Mike Konczal

Roosevelt Institute Fellow

Recent Posts by Mike Konczal

  • The UNC Coup and the Second Limit of Economic Liberalism

    Nov 13, 2014Mike Konczal

    There was a quiet revolution in the University of North Carolina higher education system in August, one that shows an important limit of current liberal thought. In the aftermath of the 2014 election, there’s been a significant amount of discussion over whether liberals have an economic agenda designed for the working and middle classes. This discussion has primarily been about wages in the middle of the income distribution, which are the first major limit of liberal thought; however, it is also tied to a second limit, which is the way that liberals want to provide public goods and services.

    So what happened? The UNC System Board of Governors voted unanimously to cap the amount of tuition that may be used for financial aid for need-based students at no more than 15 percent. With tuition going up rapidly at public universities as the result of public disinvestment, administrators have recently begun using general tuition to supplement their ability to provide aid. This cross-subsidization has been heralded as a solution to the problem of high college costs. Sticker price is high, but the net price for poorer students will be low.

    This system works as long as there is sufficient middle-class buy-in, but it’s now capped at UNC. As a board member told the local press, the burden of providing need-based aid “has become unfairly apportioned to working North Carolinians,” and this new policy helps prevent that. Iowa implemented a similar approach back in 2013. And as Kevin Kiley has reported for IHE, similar proposals have been floated in Arizona and Virginia. This trend is likely to gain strength as states continue to disinvest.

    The problem for liberals isn’t just that there’s no way for them to win this argument with middle-class wages stagnating, though that is a problem. The far bigger issue for liberals is that this is a false choice, a real class antagonism that has been created entirely by the process of state disinvestment, privatization, cost-shifting of tuitions away from general revenues to individuals, and the subsequent explosion in student debt. As long as liberals continue to play this game, they’ll be undermining their chances.

    First Limit: Middle-Class Wages

    There’s been a wave of commentary about how the Democrats don’t have a middle-class wage agenda. David Leonhardt wrote the core essay, “The Great Wage Slowdown, Looming Over Politics,” with its opening line: “How does the Democratic Party plan to lift stagnant middle-class incomes?” Josh Marshall made the same argument as well. The Democrats have many smart ideas on the essential agenda of reducing poverty, most of which derive from pegging the low-end wage at a higher level and then adding cash or cash-like transfers to fill in the rest. But what about the middle class?

    One obvious answer is “full employment.” Running the economy at full steam is the most straightforward way of boosting overall wages and perhaps reversing the growth in the capital-share of income. However, that approach hasn’t been adopted by the President, strategically or even rhetorically. Part of it might be that if the economy is terrible because of vague forces, technological changes and necessary pain following a financial crisis, then the Democrats can’t really be blamed for stagnation. That strategy will not work out for them.

    The Democrats (and even many liberals in general) also haven’t developed a story about why inequality matters so much for the middle class. There are such stories, of course: the collapse of high progressive taxation creates incentives to rent seek, financialization makes the economy focused less on innovation and more on disgorging the cash, and new platform monopolies are deploying forms of market power that are increasingly worrisome.

    Second Limit: Public Provisioning

    A similar dynamic is in play with social goods. The liberal strategy is increasingly to leave the provisioning of social goods to the market, while providing coupons for the poorest to afford those goods. By definition, means-testing this way puts high implicit taxes on poorer people in a way that decommodification does not. But beyond that simple point, this leaves middle-class people in a bind, as the ability of the state to provide access and contain costs efficiently through its scale doesn’t benefit them, and stagnating incomes put even more pressure on them.

    As noted, antagonisms between the middle class and the poor in higher education are entirely a function of public disinvestment. The moment higher education is designed to put massive costs onto individual students, suddenly individuals are forced to look out only for themselves. If college tuition was largely free, paid for by all people and income sources, then there’d be no need for a working-class or middle-class student to view poorer student as a direct threat to their economic stability. And there's no better way to prematurely destroy a broader liberal agenda by designing a system that creates these conflicts.

    These worries are real. The incomes of recent graduates are stagnating as well. The average length of time people are taking to pay off their student loans is up 80 percent, to over 13 years. Meanwhile, as Janet Yellen recently showed in the graphic below, student debt is rising as a percentage of income for everyone below the bottom 5 percent. It’s not surprising that studies find student debt impacting family formation and small business creation, and that people are increasingly looking out for just themselves.

    You could imagine committing to lowering costs broadly across the system, say through the proposal by Sara Goldrick-Rab and Nancy Kendall to make the first two years free. But Democrats aren't doing this. Instead, President Obama’s solution is to try and make students better consumers on the front-end with more disclosures and outcome surveys for schools, and to make the lowest-income graduates better debtors on the back-end with caps on how burdensome student debt can be. These solutions by the President are not designed to contain the costs of higher education in a substantial way and, crucially, they don’t increase the public buy-in and interest in public higher education.

    The Relevance for the ACA

    I brought up higher education because I think it’s relevant, but I think it also can help explain the lack of political payout for the Affordable Care Act. It’s here! The ACA is not only meeting expectations, it’s even exceeding them in major ways. Yet it still remains unpopular, even as millions of people are using the exchanges. There is no political payout for the Democrats.

    Liberals chalk this up to the right-wing noise machine, and no doubt that hurts. But part of the problem is that middle-class individuals still end up facing an individual product they are purchasing in a market, except without any subsidies. Though the insurance is better regulated, serious cost controls so far have not been part of the discussion. Polling shows half of the users of the exchange are unsure if they can make their payments and are worried about being able to afford getting sick. This, in turn, blocks the formation of a broad-based coalition capable of defending, sustaining, and expanding the ACA in the same way those have formed for Social Security and Medicare.

    Any serious populist agenda will have to have a broader agenda for wages, with full employment as the central idea. But it will also need to include social programs that are broader based and focused on cost controls; here, luckily, the public option is a perfect organizing metaphor.

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    There was a quiet revolution in the University of North Carolina higher education system in August, one that shows an important limit of current liberal thought. In the aftermath of the 2014 election, there’s been a significant amount of discussion over whether liberals have an economic agenda designed for the working and middle classes. This discussion has primarily been about wages in the middle of the income distribution, which are the first major limit of liberal thought; however, it is also tied to a second limit, which is the way that liberals want to provide public goods and services.

    So what happened? The UNC System Board of Governors voted unanimously to cap the amount of tuition that may be used for financial aid for need-based students at no more than 15 percent. With tuition going up rapidly at public universities as the result of public disinvestment, administrators have recently begun using general tuition to supplement their ability to provide aid. This cross-subsidization has been heralded as a solution to the problem of high college costs. Sticker price is high, but the net price for poorer students will be low.

    This system works as long as there is sufficient middle-class buy-in, but it’s now capped at UNC. As a board member told the local press, the burden of providing need-based aid “has become unfairly apportioned to working North Carolinians,” and this new policy helps prevent that. Iowa implemented a similar approach back in 2013. And as Kevin Kiley has reported for IHE, similar proposals have been floated in Arizona and Virginia. This trend is likely to gain strength as states continue to disinvest.

    The problem for liberals isn’t just that there’s no way for them to win this argument with middle-class wages stagnating, though that is a problem. The far bigger issue for liberals is that this is a false choice, a real class antagonism that has been created entirely by the process of state disinvestment, privatization, cost-shifting of tuitions away from general revenues to individuals, and the subsequent explosion in student debt. As long as liberals continue to play this game, they’ll be undermining their chances.

    First Limit: Middle-Class Wages

    There’s been a wave of commentary about how the Democrats don’t have a middle-class wage agenda. David Leonhardt wrote the core essay, “The Great Wage Slowdown, Looming Over Politics,” with its opening line: “How does the Democratic Party plan to lift stagnant middle-class incomes?” Josh Marshall made the same argument as well. The Democrats have many smart ideas on the essential agenda of reducing poverty, most of which derive from pegging the low-end wage at a higher level and then adding cash or cash-like transfers to fill in the rest. But what about the middle class?

    One obvious answer is “full employment.” Running the economy at full steam is the most straightforward way of boosting overall wages and perhaps reversing the growth in the capital-share of income. However, that approach hasn’t been adopted by the President, strategically or even rhetorically. Part of it might be that if the economy is terrible because of vague forces, technological changes and necessary pain following a financial crisis, then the Democrats can’t really be blamed for stagnation. That strategy will not work out for them.

    The Democrats (and even many liberals in general) also haven’t developed a story about why inequality matters so much for the middle class. There are such stories, of course: the collapse of high progressive taxation creates incentives to rent seek, financialization makes the economy focused less on innovation and more on disgorging the cash, and new platform monopolies are deploying forms of market power that are increasingly worrisome.

    Second Limit: Public Provisioning

    A similar dynamic is in play with social goods. The liberal strategy is increasingly to leave the provisioning of social goods to the market, while providing coupons for the poorest to afford those goods. By definition, means-testing this way puts high implicit taxes on poorer people in a way that decommodification does not. But beyond that simple point, this leaves middle-class people in a bind, as the ability of the state to provide access and contain costs efficiently through its scale doesn’t benefit them, and stagnating incomes put even more pressure on them.

    As noted, antagonisms between the middle class and the poor in higher education are entirely a function of public disinvestment. The moment higher education is designed to put massive costs onto individual students, suddenly individuals are forced to look out only for themselves. If college tuition was largely free, paid for by all people and income sources, then there’d be no need for a working-class or middle-class student to view poorer student as a direct threat to their economic stability. And there's no better way to prematurely destroy a broader liberal agenda by designing a system that creates these conflicts.

    These worries are real. The incomes of recent graduates are stagnating as well. The average length of time people are taking to pay off their student loans is up 80 percent, to over 13 years. Meanwhile, as Janet Yellen recently showed in the graphic below, student debt is rising as a percentage of income for everyone below the bottom 5 percent. It’s not surprising that studies find student debt impacting family formation and small business creation, and that people are increasingly looking out for just themselves.

    You could imagine committing to lowering costs broadly across the system, say through the proposal by Sara Goldrick-Rab and Nancy Kendall to make the first two years free. But Democrats aren't doing this. Instead, President Obama’s solution is to try and make students better consumers on the front-end with more disclosures and outcome surveys for schools, and to make the lowest-income graduates better debtors on the back-end with caps on how burdensome student debt can be. These solutions by the President are not designed to contain the costs of higher education in a substantial way and, crucially, they don’t increase the public buy-in and interest in public higher education.

    The Relevance for the ACA

    I brought up higher education because I think it’s relevant, but I think it also can help explain the lack of political payout for the Affordable Care Act. It’s here! The ACA is not only meeting expectations, it’s even exceeding them in major ways. Yet it still remains unpopular, even as millions of people are using the exchanges. There is no political payout for the Democrats.

    Liberals chalk this up to the right-wing noise machine, and no doubt that hurts. But part of the problem is that middle-class individuals still end up facing an individual product they are purchasing in a market, except without any subsidies. Though the insurance is better regulated, serious cost controls so far have not been part of the discussion. Polling shows half of the users of the exchange are unsure if they can make their payments and are worried about being able to afford getting sick. This, in turn, blocks the formation of a broad-based coalition capable of defending, sustaining, and expanding the ACA in the same way those have formed for Social Security and Medicare.

    Any serious populist agenda will have to have a broader agenda for wages, with full employment as the central idea. But it will also need to include social programs that are broader based and focused on cost controls; here, luckily, the public option is a perfect organizing metaphor.

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  • On Public and Profits at Boston Review

    Nov 12, 2014Mike Konczal

    Did you know that prosecutors were paid based on how many cases they tried in the 19th century? Or that Adam Smith argued for judges running on the profit motive in the Wealth of Nations? I have a new piece discussion the rise and fall of disinterested public service as a response to the abuses of the profit motive in government service, or how we got away from that system and how we are now going back to it, at Boston Review. It's called Selling Fast: Public Goods, Profits, and State Legitimacy.

    It's a review of Against the Profit Motive: The Salary Revolution in American Government, 1780–1940 by Yale legal historian Nicholas R. Parrillo, The Teacher Wars by Dana Goldstein, and Rise of the Warrior Cop by Radley Balko. There's a lot of interesting threads through all three, and I really enjoyed working on this review. I hope you check it out.

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    Did you know that prosecutors were paid based on how many cases they tried in the 19th century? Or that Adam Smith argued for judges running on the profit motive in the Wealth of Nations? I have a new piece discussion the rise and fall of disinterested public service as a response to the abuses of the profit motive in government service, or how we got away from that system and how we are now going back to it, at Boston Review. It's called Selling Fast: Public Goods, Profits, and State Legitimacy.

    It's a review of Against the Profit Motive: The Salary Revolution in American Government, 1780–1940 by Yale legal historian Nicholas R. Parrillo, The Teacher Wars by Dana Goldstein, and Rise of the Warrior Cop by Radley Balko. There's a lot of interesting threads through all three, and I really enjoyed working on this review. I hope you check it out.

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  • In Blowout Aftermath, Remember GDP Growth Was Slower in 2013 Than in 2012

    Nov 5, 2014Mike Konczal

    In the aftermath of the electoral blowout, a reminder: the Great Recession isn't over. In fact, GDP growth was slower in 2013 than in 2012. Let's go to the FRED data:

    There's dotted lines added at the end of 2012 to give you a sense that throughout 2013 the economy didn't speed up. Even though we were another year into the "recovery" GDP growth slowed down a bit.

    There's a lot of reasons people haven't discussed it this way. I saw a lot of people using year-over-year GDP growth for 2013, proclaiming it a major success. A problem with using that method for a single point is that it's very sensitive to what is happening around the end points, and indeed the quarter before and after that data point featured negative or near zero growth. Averaging it out (or even doing year-over-year on a longer scale) shows a much worse story. Also much of the celebrated convergence between the two years was really the BEA finding more austerity in 2012. (I added a line going back to 2011 to show that the overall growth rate has been lower since then. According to David Beckworth, this is the point when fiscal tightening began.)

    Other people were hoping that the Evans Rule and open-ended purchases could stabilize "expectations" of inflation regardless of underlying changes in economic activity (I was one of them), a process that didn't happen. And yet others knew the sequestration was put into place and was unlikely to be moved, so might as well make lemonade out of the austerity.

    And that's overall growth. Wages are even uglier. (Note in an election meant to repudiate liberalism, minimum wage hikes passed with flying colors.) The Federal Reserve's Survey of Consumer Finances is not a bomb-throwing document, but it's hard not to read class war into their latest one. From 2010 to 2013, a year after the Recession ended until last year, median incomes fell:

    When 45 percent of the electorate puts the economy as the top issue in exit polls, and the economy performs like it does here, it's no wonder we're having wave election after wave election of discontentment.

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    In the aftermath of the electoral blowout, a reminder: the Great Recession isn't over. In fact, GDP growth was slower in 2013 than in 2012. Let's go to the FRED data:

    There's dotted lines added at the end of 2012 to give you a sense that throughout 2013 the economy didn't speed up. Even though we were another year into the "recovery" GDP growth slowed down a bit.

    There's a lot of reasons people haven't discussed it this way. I saw a lot of people using year-over-year GDP growth for 2013, proclaiming it a major success. A problem with using that method for a single point is that it's very sensitive to what is happening around the end points, and indeed the quarter before and after that data point featured negative or near zero growth. Averaging it out (or even doing year-over-year on a longer scale) shows a much worse story. Also much of the celebrated convergence between the two years was really the BEA finding more austerity in 2012. (I added a line going back to 2011 to show that the overall growth rate has been lower since then. According to David Beckworth, this is the point when fiscal tightening began.)

    Other people were hoping that the Evans Rule and open-ended purchases could stabilize "expectations" of inflation regardless of underlying changes in economic activity (I was one of them), a process that didn't happen. And yet others knew the sequestration was put into place and was unlikely to be moved, so might as well make lemonade out of the austerity.

    And that's overall growth. Wages are even uglier. (Note in an election meant to repudiate liberalism, minimum wage hikes passed with flying colors.) The Federal Reserve's Survey of Consumer Finances is not a bomb-throwing document, but it's hard not to read class war into their latest one. From 2010 to 2013, a year after the Recession ended until last year, median incomes fell:

    When 45 percent of the electorate puts the economy as the top issue in exit polls, and the economy performs like it does here, it's no wonder we're having wave election after wave election of discontentment.

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  • Rortybomb on the March: Special Washington Monthly Inequality Issue and The Nation

    Nov 4, 2014Mike Konczal

    Hey everyone, I have two new pieces out there I hope you check out.

    The first is a piece about the financialization of the economy in the latest Washington Monthly. I'm heading up a new project at Roosevelt, more details to come soon, about the financialization of the economy, and this essay is the first product. And I'm happy to have it as part of a special issue on inequality and the economy headed up by the fine people at the Washington Center for Equitable Growth. There's a ton of great stuff in there, including an intro by Heather Boushey, Ann O'Leary on early childhood programs, Alan Blinder on boosting wages, and a conclusion by Joe Stiglitz. It's all really great stuff, and I hope it shows a deeper and wider understanding of an inequality agenda.

    The second is the latest The Score column at The Nation, which is a focus on the effect of high tax rates on inequality and structuring markets. It's a writeup of the excellent Saez, Piketty, and Stantcheva Three Elasticies paper, and a continuation of a post here at this blog.

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    Hey everyone, I have two new pieces out there I hope you check out.

    The first is a piece about the financialization of the economy in the latest Washington Monthly. I'm heading up a new project at Roosevelt, more details to come soon, about the financialization of the economy, and this essay is the first product. And I'm happy to have it as part of a special issue on inequality and the economy headed up by the fine people at the Washington Center for Equitable Growth. There's a ton of great stuff in there, including an intro by Heather Boushey, Ann O'Leary on early childhood programs, Alan Blinder on boosting wages, and a conclusion by Joe Stiglitz. It's all really great stuff, and I hope it shows a deeper and wider understanding of an inequality agenda.

    The second is the latest The Score column at The Nation, which is a focus on the effect of high tax rates on inequality and structuring markets. It's a writeup of the excellent Saez, Piketty, and Stantcheva Three Elasticies paper, and a continuation of a post here at this blog.

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  • Finance 101 Problems in National Affairs' Case For Fair-Value Accounting

    Nov 4, 2014Mike Konczal

    In the latest National Affairs, Jason Delisle and Jason Richwine make what they call ”The Case for Fair-Value Accounting.” This is the process of using the price of, say, student loans in the capital markets to budget and discount government student loans. (The issue also has articles walking back support for previously acceptable moderate-right ideas like Common Core and the EITC, showing the way conservative wonks are starting to line up for 2016.)

    In the piece Delisle and Richwine make two basic mistakes in financial theory, mistakes that undermine their ultimate argument. Let’s dig into them, because it’s a wonderful opportunity to get some finance back into this blog (like it used to have back when it was cool).

    Error 1: Their Definition of FVA Is Wrong

    What is fair-value accounting (FVA)? According to the authors, FVA “factors in the cost of market risk,” meaning “the risk of a general downturn in the economy.” This market risk reflects the potential for defaults; it’s “the cost of the uncertainty surrounding future loan payments.”

    These statements are false. There is a consensus that FVA incorporates significantly more than this definition of market risk.

    Here’s the Financial Economists Roundtable, endorsing FVA: "Use of Treasury rates as discount factors, however, fails to account for the costs of the risks associated with government credit assistance -- namely, market risk, prepayment risk, and liquidity risk."

    And the CBO specifically incorporates all these additional risks when it evaluates FVA: "Student loans also entail prepayment risk… investors… also assign a price to other types of risk, such as liquidity risk… CBO takes into account all of those risks in its fair-value estimates."

    This is a much broader set of concerns than what Delisle and Richwine bring up. For instance, FVA requires taxpayers to be subject to the same liquidity and prepayment risks as the capital markets. Remember when the federal government stepped in to provide liquidity to the capital markets when they failed in late 2008, because the markets couldn’t? That gives us a clue that there might be some differences between public and private risks.

    Crucially, it’s not clear to me that taxpayers have the same prepayment risk as the capital markets. Private holders of student loans are terrified that their loans might be paid back too quickly, because they are likely to get paid back when interest rates are low and it will be tough to reinvest at the same rate. This is a particularly big risk with the negative convexity of student loan payments, which can be prepaid without penalty. Private actors need to be compensated generously for this risk.

    Do taxpayers face the same risk? If student loans owed to the government were paid down faster than anyone expected, would taxpayers be furious? I wouldn’t. I certainly wouldn’t say “how are we going to continue to make the profit we were making?” as a citizen, though it would be an essential question as a private bondholder. Either way, it’s as much a political question as an economic one. (I make the full argument for this in a blog post here.)

    Error 2: Their Definition of Market Risk Is Wrong

    The authors like FVA because it accounts for market risk. But what is market risk? According to Delisle and Richwine, market risk is “associated with expecting future loan repayments,” as “[s]tudents might pay back the expected principal and interest” but they also may not. It is also “the risk of a general downturn in the economy… market risk cannot be diversified away.”

    So the first part is wrong: market risk is not credit risk, or the risk of default or missing payments. The International Financial Reporting Standards (IFRS7), for instance, requires reporting market risk separate from credit risk, because they are obviously two different things. I’ve generally only heard market risk used in the context of bond portfolios to mean interest rate risk, which they also don’t mention. So if market risk isn’t credit risk or interest rate risk, what is it?

    I’m not sure. What I think is going on is they are confusing the concept with the market risk of a stock, specifically its beta. A stock’s beta is its sensitivity to overall equity prices. (Pull up a random stock page and you’ll see the beta somewhere.) It’s very common phrasing to say this risk can’t be diversified away and is a proxy for the risk of general downturns in the economy, which is the same language used in this piece.

    Market risk for stocks is the question of how much your portfolio will go down if the market as a whole goes down. But this has nothing to do with student loans, because students (aside from an enterprising few) don’t sell equity; they take out loans. If students paid for school with equity, in theory an economic downturn would lead to less revenue, since students would make less money overall. But even then it’s a shaky concept.

    This isn’t just academic. There’s a reason people don’t speak of a one-to-one relationship between a market downturn and the value of a bond portfolio, as the authors’ “market risk” definition does. If the economy tanks, credit risk increases, so bonds are worth less, but interest rates fall, meaning the same bonds are worth more. How this all balances is complicated, and strongly driven by the distribution of bond maturities. This is why financial risk management distinguishes between credit, liquidity, and interest rate risks, and doesn’t conflate those concepts as the authors do.

    (Though they are writing as experts, I think they are just copying and pasting from the CBO’s confusing and erroneous definition of “market risk.” If they are sourcing any kind of common financial industry practices or definitions, I don’t see it. I guess Jason Richwine didn’t get a chance to study finance while publishing his dissertation.)

    Here again I’d want to understand more how the value of student loans to taxpayers moves with interest rates. Repayments are mentioned above. And for private lenders, higher interest rates mean that they can sell bonds for less and that they’re worth less as collateral. They need to be compensated for this risk. Do taxpayers have this problem to the same extent? If interest rates rise, do we worry we can’t sell the student loan portfolio for the same amount to another government, or that we can’t use it as collateral to fund another war? If not, why would we use this market rate?

    Is This Just About Credit Risk?

    Besides all the theoretical problems mentioned above, there’s also the practical problem that the CBO uses the already existing private market for student loans (“relied mainly on data about the interest rates charged to borrowers in the private student loan market”), even though there’s obviously a massive adverse selection problem there. Though not an error, it's a third major problem for the argument. The authors don’t even touch this.

    But for all the talk about FVA, the only real concern the authors bring up is credit risk. “What if taxpayers don’t get paid?” is the question raised over and over again in the piece. The authors don’t articulate any direct concerns about, say, a move in interest rates changing the value of a bond portfolio, aside from the possibility that it might mean more credit losses.

    So dramatically scaling back consumer protections like bankruptcy and statute of limitations for student debtors wasn’t enough for the authors. Fair enough. But there’s an easy fix: the government could buy some credit protection for losses in excess of those expected on, say, $10 billion of its portfolio, and use that price as a supplemental discount. This would be quite low-cost and provide useful information. But it’s a far cry from FVA, even if FVA’s proponents don’t quite understand that.

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    In the latest National Affairs, Jason Delisle and Jason Richwine make what they call ”The Case for Fair-Value Accounting.” This is the process of using the price of, say, student loans in the capital markets to budget and discount government student loans. (The issue also has articles walking back support for previously acceptable moderate-right ideas like Common Core and the EITC, showing the way conservative wonks are starting to line up for 2016.)

    In the piece Delisle and Richwine make two basic mistakes in financial theory, mistakes that undermine their ultimate argument. Let’s dig into them, because it’s a wonderful opportunity to get some finance back into this blog (like it used to have back when it was cool).

    Error 1: Their Definition of FVA Is Wrong

    What is fair-value accounting (FVA)? According to the authors, FVA “factors in the cost of market risk,” meaning “the risk of a general downturn in the economy.” This market risk reflects the potential for defaults; it’s “the cost of the uncertainty surrounding future loan payments.”

    These statements are false. There is a consensus that FVA incorporates significantly more than this definition of market risk.

    Here’s the Financial Economists Roundtable, endorsing FVA: "Use of Treasury rates as discount factors, however, fails to account for the costs of the risks associated with government credit assistance -- namely, market risk, prepayment risk, and liquidity risk."

    And the CBO specifically incorporates all these additional risks when it evaluates FVA: "Student loans also entail prepayment risk… investors… also assign a price to other types of risk, such as liquidity risk… CBO takes into account all of those risks in its fair-value estimates."

    This is a much broader set of concerns than what Delisle and Richwine bring up. For instance, FVA requires taxpayers to be subject to the same liquidity and prepayment risks as the capital markets. Remember when the federal government stepped in to provide liquidity to the capital markets when they failed in late 2008, because the markets couldn’t? That gives us a clue that there might be some differences between public and private risks.

    Crucially, it’s not clear to me that taxpayers have the same prepayment risk as the capital markets. Private holders of student loans are terrified that their loans might be paid back too quickly, because they are likely to get paid back when interest rates are low and it will be tough to reinvest at the same rate. This is a particularly big risk with the negative convexity of student loan payments, which can be prepaid without penalty. Private actors need to be compensated generously for this risk.

    Do taxpayers face the same risk? If student loans owed to the government were paid down faster than anyone expected, would taxpayers be furious? I wouldn’t. I certainly wouldn’t say “how are we going to continue to make the profit we were making?” as a citizen, though it would be an essential question as a private bondholder. Either way, it’s as much a political question as an economic one. (I make the full argument for this in a blog post here.)

    Error 2: Their Definition of Market Risk Is Wrong

    The authors like FVA because it accounts for market risk. But what is market risk? According to Delisle and Richwine, market risk is “associated with expecting future loan repayments,” as “[s]tudents might pay back the expected principal and interest” but they also may not. It is also “the risk of a general downturn in the economy… market risk cannot be diversified away.”

    So the first part is wrong: market risk is not credit risk, or the risk of default or missing payments. The International Financial Reporting Standards (IFRS7), for instance, requires reporting market risk separate from credit risk, because they are obviously two different things. I’ve generally only heard market risk used in the context of bond portfolios to mean interest rate risk, which they also don’t mention. So if market risk isn’t credit risk or interest rate risk, what is it?

    I’m not sure. What I think is going on is they are confusing the concept with the market risk of a stock, specifically its beta. A stock’s beta is its sensitivity to overall equity prices. (Pull up a random stock page and you’ll see the beta somewhere.) It’s very common phrasing to say this risk can’t be diversified away and is a proxy for the risk of general downturns in the economy, which is the same language used in this piece.

    Market risk for stocks is the question of how much your portfolio will go down if the market as a whole goes down. But this has nothing to do with student loans, because students (aside from an enterprising few) don’t sell equity; they take out loans. If students paid for school with equity, in theory an economic downturn would lead to less revenue, since students would make less money overall. But even then it’s a shaky concept.

    This isn’t just academic. There’s a reason people don’t speak of a one-to-one relationship between a market downturn and the value of a bond portfolio, as the authors’ “market risk” definition does. If the economy tanks, credit risk increases, so bonds are worth less, but interest rates fall, meaning the same bonds are worth more. How this all balances is complicated, and strongly driven by the distribution of bond maturities. This is why financial risk management distinguishes between credit, liquidity, and interest rate risks, and doesn’t conflate those concepts as the authors do.

    (Though they are writing as experts, I think they are just copying and pasting from the CBO’s confusing and erroneous definition of “market risk.” If they are sourcing any kind of common financial industry practices or definitions, I don’t see it. I guess Jason Richwine didn’t get a chance to study finance while publishing his dissertation.)

    Here again I’d want to understand more how the value of student loans to taxpayers moves with interest rates. Repayments are mentioned above. And for private lenders, higher interest rates mean that they can sell bonds for less and that they’re worth less as collateral. They need to be compensated for this risk. Do taxpayers have this problem to the same extent? If interest rates rise, do we worry we can’t sell the student loan portfolio for the same amount to another government, or that we can’t use it as collateral to fund another war? If not, why would we use this market rate?

    Is This Just About Credit Risk?

    Besides all the theoretical problems mentioned above, there’s also the practical problem that the CBO uses the already existing private market for student loans (“relied mainly on data about the interest rates charged to borrowers in the private student loan market”), even though there’s obviously a massive adverse selection problem there. Though not an error, it's a third major problem for the argument. The authors don’t even touch this.

    But for all the talk about FVA, the only real concern the authors bring up is credit risk. “What if taxpayers don’t get paid?” is the question raised over and over again in the piece. The authors don’t articulate any direct concerns about, say, a move in interest rates changing the value of a bond portfolio, aside from the possibility that it might mean more credit losses.

    So dramatically scaling back consumer protections like bankruptcy and statute of limitations for student debtors wasn’t enough for the authors. Fair enough. But there’s an easy fix: the government could buy some credit protection for losses in excess of those expected on, say, $10 billion of its portfolio, and use that price as a supplemental discount. This would be quite low-cost and provide useful information. But it’s a far cry from FVA, even if FVA’s proponents don’t quite understand that.

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