at Modeled Behavior has a really great post on this question. It is a reply to Paul Krugman’s argument that, basically, high-income people get back in compensation their total value creation for the entire economy. For example, if Steve Jobs made a gazillion dollars, that means he created a gazillion dollars of value, but took it all back as his compensation; therefore had Steve Jobs never existed, nobody else in the world would have been any worse off. This is a simplification, but one of the great things about the post is that Ozimek carefully pins down the reasonable interpretation of Krugman’s actual assertion by going back to Krugman’s textbook writing.

Krugman argues that if we accept the premise that people get their marginal product of labor back as compensation, then why not set marginal tax rates to the level that maximizes government revenue: 70%?

Ozimek’s simple, great thought-experiment in the post:

Consider, for instance, that if we suddenly kicked out the top 10% of high IQ people (or 10% most productive people, or 10% most creative people, or whatever) in the U.S.. It strikes me as fairly likely that the total output of the remaining 90% would go down. Krugman seems to argue that this would not be the case. But even if you disagree with me in the short run, in the long-run the productivity increasing innovations these people would have made won’t show up, and the rest of us would have lower productivity as a result.

Now, instead of kicking out the top 10% of workers, just make them work less as a result of high income taxes. See my concern?

Lowered incentives of job creators and other innovators should be considered as one of the likely downsides to higher taxes.

Note that if you don’t think this is true, then what business do we have subsidizing higher education? If workers capture the entirety of their higher productivity, then I don’t see who gains by giving young people money to go to college rather than just cash.

I’d only add one observation.

Krugman ends his piece with this:

My point, then, is that this claim — and the lionization of high earners as people who make a vast contribution to society — is not, in fact, something that comes out of the free-market economic principles these people claim to believe in. Even if you believe that the top 1% or better yet the top 0.1% are actually earning the money they make, what they contribute is what they get, and they deserve no special solicitude. [Bold added]

What’s so funny about this is that Krugman is arguing that “these people” (i.e., people like me who think that a 70% marginal tax rate is not necessarily a good idea for America as whole) base our beliefs about political economy on his textbooks. He is pointing out a contradiction that exists only in his mind. I don’t accept his pseudo-scientific claims to knowledge about the impacts of doubling our maximum tax rate; my “free-market economic principles” are in fact based in part on my beliefs about the inherent uncertainty of such predictions.

(Cross-posted to The Corner)

Ever Deeper Union, Now and Forever, World Without End

I haven’t really said much about the catastrophic debt crisis unfolding in Europe, other than to say that it would be really bad for America to play beggar-thy-neighbor when the whole continent is at real risk of pitching over into the drink, and to wonder why, if the Germans decide they don’t want to bail out Italy, the northern Italians should decide they want to do so (in other words: why is the Eurozone more likely to break up than the Italian state).

But what’s unfolding is enormously important, not only to the world’s short-term economic outlook (if Europe collapses into a depression, they’ll surely drag the rest of the world with them at least part-way down), but to pretty much every aspect of America’s foreign policy going forward.

First: background. The European Union, is, was, and always will be a primarily political project. The gains to be had from businesses no longer having to hedge a variety of small currencies were always small and are now really negligible. For both France and Germany, the central partners in the enterprise, it meant not only a kind of formal commitment to the notion that there would never again be a war between the two largest continental powers, it also meant playing a larger role in world affairs, and a massively larger role in continental affairs, than either country could on its own, in France’s case because it just wasn’t all that big anymore, in Germany’s because it was, well, Germany. These goals could only be achieved by a progressive deepening of the Union, from being a trade and customs union, through regulatory harmonization and a common currency, to a common foreign and defense policy and some degree of fiscal union. So long as Europe remained purely a collection of states, unable to act as a union, the fundamental political objectives of the European project were not achieved. And these objectives were the reason for the project in the first place.

For many other countries in Europe – and particularly for Britain, for whom it spelled the end of the traditional British foreign policy objective of avoiding any single power dominating the continent (and objective that, by the time the US-Soviet rivalry matured, to say nothing of once it had ended, was thoroughly obsolete, but still) – the prospect of ever-deeper-union presented a Hobson’s choice: join, and give up a measure of independence for some share of decisionmaking; or don’t join, and retain formal independence but be dependent, practically, on the decisions made by the rising power in Brussels. Different European states have chosen differently – which is both what one would expect and entirely appropriate.

For certain countries – Italy being the most important – with longstanding, shall we say, governance issues, the European project presented an additional opportunity: the opportunity to do an end-run around their own government. Back in the days of the Lira, Rome resorted to regular devaluations to compensate for its chronic over-indebtedness. This, in turn, meant that Italian debt always carried a higher interest rate than German debt – reflecting market expectations that the Lira would generally decline versus the Deutschmark. Joining the Euro, for Italy, meant paying lower – more like German – interest rates on their debt in the future. In exchange, Italy would simply have to gets its fiscal house in something resembling better order – less like Italy, more like Germany. Which it promised to do.

And which, to some extent, Italy did – at least in terms of the budget. But that hasn’t mattered in the current crisis. The current crisis started off being about a country – Greece – that borrowed fraudulently, actively lying about its budgetary situation. But it’s not about that anymore. Spain was in excellent budgetary shape before the crisis. Italy wasn’t in great shape by any means, but it was in better shape than was the historic norm – and the trend line was going the right way. The current crisis is due to the fact that no country in Europe has a central bank; none have the option of using unorthodox monetary policy to avoid slipping into another recession; and countries across Europe have been thrown into budgetary crises by the recession that followed the financial crisis. Radical austerity across the continent would trigger a new recession, which would worsen the budgetary situation. Within the existing framework of decisionmaking, there’s no way for Italy to solve its budgetary problems – which is why Italian bonds now trade at a much higher yield than German bonds, precisely what joining the Euro was supposed to prevent. And as market fears of a possible Italian default or a breakup of the Euro have gotten more serious, the crisis has spread to France, the Netherlands, and even Germany – because none of these countries will avoid catastrophe if the Euro collapses.

What’s going on now is, I believe, an extremely high-stakes game of chicken. The acute crisis could be resolved immediately if the ECB would simply agree to buy Italian bonds in sufficient quantities to drive Italian interest rates down to a sustainable level. A firm commitment of that sort, backed up by market intervention, should have the desired effect. In the absence of any change in the structure of decision-making in Europe, however, this would amount to writing Italy a blank check. Because for the commitment to be credible, it needs to be unconditional – the ECB can’t say, “we’ll buy bonds if Italy keeps its debt ratio below so-and-so” because then the market can wonder, “well, what if the recession gets worse, and tax receipts drop; or what if Italy’s politicians simply rescind some of the austerity measures passed, pocketing the ECB’s commitment and going back to business as usual – what then?” And once the market wonders that, credit spreads widen out again – and the ECB has to either take stronger action, and you begin a race to the bottom as other countries scramble to be less-responsible than Italy; or the ECB surrenders and we’re back where we are now, only worse.

For a credible intervention not to amount to a blank check, the market would need to be satisfied that there was a mechanism in place to ensure that Italy could not cash the blank check. In other words, Italy would have to surrender a pretty significant degree of control over its own budget. Whatever form such an arrangement might take – whether it was run through the ECB or through some more accountable branch of the European bureaucracy – it amounts to fiscal union.

This isn’t, of course, how anybody wanted to get here. But it is, in fact, where the people who championed the creation of the Euro wanted to go. Monetary union could only work in combination with fiscal union. The architects of Europe were never able to sell “Europe” as a concept to the various peoples of Europe – they have generally proceeded on the assumption that democratic accountability was an obstacle to be avoided rather than a goal to be achieved. It looks to me like that continues to be their preferred mode of operation, and that what the leaders of Europe are looking for is to be forced into fiscal union rather than assenting to it, and for that union to be accomplished through the least-accountable governmental bodies possible.

But that, I believe, is what this game of chicken is about: the terms of deeper union. What Italy – and, subsequently, the other nations of the Euro-zone – will have to give up in order to qualify for support by the ECB in a crisis.

At least I hope that’s the case. Because if it isn’t, and there isn’t a “yes” to be gotten to, then we can kiss the world economy goodbye.

As a post-script, let me say this. The United States has, from the beginning, approached Europe from the perspective that we prefer it to get broader rather than deeper. We don’t want a European army, or a common European foreign policy; we are not particularly interested in fiscal union or even in the common currency; but we definitely want Britain and Turkey and heck, Ukraine to be part of the European Union – we want the Union to be as diffuse as possible. This diffusion has made it progressively harder for the EU to actually do anything as a corporate body – which, I think, was a feature, not a bug, from the American perspective.

But I have always felt that this perspective was wrong – in terms of American and global interests, not just the interests of Europe. Nobody’s interests are served when the world’s largest economy is effectively ungoverned. And if America’s interests were profoundly threatened by the emergence of a functional Europe on the diplomatic stage, then we really have to question how we conceive of our interests – is it not enough that there is no power on Earth capable of standing up to us; must there be no power capable of standing beside us either? American interests would have been better served by advising the architects of Europe to pay attention to the democratic deficit, and to grow the EU only at such a pace as was consistent with the development of functional European institutions. Peripheral countries would always be free to join the customs union, to voluntarily harmonize various regulatory matters, to peg their currencies to the Euro, etc. – without submitting to being governed from Brussels. I don’t, frankly, understand why America has any interest in whether London or Ankara or Kiev do submit to such governance – nor, for that matter, Paris or Berlin, but if Paris and Berlin were dead-set on creating Europe then it is in our interest for Europe to function. Which required, and now requires more than ever, deeper union.

Conservative Institutions, Radical Circumstances

Following Matt Yglesias to his new digs, I see he hasn’t changed either his views on monetary policy or his views on correcting typos before he posts:

[I]t’s encouraging that the Federal Reserve’s Open Market Committee considered [NGDP level targeting] at their meeting early this month. Unfortunately, according to the minutes they rejected it for reasons that seem pretty shallow. . .

The claim that this would “heighten uncertainty” seems to me to be just flat-out wrong. Normally there’s very little uncertainty about the Fed’s attitude. Normally we’re close to full employment and close to the Fed’s inflation target. . . . Today, however, there’s a great deal of uncertainty. We’re close to the Fed’s inflation target but nowhere near full employment. If millions of currently jobless people return to daily commuting, that’s all but certain to push gasoline prices up. If millions of currently jobless people living with parents or siblings get jobs and move into places of their own, that’s all but certain to push rents up. If that happens will the Fed tighten money to curb the inflation, or will it tolerate the inflation as passing pain needed to return to full employment? Nobdoy really knows, so nobody dares expect growth. One of the great virtues of a move toward NGPD level targeting is precisely to provide certainty on this point. The Fed will tighten if and only if total economy-wide spending increases so fast as to push us above the desired trend level.

True – but trivial. If “uncertainty” in this trivial sense were the problem, the Fed could always eliminate it by simply saying: we will do “X” no matter what, whatever “X” might be. “We won’t tighten until measured inflation is above 3% for two consecutive quarters,” is clear. So is, “we won’t tighten until unemployment goes below 7%.” So is, “we are standing pat until inflation expectations as measured by TIPS spreads drop below 2%, at which point we will do additional quantitative easing until expectations go above 2%.” Any fixed, inflexible rule would eliminate uncertainty.

And it would also eliminate any policy flexibility. Indeed, it eliminates the need for having a Fed – you could just have a computer program setting monetary policy. The very fact that you have a group of people in a room deciding what the rule is going to be means that there can never, ever be a totally credible and inflexible rule of the sort that Yglesias imagines he wants. “We are now moving to NGDP level targeting” sounds pretty clear – but what if inflation expectations jump to 4% overnight and employment growth doesn’t show up immediately? Won’t that put a lot of pressure on the Fed to reverse course? Doesn’t everybody know that it would put a lot of pressure on the Fed to reverse course? Heck, if NGDP level targeting worked it should lead to a sharp rise in nominal interest rates on Federal debt – that would be the market pricing in an expectation of much higher nominal growth. But the immediate result of such a spike would be a sharp increase in the cost of rolling over Federal debt, which might well create strong political pressure for greater short-term budgetary discipline to avoid locking in a huge interest overhang for years to come. Which, in turn, would be contractionary if it actually happened, and didn’t just force the Fed to change policy directions.

The Fed is a big, important, highly conservative institution. Quite properly, it doesn’t change its policy framework easily. If it did, that would lead to a widespread loss of confidence in the Fed as an institution, which would mean any rule it adopted wouldn’t be terribly effective.

Now, the current circumstances are extraordinary. The Fed has responded to those extraordinary circumstances by signalling that it will do pretty much anything to avoid us tripping into a double-dip recession. They’ve declined to be more daring than that, and have basically begged the fiscal side to do more to help them out. That, in turn, implies that they would welcome fiscal action that improved the long-term real growth prospects of the economy. That could mean tax reform that reduced economically distorting deductions; it could mean a shift in spending priorities away from defense and health-care and towards investments in physical infrastructure and human capital; it could mean dozens of other things that the Federal government isn’t doing, that would give either monetary or fiscal policy more running room for straight-out Keynesian expansion without igniting fears of an inflationary spiral.

I find it really hard to blame the Fed for being minimally conservative – not being eager to change its entire framework for thinking about monetary policy – when the fiscal side can’t seem to do anything at all.

Now, none of that means that the Fed shouldn’t consider an NGDP level target. But I’d expect it to want to see a bit more of a “developing consensus” in the profession before making the jump, precisely because you can’t change frameworks very often and remain credible. And if a new consensus is developing, it’s in the very early stages of doing so.

Finally, just to recap, here are the important points I think NGDP targeting needs to address:

- I understand why one implication of an NGDP-level targeting is that a negative supply shock should lead to looser, not tighter, money, and that a positive supply shock should lead to tighter, not looser, money. That makes sense to me. If oil prices spike, that’s not going to trigger an inflationary spiral – it’s going to trigger an economic contraction. So we should loosen. If oil prices crater, that’s going to temporarily goose growth, but there’s no underlying improvement in productivity to make that sustainable; the right response isn’t to loosen in response to lower inflation, but to tighten in response to rising nominal growth. This is not the way the Fed reacts currently – in particular, it’s not how it reacted at the beginning of the financial crisis, when commodity prices spiked even as we started to slip into recession – and this is an area that, I think, deserves very close scrutiny by the Fed, and potentially a declaration of their intent in the event of a future spike in commodity prices.

- But I don’t understand why a sustainable increase in productivity should lead to tighter money. I don’t know how the Fed can know whether productivity “should” increase at 3% or 2% per year over a given decade. And I don’t understand why, effectively, lowering the inflation target when productivity growth is high and raising the inflation target when productivity growth is low makes any sense. I’m not saying outright that it doesn’t make sense. I’m saying I don’t understand the logic of it. Put another way: how do we know that the American economy “should” grow at 5% per year? Where did that 5% come from? Presumably from our historic experience of what stable growth looked like – low inflation, modest population growth, productivity growth in the 2%-3% range. But if either of the latter two variables change, it seems to me that the NGDP level target should change, because they are the “real” drivers of the “real” growth rate of the economy.

- I continue to worry that NGDP has been significantly more volatile than inflation expectations have been, and that therefore an NGDP level target would imply a much more volatile Fed policy. If the Fed is supposed to use medium-term NGDP expectations to guide policy, that means the Fed would loosen preemptively whenever the market predicted a recession. The best instrument for measuring future expectations of nominal GDP growth is probably yields on the 10-year bond. I’m pretty sure, though not certain, that the 10-year bond yield is more volatile than the TIPS spread. But that might reflect the fact that the Fed is actually trying to fix inflation expectations, and is not trying to fix the 10-year bond yield. In any event, this is another area that would deserve real analysis before the Fed made such a shift.

Back Off Man, We’re Scientists

In an editorial in Monday’s New York Times, Adam S. Posen, an American economist, and a member of the Monetary Policy Committee of the Bank of England, provides an excellent illustration of an economist asserting that his policy preferences are literally scientific truth:

Scientific research tells us that high blood pressure and cholesterol are associated with a higher risk of heart disease and stroke, and that certain prescription medications reduce cholesterol and blood pressure. Yes, it is difficult to prove directly that taking these medicines prevents heart disease and stroke, and taking them is no guarantee of health. But still we should take them, and our doctors should prescribe them if they are indicated. This is the same situation we are in now, with our economy’s financial circulation at risk, and quantitative easing the indicated medicine. [Bold added]

Only, it’s not quite “the same situation” at all.

The problem is that medical science has conducted randomized clinical trials that show precisely this link between cholesterol-reducing drugs and reductions in strokes and morbidity. For example, a 1999 meta-analysis of more than a dozen randomized experiments testing the effect of statins (cholesterol-lowering drugs), showed that that “on average one stroke is prevented for every 143 patients treated with statins over a 4-year period.”

Note that the first sentence of the Lancet paper describing one of the early experiments to establish the effect of a cholesterol-reducing drug on mortality is: “Drug therapy for hypercholesterolaemia has remained controversial mainly because of insufficient clinical trial evidence for improved survival.” Precisely the lack of such experimental evidence engendered a debate; resolution required experiments that established definitively the effects of the interventions.

We have nothing like this for quantitative easing. Lacking experimental evidence doesn’t mean that therefore we should not undertake quantitative easing, but the editorial is an attempt to browbeat opposition by appeal to a purported, but unsubstantiated, scientific authority.

(Cross-posted to The Corner)

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Question For People Who Know More About Italy Than I Do

Why are the odds on the breakup of the Euro zone rated so much higher than the odds of the breakup of Italy?

If you were a voter in Lombardy, why would you prefer to stay with an Italy in a tailspin that had been expelled from the Euro, rather than sticking with the Euro and letting the southerners fend for themselves?

And what ratio of debt-devolution to the regions of Italy would you guess is the indifference point for the median Italian voter – that is to say, how much of Italy’s sovereign debt would need to stay with Padania and how much with a rump non-Euro Italia for both north and south to say: breaking up on these terms is fair?

I ask this question because this, it seems to me, is the key difference between Italy and Spain, even more important than the atrocious personality of Silvio Berlusconi. Catalonia would be eminently viable separate from Spain, but it wouldn’t take most of the Spanish economy with it if it separated. The northern European reluctance to bail out southern Europe is replicated in northern Italy’s desire to stop having to bail out southern Italy. If the Euro is in danger of breaking up largely because Germany prefers that, and the chaos that would follow, to fiscal union and the resultant permanent drain on its treasury, why isn’t Italy in danger of breaking up for the same reason?

Just curious.

Preventing Deflation Should Be The Fed's Top Priority

A high percentage of my recent posts (scratch that; I have no recent posts – say a high percentage of my posts since the summer) have been devoted to voicing my skepticism that looser monetary policy can engineer a meaningful recovery. My own view is that what you’d get instead is new speculative bubbles and a new crisis.

But that doesn’t mean monetary policy should err on the side of tightness in all circumstances. And if we’re at a real risk of slipping into a new round of deflation we should be erring very heavily on the side of looser money. That’s particularly true because the situation with the Euro is sufficiently touchy that we could experience a sudden and substantial liquidity shock with very little warning.

Inflation is dangerous. Deflation is much more dangerous. The Fed should be signalling very clearly that they have the tools available to prevent deflation, that they are ready to use them, and that preventing deflation is their top priority, even if it means overshooting on in an inflationary direction.

So for the time being, the inflationists and I are on the same side. Hopefully, clear messaging and prompt action on the Fed’s part will do the trick, and in a quarter or two we can go back to arguing about how to generate a real, sustainable recovery.

Crime Shouldn't Pay; Working Should

The American Conservative has an interesting cover story by the always intriguing Ron Unz, which you might have skipped because of the terrible title.

That title is: “Immigration, the Republicans and the End of White America.”

Now, you’d think that, with such a title, the article would be about how awful immigration is because it’s leading to the end of white America and of the Republican Party (the presumed protectors of white America). But that’s not the article’s point at all. Rather, Unz’s argument is that “white America,” if it isn’t a thing of the past already, is going to be one in the near future no matter what; the demographic change, good or bad, is already baked in. Campaigns based on outright demonization of immigrants, whether or not they are morally wrong, are a practical mistake, because they will solidify the perception that the GOP is a white ethnic party.

However, Unz goes on, mass immigration is a problem because, by keeping wages persistently low at the lower end of the scale, it is leading to an economically more stratified society, which may be a bad thing in its own right but also leads to persistent economic and political problems.

Unz’s solution, therefore, is to tackle the problem from the other end. Rather than try to restrict immigration, legislate a rise in wages. With a national minimum wage in the $10-12 range, the jobs that currently go to low-skilled immigrants from much poorer countries would go one of three places: either overseas (where they might wind up employing the same people in their home countries), or away altogether (substituting capital for labor through innovation), or to natives willing to do the work if it paid a more reasonable wage. Enforcement would still be an issue, of course, but the constellation of interests in favor of “enforce minimum wage laws” would be much stronger than that in favor of “enforce immigration laws.” Labor unions that are ambivalent about mass immigration (immigration holds down wages, but increases the number of public-sector jobs) would be unequivocally in favor of enforcing minimum wage laws. Hispanic politicians, who generally favor a high-immigration regime, also favor a regime that is more friendly to poor immigrants once they are here, and that leaves them less-subject to economic exploitation. They would certainly also be on the “enforce the minimum wage” side of the fence. And so forth.

I think Unz’s argument merits real consideration. It’s very much in the same universe as two reform proposals that I’ve long found attractive: replacing some or all of the payroll tax with a value-added tax, and replacing the existing patchwork system of visas with a simple auction, the proceeds of the auction going to offset the costs that areas with high levels of immigration bear due to rapid population growth (and, in particular, rapid growth in the relatively poorer segment of the population). The payroll tax is no big deal for a large employer, but it’s a meaningful burden on, for example, household employers, and creates an incentive to hire people off the books – which, in turn, is easier to do if the employees aren’t here legally. A VAT would bring those wages (when they are consumed) under the tax umbrella without creating a disincentive to employment; some kind of payroll-tax exemption for very small employers, meanwhile, would eliminate the incentive to hire illegal immigrants for these jobs.

My other proposal, a visa auction, would open the “front door” of legal immigration (the process for getting a visa to work at a large firm would become trivial; instead of hiring a lawyer, taking out ads, and bearing the costs of endless bureaucratic delays, you’d just pay the cost of the visa and be done with it) while simultaneously aligning forces correctly for closing the “back door” of illegal immigration (someone who employed an illegal immigrant would be illegally depriving the government of revenue; the IRS is very good at catching and punishing people who do that). Moreover, the auction would bring in revenue, which would not only offset the social costs of immigration but would create an incentive to open the “front door” to the optimally-wide level (if we could bring in billions of dollars per year by increasing the number of visas, Congress – and the electorate – might feel differently about the subject than now, when costs are socialized and benefits are largely privatized). Finally, you’d expect a visa auction to uptier the average skill level of the immigrant population relative to the current system of making it very difficult to hire skilled immigrants on the books, and relatively easy to hire unskilled immigrant laborers off the books.

A higher national minimum wage would be complementary to these kinds of reforms. Yes, it would impose a burden on very small employers – but if you also eliminated the payroll tax for such employers, the net effect might not be so significant. A visa auction system would be vulnerable to parochial lobbying by, for example, agribusiness seeking special “seasonal” visas at a lower price. But if the minimum wage were hiked as well, those employers would have to lobby for an exemption to the minimum wage as well – a taller political order. The difficulty of that lobbying effort might be enough to tip the balance in favor of restructuring their enterprises to work within the law rather than trying to change or evade the law so their operations can continue as currently structured.

Wouldn’t raising the minimum wage increase unemployment? Isn’t that a terrible idea right now? Well, maybe, but not necessarily. Businesses that had to pay a higher minimum wage would have to do one of the following things: (1) raise prices to compensate; (2) apply capital in innovative new ways to reduce the need for the job and/or make the job more productive, so it “earns” a higher real wage; or (3) shut down or relocate operations. If the inflationists are right, and what we need is coordinated expectations of higher nominal prices, then (1) is exactly what we need in our current economic circumstances. If I’m right, and what we need is coordinated expectations of higher real wages, then (2) is exactly what we need in our current economic circumstances. To the extent that (3) means that instead of people coming from Mexico, capital flows to Mexico and the people stay there, then a reduction in the growth of the American workforce doesn’t lead to higher American unemployment. And to the extent that (3) means that smaller operations simply go out of business, we should think about offsets to prevent that happening (such as payroll tax relief).

But I’d also turn the question around. Does anyone think that unemployment would drop significantly if nominal wages at the low end of the wage scale dropped suddenly? If the inflationists are right, we need real wages to drop to get out of the recession, but that’s across the board – a very different proposition from saying that declining real wages at the low end of the spectrum are beneficial. The opposite, in fact, may be true. Deflation benefits creditors at the expense of debtors. Debtors are, generally, the folks to the left of the median in terms of wages. So if those wages come under pressure, but wages at the other end, where the creditors are, remain stable, then you’re exacerbating the effects of deflation, not counteracting them.

I’m not so much endorsing Unz’s specific proposal – or even my own ideas – so much as saying that we should be thinking about the problem in terms of the title of this post. Crime shouldn’t pay. Working should. The best way to make that true isn’t to build a huge punitive infrastructure organized around stopping some people from working (an infrastructure which is then only applied fitfully and inconsistently, as any punitive infrastructure will be when you’re dealing with a large class of lawbreakers). It’s to align incentives properly. Make breaking the law more expensive. Make following the law more remunerative. And align the law more sensibly with what’s good, in general, for those from whom the law’s authority ultimately derives.

Back To The Future: Healthcare Edition

Health care really isn’t my issue, but I’m going to wade into it anyway. This weekend, Matt Yglesias (probably my favorite blogger to argue with) said:

I think that too often people’s pet concerns about health care costs point to things that increase the level of health care spending rather than the high growth rate of health care spending.

Think about the market for cars. Cars are pretty expensive. They’re sold at a wide variety of price points. And quality-adjusted prices for cars don’t show any noteworthy crazy trends. Now suppose the government made cars tax deductible, what would happen? Well I assume that at the margin people would start buying more expensive cars. So for a few years, car spending as a share of GDP would accelerate. But pretty soon the American automobile fleet would have turned over and the acceleration would stop. The subsidy, in other words, provides a one-off boost to automobile spending but it doesn’t do anything to change the underlying cost structure of the system.

Health care, I think, is like that. But what’s really distressing people about health care isn’t the absolute level of spending, it’s the very rapid pace at which prices are rising.

Except that, if we look at spending on an internationally comparative basis, and look at percentage changes here and elsewhere, they aren’t rising very rapidly here. From 2002 to 2008, US per-capital health-care spending grew a bit faster than five and a half percent a year. That puts us in the middle of the pack of industrialized countries; Dutch spending grew nearly 7% per year, Canadian spending more than 5.7% per year, and UK spending more than 7%; by contrast, French spending grew less than 4.5% per year and Swiss spending grew a bit more than 5%. A similar picture obtains if you look back at the previous six-year period; American health-care spending per-capita grew a bit under 6% per year in that period, a slower rate of growth than the Dutch, British, Danes or Swedes, but faster than the French or Swiss, much faster than the Germans, and slightly faster than the Canadians.

The problem is not primarily the high growth rate of our health-care spending; the problem is precisely the high level of our health-care spending. Which in turn means that a growth rate that looks reasonable when compared internationally is unsustainable in terms of the bite it takes out of the domestic economy.

We got into this mess primarily because our per-capita health-care spending growth rate didn’t slow as quickly as our peer countries. Back in 1972, American health care was already dramatically more expensive on a per-capita basis than the British system, which operates very differently. But it was only modestly more expensive than Danish, Swedish, Canadian, German or Swiss health care. And health care expenditures were rising across the board in this period. From 1972 to 1978, American health care expenditures per-capita grew by a bit over 12% per year. But German per-capita expenses went up by 14%. British per-capita expenses went up by just under 12%. French per-capita expenses went up by over 13%. Swiss expenses went up by 11.3%. And this was the era of double-digit inflation; similar increases in prices and wages in all sorts of sectors were normal.

The problem is that America maintained a very high rate of growth in per-capita health care expenses well into the 1980s, well after inflation in general was tamed, and didn’t bring our growth rates down to internationally comparable levels until the 1990s. From 1978 to 1984, America’s per-capita health-care expenses grew nearly 12%, versus a bit over 8% for the Netherlands and a bit over 9% for Germany. In the next six-year period, America’s expenses grew over 9%, versus less than 7.5% for the Netherlands and a bit over 5% for Germany. Similar comparisons obtain with Switzerland, Canada, Belgium, the UK, France. It was in the 1980s that American health care went from being modestly more expensive than other wealthy countries with mixed public-private systems, to being wildly more expensive than other wealthy countries with mixed public-private systems.

Because we’re growing off such a high cost base, even as we have dramatically reduced the rate of growth of per-capita health-care expenditures the absolute bite we’re taking out of GDP is getting out of hand. From 1978 to 1990, German heath-care expenses as a percent of GDP did not change; they were 8.4% at the start of that period and 8.3% at the end. During the same period, American health care expenses as a percentage of GDP went from 8.4% – the same as Germany – to 12.4%, a nearly 50% increase in relative share of GDP. From 1990 to 2008, German health-care expenses have increased from 8.3% to 10.7%. Looked at one way, that’s a 2.4% increase – looked at another way, that’s a 29% increase in relative share. During that same period, American health care costs went from 12.4% of GDP to 16.4% – a 4% increase. But that’s only a 32% increase in relative share – very comparable to Germany. The high cost base means that internationally comparable growth rates in health care expenses, measured either in per-capita terms or as percent of GDP, are unsustainable for the United States.

To solve our health care problem, we have to do one of three things that no other developed country is doing.

- Either we have to grow nominal GDP much more rapidly than other developed countries while holding health-care cost inflation down to levels comparable to other developed countries.

- Or we have to slow health-care cost growth to rates much lower than those achieved by our peer countries, and keep those growth rates low for an extended period, without, in the process, sacrificing growth in nominal GDP.

- Or we have to take a one-time axe to health-care costs in some fashion so that we can, from that point, grow from a more manageable base.

I think any of these is a tall order for reformers of either the right or the left. Not because the reforms are poorly designed, but because restructuring more than 15% of the economy is hard, and when that restructuring has to be led by the government it’s even harder, because there are a lot of ways to put pressure on the government not to do it. If we could switch to the Canadian system tomorrow, and thereby achieve Canadian levels of cost control, this would not solve our problems. We would not only have to switch to the Canadian system, but then use the government’s monopsody power much more aggressively than the Canadian government has to. Static international comparisons – we spend twice as much per capita or as a percent of GDP as this or that country, without getting better health-care outcomes – are probably not as relevant for figuring out where to go as elucidating the levers that would make it possible to get from here to there. Because whatever happened in the 1980s happened. We can’t go back and make it un-happen.

Diverting Money Into Speculation is Contractionary, Now Or Later

Fed Chairman Yglesias says:

I’m going to have the Federal Reserve purchase lots of stuff, with the quantities of the stuff, the nature of the stuff purchased, and the timing of the purchases done at my discretion. And I’m going to keep doing it until unemployment is down to 6.5 percent or so unless core inflation gets over 5 percent. If core inflation goes over five percent, then I’ll conclude that my estimate [of what constitutes full employment] was off and we need to reconsider. But as long as inflation is below 5 percent and unemployment is above 6.5 percent, my conclusion will be that the Fed needs to buy more stuff and buying more stuff is exactly what we’ll be doing.

Then what happens? It’s like FDR and the gold standard redux. A minority of rich businessmen will think to themselves that this is a great idea, and revise upwards the quantity of potential customers for their products or services in the medium term and start investing to hire workers and equipment while idle resources are still cheap and plentiful. The majority of rich businessmen will think to themselves that this guy is an insane socialist who’s going to produce runaway inflation, and will start ditching cash and low-yield dollar-denominated financial instruments in favor of some mix of foreign currencies, commodities, and concrete assets like bigger houses and fancier yachts. Both the majority who think I’m an idiot and the minority who think I’m a genius will be taking steps that boost real output.

I want to poke some holes in the notion that the actions of the majority in this hypothetical will assist in the recovery.

Let’s take an extreme scenario: the majority takes all their money out of circulation and puts it into gold. Gold’s the classic inflation hedge. Why shouldn’t they buy gold if they think the dollar is going to be debased? Obviously, gold isn’t going to absorb 100% of the cash currently in low-yielding financial instruments – but what if it did? What would be the economic consequences?

Well, that money would now be out of circulation. The Federal Reserve would have added a certain amount of money to the economy, by buying a variety of debt instruments. The sellers of those instruments, instead of putting the proceeds of their sales to work generating employment and income, stuffed it in a shiny yellow mattress. The Fed has expanded its balance sheet without boosting the economy in any way – but the market is aware of this expanded balance sheet, and aware that, eventually, it has to be unwound. And thus the net effect is contractionary.

As I say, this won’t actually happen. So what if some of the money goes into other assets that are likely to perform well in an inflationary climate – oil, say. Will that boost economic activity? Quite the contrary. Because of America’s dependence on oil as an economic input, a speculation-driven spike in oil prices would be an immediate negative shock to the economy. Now, if the rise in prices was driven by higher end-user demand, it might boost more investment in things like refining capacity. But if it’s driven by inflation concerns, not so much. You might still get an increase in extraction efforts, and some increase in employment as a consequence. But mostly not; oil prices are high enough already that there’s a lot of investment going on in this area. Incremental increases in the price of oil would probably just be a tax on productive activity that uses oil as an input, distributed into the coffers of entities who already own or lease oil properties. Again, the net effect is contractionary.

What about land? Surely increases in the price of land would be a good thing; after all, the collapse in the housing market is what got us into this mess in the first place. Well, don’t be so quick. Yes, an increase in land prices would help alleviate the problem of so many underwater mortgages. But expensive housing is, all else being equal, a drag on economic activity, a barrier to establishing a household. Yglesias himself has pointed out that the insane housing boom of the 2000s was mostly a boom in land prices; the boom in housing construction was well within historic norms (albeit building went quite nuts in specific regions like California’s Inland Empire and south Florida). In current conditions, reflating the housing bubble will alleviate the debt overhang, but it’ll leave us with a new problem: housing prices that are out of line with reasonable expectation for future wages, which would either imply another crash in the future (which would precipitate another recession) or a long-term economic drag. Because the bottom line is: land as such doesn’t generate much economic activity. As they say: we aren’t making more of it. So rises in land prices, unlike rises in the price of, say, automobiles, don’t create an incentive to produce more land more cheaply.

So how can speculative bubbles be expansionary? Why did we see strong NGDP growth in the middle of the 2000s, when this was substantially underwritten by the housing bubble? Well, because higher prices made it possible for incumbents to spend their increase in paper wealth through debt, and the combination of low interest rates, poor credit standards and exotic products made it possible to increase debt at little or no increase in the cost of debt service, at least for the short term (many of these exotic products raised the service cost substantially down the road). This produces a short-term increase in demand, but it’s borrowed from the future. Now, that’s fine – if you’re borrowing to increase your earnings capacity in the future. Then you come out ahead. But that’s not what we were doing in the 2000s.

The crash and subsequent recession are a consequence of the false growth of the 2000s. To the extent that monetary expansion fails to create real economic activity, but instead fuels speculation, it’s creating new economic problems. Those problems might be immediate – if they amount to alternative forms of money stuffed in mattresses – or they might take a while to manifest – if we dig our way out of our problem by reflating the housing bubble, for example, then we’ll have the bubble to deal with.

Chairman Yglesias, in other words, could, by pursuing an inflationary strategy, actually push the NAIRU up even as he pushes unemployment down. Instead of 4% inflation and 6.5% unemployment, he could wind up with 5% inflation and 8% unemployment. And then he has a problem.

I don’t know how much of the monetary stimulus will “leak” into this kind of unproductive speculative activity, and neither does he. Some of it will. If very little does, then the Yglesias strategy will work. If lots of it does, it’ll backfire – badly. But I do think it’s a mistake to be sanguine that whatever the holders of cash do in response to rising inflation expectations will assist in the economic recovery.

And that’s why I keep coming back to the need to tackle the structural problems in the economy. Among other things, tackling these will make monetary stimulus more effective – because they will provide a rationale for diverting money into productive activity rather than into speculation.

Mike Konczal Makes Cool Venn Diagrams

Check ‘em out.

Based on what I’ve written before, I agree with some combination of the lower-right segments of both the demand-side and supply-side charts: I think we need to tackle the overhang of consumer debt directly (rather than by trying to reinflate the housing bubble through monetary policy) and I think we need to take actions to improve labor productivity, which means putting people directly back to work (nobody is less productive than somebody unemployed), investing in human and physical capital, and identifying ways to reduce friction in the labor market (some of which will mean changing or even increasing the way government intervenes – for example, in the health insurance market – and some of which will mean the opposite, reducing regulations of various sorts).

I’m more skeptical of the top side of the demand-side chart (what we need is more inflation) and much more skeptical of the left side of the supply-side chart (basically, explanations that blame the Obama Administration’s responses for increasing “uncertainty”).