Introducing Our Latest Report: Defining Financialization

Jul 27, 2015Mike Konczal

We’re releasing a new report today as part of the Roosevelt Institute’s Financialization Project: Definining Financialization.

Following the well-received Disgorge The Cash, this is really the foundational paper that outlines a working definition of financialization, some of the leading concerns, worries, and research topics in each area, and a plan for future research and action. Since this is what we are building from, we’d love feedback.

Prior to this, I couldn’t find a definition of financialization broad enough to account for several different trends and accessible enough for a general, nonacademic audience. So we set out to create our own solid definition of financialization that can serve as the foundation for future research and policy. That definition includes four core elements: savings, power, wealth, and society. Put another way, financialization is the growth of the financial sector, its increased power over the real economy, the explosion in the power of wealth, and the reduction of all of society to the realm of finance.

Each of these four elements is essential, and together they tell a story about the way the economy has worked, and how it hasn’t, over the past 35 years. This enables us to understand the daunting challenges involved in reforming the financial sector, document the influence of finance over society and the economy as a whole, and clarify how finance has compounded inequality and insecurity while creating an economy that works for fewer people.

Savings: The financial sector is responsible for taking our savings and putting it toward economically productive uses. However, this sector has grown larger, more profitable, and less efficient over the past 35 years. Its goal of providing needed capital to citizens and businesses has been forgotten amid an explosion of toxic mortgage deals and the predatory pursuit of excessive fees. Beyond wasting financial resources, the sector also draws talent and energy away from more productive fields. These changes constitute the first part of our definition of financialization.

Power: Perhaps more importantly, financialization is also about the increasing control and power of finance over our productive economy and traditional businesses. The recent intellectual, ideological, and legal revolutions that have pushed CEOs to prioritize the transfer of cash to shareholders over regular, important investment in productive expansion need to be understood as part of the expansion of finance.

These historically high payouts drain resources away from productive investment. But beyond investment, there are broader worries about firms that are too dominated by the short-term interests of shareholders. These dynamics increase inequality and have a negative impact on innovation. Firms only interested in shareholder returns may be less inclined to take on the long-term, risky investment in innovation that is crucial to growth. This has spillover effects on growth and wages that can create serious long-term problems for our economy. This also makes full employment more difficult to achieve, as the delinking of corporate investment from financing has posed a serious challenge for monetary policy.

Wealth: Wealth inequality has increased dramatically in the past 35 years, and financialization includes the ways in which our laws and regulations have been overhauled to protect and expand the interests of those earning income from their wealth at the expense of everyone else. Together, these factors dramatically redistribute power and wealth upward. They also put the less wealthy at a significant disadvantage.

More important than simply creating and expanding wealth claims, policy has prioritized wealth claims over competing claims on the economy, from labor to debtors to the public. This isn’t just about increasing the power of wealth; it’s about rewriting the rules of the economy to decrease the power of everyone else.

Society: Finally, following the business professor Gerald Davis, we focus on how financialization has brought about a “portfolio society,” one in which “entire categories of social life have been securitized, turned into a kind of capital” or an investment to be managed. We now view our education and labor as “human capital,” and we imagine every person as a little corporation set to manage his or her own investments. In this view, public functions and responsibilities are mere services that should be run for profit or privatized, or both.

This way of thinking results in a radical reworking of society. Social insurance once provided across society is now deemphasized in favor of individual market solutions; for example, students take on an ever-increasing amount of debt to educate themselves. Public functions are increasingly privatized and paid for through fees, creating potential rent-seeking enterprises and further redistributing income and wealth upward. This inequality spiral saps our democracy and our ability to collectively address the nation’s greatest problems.

We have a lot of future work coming from this set of definitions, including a policy agenda and FAQ on short-termism in the near future. I hope you check this out!

Follow or contact the Rortybomb blog:
 
  

 

We’re releasing a new report today as part of the Roosevelt Institute’s Financialization Project: Definining Financialization.

Following the well-received Disgorge The Cash, this is really the foundational paper that outlines a working definition of financialization, some of the leading concerns, worries, and research topics in each area, and a plan for future research and action. Since this is what we are building from, we’d love feedback.

Prior to this, I couldn’t find a definition of financialization broad enough to account for several different trends and accessible enough for a general, nonacademic audience. So we set out to create our own solid definition of financialization that can serve as the foundation for future research and policy. That definition includes four core elements: savings, power, wealth, and society. Put another way, financialization is the growth of the financial sector, its increased power over the real economy, the explosion in the power of wealth, and the reduction of all of society to the realm of finance.

Each of these four elements is essential, and together they tell a story about the way the economy has worked, and how it hasn’t, over the past 35 years. This enables us to understand the daunting challenges involved in reforming the financial sector, document the influence of finance over society and the economy as a whole, and clarify how finance has compounded inequality and insecurity while creating an economy that works for fewer people.

Savings: The financial sector is responsible for taking our savings and putting it toward economically productive uses. However, this sector has grown larger, more profitable, and less efficient over the past 35 years. Its goal of providing needed capital to citizens and businesses has been forgotten amid an explosion of toxic mortgage deals and the predatory pursuit of excessive fees. Beyond wasting financial resources, the sector also draws talent and energy away from more productive fields. These changes constitute the first part of our definition of financialization.

Power: Perhaps more importantly, financialization is also about the increasing control and power of finance over our productive economy and traditional businesses. The recent intellectual, ideological, and legal revolutions that have pushed CEOs to prioritize the transfer of cash to shareholders over regular, important investment in productive expansion need to be understood as part of the expansion of finance.

These historically high payouts drain resources away from productive investment. But beyond investment, there are broader worries about firms that are too dominated by the short-term interests of shareholders. These dynamics increase inequality and have a negative impact on innovation. Firms only interested in shareholder returns may be less inclined to take on the long-term, risky investment in innovation that is crucial to growth. This has spillover effects on growth and wages that can create serious long-term problems for our economy. This also makes full employment more difficult to achieve, as the delinking of corporate investment from financing has posed a serious challenge for monetary policy.

Wealth: Wealth inequality has increased dramatically in the past 35 years, and financialization includes the ways in which our laws and regulations have been overhauled to protect and expand the interests of those earning income from their wealth at the expense of everyone else. Together, these factors dramatically redistribute power and wealth upward. They also put the less wealthy at a significant disadvantage.

More important than simply creating and expanding wealth claims, policy has prioritized wealth claims over competing claims on the economy, from labor to debtors to the public. This isn’t just about increasing the power of wealth; it’s about rewriting the rules of the economy to decrease the power of everyone else.

Society: Finally, following the business professor Gerald Davis, we focus on how financialization has brought about a “portfolio society,” one in which “entire categories of social life have been securitized, turned into a kind of capital” or an investment to be managed. We now view our education and labor as “human capital,” and we imagine every person as a little corporation set to manage his or her own investments. In this view, public functions and responsibilities are mere services that should be run for profit or privatized, or both.

This way of thinking results in a radical reworking of society. Social insurance once provided across society is now deemphasized in favor of individual market solutions; for example, students take on an ever-increasing amount of debt to educate themselves. Public functions are increasingly privatized and paid for through fees, creating potential rent-seeking enterprises and further redistributing income and wealth upward. This inequality spiral saps our democracy and our ability to collectively address the nation’s greatest problems.

We have a lot of future work coming from this set of definitions, including a policy agenda and FAQ on short-termism in the near future. I hope you check this out!

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At Vox, Dodd-Frank at 5

Jul 27, 2015Mike Konczal

In honor of Dodd-Frank's fifth birthday party last week, I wrote a 4,000 word summary of the major accomplishments of the financial reform act. It includes what is working as well as what is stalled, what needs to be amplified and what isn't yet tackled. There's a focus on the CFPB, derivatives, capital, and ending Too Big To Fail. It's aimed at both readers with little background as well as people with some familiarity, so I hope you check it out and share.

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In honor of Dodd-Frank's fifth birthday party last week, I wrote a 4,000 word summary of the major accomplishments of the financial reform act. It includes what is working as well as what is stalled, what needs to be amplified and what isn't yet tackled. There's a focus on the CFPB, derivatives, capital, and ending Too Big To Fail. It's aimed at both readers with little background as well as people with some familiarity, so I hope you check it out and share.

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On Paleo and Faith in Government

Jul 15, 2015Mike Konczal

Our Rewriting the Rules report is in the news as part of a debate over the more liberal push in economic thinking. Matt Yglesias argues that this report and the new agenda “reverse the neoliberal formula.” He coins the term “new paleoliberalism” to describe it. David Brooks adds to this, arguing that said paleoliberalism displays “a naïve faith” in government. I want to respond to these three points in turn.

First, Yglesias says the new agenda breaks with the consensus. The old consensus, to him, was that “[t]he main way the government can impact the pre-tax distribution of income is by providing high-quality education,” and if that fails, “progressive taxes should fund redistributive programs to produce a better outcome.”

I think focusing on a new consensus is correct, but I’d think about it a different way. For us, the old consensus was built around two economic folk theories: that as an economy matures, inequality will decrease and all incomes will go up; and that any efforts to combat inequality have a serious negative impact on growth. (It’s not clear whether Kuznets or Okin, respectively, would have agreed with the extreme versions of their arguments that became this consensus.)

The new liberal economic consensus has three elements. To start, you can’t really distinguish between pre-and-post tax income the way these old arguments do. The market structures that determine final income, including taxes, also are a serious determinant of market income. This is pretty obvious if you say it in English: The rules of the economy matter. But this gets lost in the consistent idealization of abstract, perfect markets.

Also, in a world without perfect markets, efforts to fight inequality have fewer strict tradeoffs than people imagined, especially at the margins. We certainly see this internationally, with a wide variety of efforts to change the distribution of income and no obvious impact on growth. As a result, as economies grow, inequality can do any number of things—but it is a choice determined by the market.



Not Paleo

The second question is whether the new liberal consensus is “paleo.” Inasmuch as the term means nostalgia, recycling old theories, and is bordering on revanchist, I like to think it is not.

The focus is very much a reaction to the facts on the ground, including a financial system that isn’t working to channel good investments, new forms of monopoly power, lack of institutions that support the working lives of women, a criminal justice system that has become too punitive, full employment in a period of weak demand, and so on.

The tools remain those that Franklin Roosevelt formalized: a mixed economy, a regulatory state, and social insurance as the bedrock of a thriving economy. Those are the right tools to build on. But how those tools are deployed changes with the times.

There is a strain of liberal thinking that imagines we can wish the labor movement of the 1940s or the 1890s back into existence. Our report has a detailed labor section that I think is really important. But it doesn’t simply imagine we can recreate an economy that no longer exists. Instead, it builds from where we are now.

As a third point, David Brooks, talking about Clinton but mentioning the same liberal economic consensus as Yglesias, asks if we have too much “unchastened faith in the power of government,” a faith that is “epistemologically naïve.”

What strikes me about this argument is that the Republicans have no less faith in the power of government. They have faith that the government can privatize social insurance in a way that won’t involve weaker security and higher costs. They have faith that if the government gives employers wage subsidies for poorer workers, employers won’t simply pocket them in wage bargaining. They have faith, against evidence, that the government having no taxes on capital will cause a boom in private investment. They have faith that the government cutting taxes will more than make up the lost revenue. Their faith leads them to conflate building a robust civil society and economic security with laissez-faire economics.

You could say that this is a faith in “the market.” Yet rules and institutions will always shape markets; the nature of rules is what determines what the economy will look like. The transfer of power to employers and owners isn’t “less government” in any real sense of the term. Structuring markets to give employers and owners more power based on a faith that this will usher in more prosperity is not just naïve; the past few decades have shown it to be a failure.

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Our Rewriting the Rules report is in the news as part of a debate over the more liberal push in economic thinking. Matt Yglesias argues that this report and the new agenda “reverse the neoliberal formula.” He coins the term “new paleoliberalism” to describe it. David Brooks adds to this, arguing that said paleoliberalism displays “a naïve faith” in government. I want to respond to these three points in turn.

First, Yglesias says the new agenda breaks with the consensus. The old consensus, to him, was that “[t]he main way the government can impact the pre-tax distribution of income is by providing high-quality education,” and if that fails, “progressive taxes should fund redistributive programs to produce a better outcome.”

I think focusing on a new consensus is correct, but I’d think about it a different way. For us, the old consensus was built around two economic folk theories: that as an economy matures, inequality will decrease and all incomes will go up; and that any efforts to combat inequality have a serious negative impact on growth. (It’s not clear whether Kuznets or Okin, respectively, would have agreed with the extreme versions of their arguments that became this consensus.)

The new liberal economic consensus has three elements. To start, you can’t really distinguish between pre-and-post tax income the way these old arguments do. The market structures that determine final income, including taxes, also are a serious determinant of market income. This is pretty obvious if you say it in English: The rules of the economy matter. But this gets lost in the consistent idealization of abstract, perfect markets.

Also, in a world without perfect markets, efforts to fight inequality have fewer strict tradeoffs than people imagined, especially at the margins. We certainly see this internationally, with a wide variety of efforts to change the distribution of income and no obvious impact on growth. As a result, as economies grow, inequality can do any number of things—but it is a choice determined by the market.



Not Paleo

The second question is whether the new liberal consensus is “paleo.” Inasmuch as the term means nostalgia, recycling old theories, and is bordering on revanchist, I like to think it is not.

The focus is very much a reaction to the facts on the ground, including a financial system that isn’t working to channel good investments, new forms of monopoly power, lack of institutions that support the working lives of women, a criminal justice system that has become too punitive, full employment in a period of weak demand, and so on.

The tools remain those that Franklin Roosevelt formalized: a mixed economy, a regulatory state, and social insurance as the bedrock of a thriving economy. Those are the right tools to build on. But how those tools are deployed changes with the times.

There is a strain of liberal thinking that imagines we can wish the labor movement of the 1940s or the 1890s back into existence. Our report has a detailed labor section that I think is really important. But it doesn’t simply imagine we can recreate an economy that no longer exists. Instead, it builds from where we are now.

As a third point, David Brooks, talking about Clinton but mentioning the same liberal economic consensus as Yglesias, asks if we have too much “unchastened faith in the power of government,” a faith that is “epistemologically naïve.”

What strikes me about this argument is that the Republicans have no less faith in the power of government. They have faith that the government can privatize social insurance in a way that won’t involve weaker security and higher costs. They have faith that if the government gives employers wage subsidies for poorer workers, employers won’t simply pocket them in wage bargaining. They have faith, against evidence, that the government having no taxes on capital will cause a boom in private investment. They have faith that the government cutting taxes will more than make up the lost revenue. Their faith leads them to conflate building a robust civil society and economic security with laissez-faire economics.

You could say that this is a faith in “the market.” Yet rules and institutions will always shape markets; the nature of rules is what determines what the economy will look like. The transfer of power to employers and owners isn’t “less government” in any real sense of the term. Structuring markets to give employers and owners more power based on a faith that this will usher in more prosperity is not just naïve; the past few decades have shown it to be a failure.

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The Hard Work of Taking Apart Post-Work Fantasy

Jun 29, 2015Mike Konczal

Derek Thompson has a 10,000 word cover story for The Atlantic, “A World Without Work,” about the possibilities of “post-work” in an economy where technology and capital has largely displaced labor. Though Thompson is clear to argue that this isn’t certain, as the “signs so far are murky and suggestive,” he takes the opportunity to describe how a post-work future might look.

There’s been a consistent trend of these stories going back decades, with a huge wave of them coming after the Great Recession. Thompson’s piece is likely to be the best of the bunch. It’s empathetic, well reported, and imaginative. I also hope it’s the last of these end-of-work stories for the time being.

At this point, the preponderance of stories about work ending is itself doing a certain kind of labor, one that distracts us and leads us away from questions we need to answer. These stories, beyond being untethered to the current economy, distract from current problems in the workforce, push laborers to identify with capitalists while ignoring deeper transitional matters, and don’t even challenge what a serious, radical story of ownership this would bring into question.

Unlikely

Before we begin, I think it’s important to note how unlikely this scenario remains. We can imagine the Atlantic of the 1850s running a “The Post-Agriculture, Post-Work World” cover story, correctly predicting farming would go from 70 percent of the workforce to 20 percent over the next 100 years, yet incorrectly predicting this would end work. We don’t think of what happened afterward as “post-work.” The economy managed to continue on, finding new work and workers in the process.

There are other minor problems. Globalization and technological advancement are treated as the same thing, when they are not. There’s also a slippage common in the critical discussion of these articles (you can see it from this tweet from Thompson here) of substituting in the argument that technology has weakened wages and excluded some workers in recent decades for an argument about the long-run trajectory of technology itself. These are two different, distinct stories, with the first just as much about institutions as actual technology, and evidence for the first certainly doesn’t prove the second.

We’ll Still Be Working

But what is the impact of these stories? In the short term, the most important is that they allow us to dream about a world where the current problems of labor don’t exist, because they’ve been magically solved. This is a problem, because the conditions and compensation of work are some of our biggest challenges. In these future scenarios, there’s no need to organize, seek full employment, or otherwise balance the relationship between labor and capital, because the former doesn’t exist anymore.

This is especially a problem when it leaves the “what if” fiction writings of op-eds, or provocative calls to reexamine the nature of work in our daily lives, and melds into organizational politics. I certainly see a “why does this matter, the robots are coming” mentality among the type of liberal infrastructure groups that are meant to mobilize resources and planning to build a more just economy. The more this comforting fiction takes hold, the more problematic it becomes and easier it is for liberals to become resigned to low wages.

Because even if these scenarios pan out, work is around for a while. Let’s be aggressive with a scenario here: Let’s say the need for hours worked in the economy caps right now. This is it; this is the most we’ll ever work in the United States. (It won’t be.) In addition, the amount of hours worked decreases rapidly by 4 percent a year so that it is cut to around 25 percent of the current total in 34 years. (This won’t happen.)

Back of the envelope, during this time period people in the United States will work a total of around 2 billion work years. Or roughly 10,000 times as long as human beings have existed. What kinds of lives and experiences will those workers have?

Worker power matters, ironically, because it’s difficult to imagine the productivity growth necessary to get to this world without some sense that labor is strong. If wages are stagnant or even falling, what incentive is there to build the robots to replace those workers? Nothing is certain here, but you can see periods where low unemployment is correlated with faster productivity gains. The best way forward to a post-work atmosphere will probably be to embrace labor, not hope it goes away.

How Did We Get There?

Another major problem of this popular genre is that it immediately places us at the end of the story, with no explanation of the transition. Work has already disappeared, it’s over, so the only question that remains is how we can envision our lives in the new world. This has two major consequences.

First, by compressing this timeline and making it seem like only capital will be around after a short period, it preemptively identifies the interest of workers with the interests of capital and owners. If post-work is right around the corner, people won’t have any labor (or human capital, if you must) to allow them to survive, so it’s essential to turn them into miniature capitalists immediately. That’s why it’s not abnormal to see descriptions of post-work immediately call for the repeal of Sarbanes-Oxley or the privatization of Social Security.

Secondly, this story also doesn’t explain the transition of labor among workers as it disappears. As Seth Ackerman notes, decreases in the amount of work done can result either from some people leaving the labor force (extensive margin) or from decreasing the amount of work all people do (intensive margin). In other words, do we want some people to leave the workforce entirely, or for us all to work less overall? These are two different projects, with different assumptions and actions necessary to advance them. Resolving these questions would be the fundamental problem of an actual decline in labor force participation, but they tend to be abstracted away in these discussions.

Projecting the Past Forward

Going further, the idea that a post-work economy would involve simply choosing between a handful of quasi-utopias strikes me as completely naive. In Thompson’s piece, for instance, the problem seems to be whether post-work people would spend their time in intellectual pursuits or as independent artisans. But it’s just as likely people would spend their days as refugees trying not to starve.

You can get the sense that something is missing because virtually all of these articles consider radical forms of leisure instead of ownership. (Indeed, in assuming that prosperity leads to redistribution leads to leisure and public goods, it’s really a forward projection of the Keynesian-Fordism of the past.) I rarely see any of these mass media post-work scenarios tackle these issues head-on, much less talk about “post-ownership” instead of just “post-work.” (Friend of the blog Peter Frase is one of the few who does.)

It’s just as likely that the result will be a catastrophe for those who lose the value of their human capital. It seems unlikely that the political economy would become more conducive to redistribution, as these articles usually imply, because the value of capital assets would probably skyrocket. With that value high and ownership concentrated, it would potentially lead to a political economy more favorable to fascism than to robust egalitarianism. Who owns the robots, and what that even means in such a world, will be just as much a question as what we do to occupy ourselves; the first, really, will determine the second.

As a result, discussions of the idyllic robot future give working people a desire that is an obstacle to the actual flourishing of their lived conditions, and it remains an ideology completely divorced from the lived experiences of everyday people. I hereby nominate this as Pure Ideology. Who seconds the motion?

Follow or contact the Rortybomb blog:
 
  

 

Derek Thompson has a 10,000 word cover story for The Atlantic, “A World Without Work,” about the possibilities of “post-work” in an economy where technology and capital has largely displaced labor. Though Thompson is clear to argue that this isn’t certain, as the “signs so far are murky and suggestive,” he takes the opportunity to describe how a post-work future might look.

There’s been a consistent trend of these stories going back decades, with a huge wave of them coming after the Great Recession. Thompson’s piece is likely to be the best of the bunch. It’s empathetic, well reported, and imaginative. I also hope it’s the last of these end-of-work stories for the time being.

At this point, the preponderance of stories about work ending is itself doing a certain kind of labor, one that distracts us and leads us away from questions we need to answer. These stories, beyond being untethered to the current economy, distract from current problems in the workforce, push laborers to identify with capitalists while ignoring deeper transitional matters, and don’t even challenge what a serious, radical story of ownership this would bring into question.

Unlikely

Before we begin, I think it’s important to note how unlikely this scenario remains. We can imagine the Atlantic of the 1850s running a “The Post-Agriculture, Post-Work World” cover story, correctly predicting farming would go from 70 percent of the workforce to 20 percent over the next 100 years, yet incorrectly predicting this would end work. We don’t think of what happened afterward as “post-work.” The economy managed to continue on, finding new work and workers in the process.

There are other minor problems. Globalization and technological advancement are treated as the same thing, when they are not. There’s also a slippage common in the critical discussion of these articles (you can see it from this tweet from Thompson here) of substituting in the argument that technology has weakened wages and excluded some workers in recent decades for an argument about the long-run trajectory of technology itself. These are two different, distinct stories, with the first just as much about institutions as actual technology, and evidence for the first certainly doesn’t prove the second.

We’ll Still Be Working

But what is the impact of these stories? In the short term, the most important is that they allow us to dream about a world where the current problems of labor don’t exist, because they’ve been magically solved. This is a problem, because the conditions and compensation of work are some of our biggest challenges. In these future scenarios, there’s no need to organize, seek full employment, or otherwise balance the relationship between labor and capital, because the former doesn’t exist anymore.

This is especially a problem when it leaves the “what if” fiction writings of op-eds, or provocative calls to reexamine the nature of work in our daily lives, and melds into organizational politics. I certainly see a “why does this matter, the robots are coming” mentality among the type of liberal infrastructure groups that are meant to mobilize resources and planning to build a more just economy. The more this comforting fiction takes hold, the more problematic it becomes and easier it is for liberals to become resigned to low wages.

Because even if these scenarios pan out, work is around for a while. Let’s be aggressive with a scenario here: Let’s say the need for hours worked in the economy caps right now. This is it; this is the most we’ll ever work in the United States. (It won’t be.) In addition, the amount of hours worked decreases rapidly by 4 percent a year so that it is cut to around 25 percent of the current total in 34 years. (This won’t happen.)

Back of the envelope, during this time period people in the United States will work a total of around 2 billion work years. Or roughly 10,000 times as long as human beings have existed. What kinds of lives and experiences will those workers have?

Worker power matters, ironically, because it’s difficult to imagine the productivity growth necessary to get to this world without some sense that labor is strong. If wages are stagnant or even falling, what incentive is there to build the robots to replace those workers? Nothing is certain here, but you can see periods where low unemployment is correlated with faster productivity gains. The best way forward to a post-work atmosphere will probably be to embrace labor, not hope it goes away.

How Did We Get There?

Another major problem of this popular genre is that it immediately places us at the end of the story, with no explanation of the transition. Work has already disappeared, it’s over, so the only question that remains is how we can envision our lives in the new world. This has two major consequences.

First, by compressing this timeline and making it seem like only capital will be around after a short period, it preemptively identifies the interest of workers with the interests of capital and owners. If post-work is right around the corner, people won’t have any labor (or human capital, if you must) to allow them to survive, so it’s essential to turn them into miniature capitalists immediately. That’s why it’s not abnormal to see descriptions of post-work immediately call for the repeal of Sarbanes-Oxley or the privatization of Social Security.

Secondly, this story also doesn’t explain the transition of labor among workers as it disappears. As Seth Ackerman notes, decreases in the amount of work done can result either from some people leaving the labor force (extensive margin) or from decreasing the amount of work all people do (intensive margin). In other words, do we want some people to leave the workforce entirely, or for us all to work less overall? These are two different projects, with different assumptions and actions necessary to advance them. Resolving these questions would be the fundamental problem of an actual decline in labor force participation, but they tend to be abstracted away in these discussions.

Projecting the Past Forward

Going further, the idea that a post-work economy would involve simply choosing between a handful of quasi-utopias strikes me as completely naive. In Thompson’s piece, for instance, the problem seems to be whether post-work people would spend their time in intellectual pursuits or as independent artisans. But it’s just as likely people would spend their days as refugees trying not to starve.

You can get the sense that something is missing because virtually all of these articles consider radical forms of leisure instead of ownership. (Indeed, in assuming that prosperity leads to redistribution leads to leisure and public goods, it’s really a forward projection of the Keynesian-Fordism of the past.) I rarely see any of these mass media post-work scenarios tackle these issues head-on, much less talk about “post-ownership” instead of just “post-work.” (Friend of the blog Peter Frase is one of the few who does.)

It’s just as likely that the result will be a catastrophe for those who lose the value of their human capital. It seems unlikely that the political economy would become more conducive to redistribution, as these articles usually imply, because the value of capital assets would probably skyrocket. With that value high and ownership concentrated, it would potentially lead to a political economy more favorable to fascism than to robust egalitarianism. Who owns the robots, and what that even means in such a world, will be just as much a question as what we do to occupy ourselves; the first, really, will determine the second.

As a result, discussions of the idyllic robot future give working people a desire that is an obstacle to the actual flourishing of their lived conditions, and it remains an ideology completely divorced from the lived experiences of everyday people. I hereby nominate this as Pure Ideology. Who seconds the motion?

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Why an Inequality Agenda Matters: A Response to John Judis

Jun 24, 2015Mike Konczal

John Judis believes that Democrats are on the wrong path and the Roosevelt Institute is partially to blame. In his recent piece, “Dear Democrats: Populism Will Not Save You,” he attacks the growing liberal consensus on economic issues, using our recent Rewriting the Rules report as an example, on both substantive and electoral grounds.

Judis’s core argument is that it is crucial “to develop a sophisticated politics” to turn economic appeals into electoral success. I couldn’t agree more, though I feel this issue is caught in the crossfire of Judis walking back his previous Democratic demographic triumphalism. His second point is that the economic platform we’ve outlined is a terrible basis for a Democratic majority because voters are “fearful of big government, worried about new taxes, skeptical about programs they think are intended to aid someone else,” and otherwise not motivated by inequality and turned off by economic “populism.”

As a coauthor on our report and as someone involved throughout its creation, I’d like to address these criticisms. I can only speak to our report, which argues that public policy and the rules of the economy are more responsible for our tough economic situation than technology, globalization, sociology, or any of the other factors normally cited. Judis, I think, misses how robust this approach can be, how much it diverges from caricatures of big government liberalism, and how a lot of forces brought us to this point.

A Broader Vision

Roosevelt’s Rewriting the Rules plan isn’t simply centered around fighting inequality, and it’s not just about fairness, which is an argument that Judis says tends to turn off voters. Instead, we view it as tackling central concerns over investment, growth, opportunity, shared prosperity, and economic security. The subtitle of the report is “An Agenda for Growth and Shared Prosperity.” During the creation process, we kept two specific things in mind: First, nobody cares about inequality abstractly, they care about specific economic issues; and second, our vision can’t be simply returning to the past.

We do argue that you can’t address the economic concerns I mentioned without going big. You can’t tackle investment without looking at the financial sector, you can’t address opportunity without looking at structural discrimination, you can’t view economic security without looking at the labor market, and you don’t get growth without doing all of the above. But the liberal economic consensus isn’t about adjusting this or that statistical abstraction, or about building a time machine to return to an era that probably didn’t exist: It’s about solving real problems with long-term consequences for our future.

This is hard to balance, especially for an economic report that wants to highlight the latest research in inequality across fields. The team is full of economists, not political messengers. But since a forward, positive agenda is built into the DNA of these arguments, it is not hard for a talented political movement to use these economic arguments to talk about how Democrats can deliver the goods people care about when it comes to the future of the economy.

Deeper Dive into Markets

But isn’t it all just tax-and-spend and big government liberalism? As a second point, we think looking at the market structures that generate inequality in the first place is a way to both meaningfully address inequality and also move us in a different policy direction. The idea that the rules are rigged isn’t in the current dialogue, and it’s one worth testing out with the public as part of a comprehensive argument about the economy.

The policy section of the report is a call for further discussion (some of which will be elaborated on in future Roosevelt products), but what I think is important is that, in addition to higher top marginal tax rates and income support, there’s an entire suite of policies focused on the rules of the economy itself.

These are not trivial. We examine how changes to corporate governance encourage short-termism, how the ramp-up of the criminal justice system reduces wages and opportunities for people of color, and how the falling value of the minimum wage increases poverty. These “market conditioning” effects complement whatever emphasis political leaders put on tax-and-spend issues.

I think that’s worthwhile, because it gives Democrats an in to talk about economic problems with people who want to become rich or don’t think of themselves as class warriors, but do care about promoting broadly shared opportunity. It also short-circuits many of the libertarian arguments about the state, because people get that the economy needs rules—and that not having rules is still a form of rules.

(Ironically, by calling upon the work of Stephen Rose, who argues everything is fine with the macroeconomy because government transfers can just take care of any weaknesses, Judis is far more reliant on tax-and-spend liberalism that he accuses us of being. I’m fine with transfers, of course, as income support was crucial to fighting the Great Recession. But there are also electoral limits to this strategy.)

As for the electoral appeal, these ideas aren't part of the normal policy discussion, but to the extent that they are, they are quite popular. The minimum wage is winning in red states, and financial reform is broadly popular as a topic.

The Natural Next Step

Judis’s narrative is focused on the idea that the Democrats have been hijacked (with ACORN a culprit, no less) with this agenda. At times, he forces this story into a symmetry with what is happening on the right to get some easy “pox on both houses” points.

But this doesn’t reflect the actual path we’ve taken to get here. One thing we tried to demonstrate in Rewriting the Rules is that the research has been moving in this direction for the past decade. Many of these policy items build on or expand what President Obama has proposed (infrastructure, financial reform, minimum wage, etc.)—proposals that still remain good ideas in 2016. The political success of the Fight for 15 workers has also shown that there’s energy at the local level that people are looking to help scale.

The other reason this agenda has gained traction is that the other approaches have collapsed in the past year. Education doesn’t look like the silver bullet people had believed it to be in the past. The idea that the Great Recession would be a minor hiccup and we’d be back on track has proved false. Centrist claims about the need for immediate austerity and a Grand Bargain have also failed to pan out.

Oddly, I’m not sure I’ve heard a compelling counter-strategy about how to describe the economy, and Judis proposes no such thing. The 2016 nominee won’t be able to run on an “overcoming partisanship” strategy like President Obama in 2008 or a “let’s give Obamacare and the recovery a chance” strategy like in 2012.

One could just downplay the economy, of course, and if next year gives us a large increase in wages the story will change with it. But polls now show economic issues are coming to dominate the discussion, median family incomes are down 7 percent since 2000, and the argument that President Obama pulled us back from an economic collapse and rebuilt jobs, and now we need to turn to a more secure future with better wages, investment, and security, seems the most natural transition.

Economic issues will dominate on the right, and while they mimic our language, their proposals will likely be very regressive. Even the GOP’s leading reformer, Marco Rubio, is calling for eliminating all taxes on capital and inheritances. Whoever wins the Republican nomination is going to be controlled by a base that wants the Ryan Plan immediately. But rather than simply calling out what’s wrong with the right’s approach, it will be essential for liberals to have their own vision of opportunity, investment, growth, and security. We think our report is a crucial building block for this.

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John Judis believes that Democrats are on the wrong path and the Roosevelt Institute is partially to blame. In his recent piece, “Dear Democrats: Populism Will Not Save You,” he attacks the growing liberal consensus on economic issues, using our recent Rewriting the Rules report as an example, on both substantive and electoral grounds.

Judis’s core argument is that it is crucial “to develop a sophisticated politics” to turn economic appeals into electoral success. I couldn’t agree more, though I feel this issue is caught in the crossfire of Judis walking back his previous Democratic demographic triumphalism. His second point is that the economic platform we’ve outlined is a terrible basis for a Democratic majority because voters are “fearful of big government, worried about new taxes, skeptical about programs they think are intended to aid someone else,” and otherwise not motivated by inequality and turned off by economic “populism.”

As a coauthor on our report and as someone involved throughout its creation, I’d like to address these criticisms. I can only speak to our report, which argues that public policy and the rules of the economy are more responsible for our tough economic situation than technology, globalization, sociology, or any of the other factors normally cited. Judis, I think, misses how robust this approach can be, how much it diverges from caricatures of big government liberalism, and how a lot of forces brought us to this point.

A Broader Vision

Roosevelt’s Rewriting the Rules plan isn’t simply centered around fighting inequality, and it’s not just about fairness, which is an argument that Judis says tends to turn off voters. Instead, we view it as tackling central concerns over investment, growth, opportunity, shared prosperity, and economic security. The subtitle of the report is “An Agenda for Growth and Shared Prosperity.” During the creation process, we kept two specific things in mind: First, nobody cares about inequality abstractly, they care about specific economic issues; and second, our vision can’t be simply returning to the past.

We do argue that you can’t address the economic concerns I mentioned without going big. You can’t tackle investment without looking at the financial sector, you can’t address opportunity without looking at structural discrimination, you can’t view economic security without looking at the labor market, and you don’t get growth without doing all of the above. But the liberal economic consensus isn’t about adjusting this or that statistical abstraction, or about building a time machine to return to an era that probably didn’t exist: It’s about solving real problems with long-term consequences for our future.

This is hard to balance, especially for an economic report that wants to highlight the latest research in inequality across fields. The team is full of economists, not political messengers. But since a forward, positive agenda is built into the DNA of these arguments, it is not hard for a talented political movement to use these economic arguments to talk about how Democrats can deliver the goods people care about when it comes to the future of the economy.

Deeper Dive into Markets

But isn’t it all just tax-and-spend and big government liberalism? As a second point, we think looking at the market structures that generate inequality in the first place is a way to both meaningfully address inequality and also move us in a different policy direction. The idea that the rules are rigged isn’t in the current dialogue, and it’s one worth testing out with the public as part of a comprehensive argument about the economy.

The policy section of the report is a call for further discussion (some of which will be elaborated on in future Roosevelt products), but what I think is important is that, in addition to higher top marginal tax rates and income support, there’s an entire suite of policies focused on the rules of the economy itself.

These are not trivial. We examine how changes to corporate governance encourage short-termism, how the ramp-up of the criminal justice system reduces wages and opportunities for people of color, and how the falling value of the minimum wage increases poverty. These “market conditioning” effects complement whatever emphasis political leaders put on tax-and-spend issues.

I think that’s worthwhile, because it gives Democrats an in to talk about economic problems with people who want to become rich or don’t think of themselves as class warriors, but do care about promoting broadly shared opportunity. It also short-circuits many of the libertarian arguments about the state, because people get that the economy needs rules—and that not having rules is still a form of rules.

(Ironically, by calling upon the work of Stephen Rose, who argues everything is fine with the macroeconomy because government transfers can just take care of any weaknesses, Judis is far more reliant on tax-and-spend liberalism that he accuses us of being. I’m fine with transfers, of course, as income support was crucial to fighting the Great Recession. But there are also electoral limits to this strategy.)

As for the electoral appeal, these ideas aren't part of the normal policy discussion, but to the extent that they are, they are quite popular. The minimum wage is winning in red states, and financial reform is broadly popular as a topic.

The Natural Next Step

Judis’s narrative is focused on the idea that the Democrats have been hijacked (with ACORN a culprit, no less) with this agenda. At times, he forces this story into a symmetry with what is happening on the right to get some easy “pox on both houses” points.

But this doesn’t reflect the actual path we’ve taken to get here. One thing we tried to demonstrate in Rewriting the Rules is that the research has been moving in this direction for the past decade. Many of these policy items build on or expand what President Obama has proposed (infrastructure, financial reform, minimum wage, etc.)—proposals that still remain good ideas in 2016. The political success of the Fight for 15 workers has also shown that there’s energy at the local level that people are looking to help scale.

The other reason this agenda has gained traction is that the other approaches have collapsed in the past year. Education doesn’t look like the silver bullet people had believed it to be in the past. The idea that the Great Recession would be a minor hiccup and we’d be back on track has proved false. Centrist claims about the need for immediate austerity and a Grand Bargain have also failed to pan out.

Oddly, I’m not sure I’ve heard a compelling counter-strategy about how to describe the economy, and Judis proposes no such thing. The 2016 nominee won’t be able to run on an “overcoming partisanship” strategy like President Obama in 2008 or a “let’s give Obamacare and the recovery a chance” strategy like in 2012.

One could just downplay the economy, of course, and if next year gives us a large increase in wages the story will change with it. But polls now show economic issues are coming to dominate the discussion, median family incomes are down 7 percent since 2000, and the argument that President Obama pulled us back from an economic collapse and rebuilt jobs, and now we need to turn to a more secure future with better wages, investment, and security, seems the most natural transition.

Economic issues will dominate on the right, and while they mimic our language, their proposals will likely be very regressive. Even the GOP’s leading reformer, Marco Rubio, is calling for eliminating all taxes on capital and inheritances. Whoever wins the Republican nomination is going to be controlled by a base that wants the Ryan Plan immediately. But rather than simply calling out what’s wrong with the right’s approach, it will be essential for liberals to have their own vision of opportunity, investment, growth, and security. We think our report is a crucial building block for this.

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Two Opposing Methods Tell Us the Too Big To Fail Subsidy Has Collapsed

Jun 11, 2015Mike Konczal

Is there a Too Big to Fail (TBTF) subsidy? If so, is it large, sustained, and institutionalized by Dodd-Frank, as many conservatives claim? Since this is always coming up in the discussion over financial reform, and especially since both those who think Dodd-Frank should be repealed and those who think it didn’t go anywhere near far enough have an incentive to argue for it, let me put out my marker.

I think the TBTF subsidy was real in the aftermath of the crisis, when it was an obvious policy to prevent a collapse of the financial system. But, contrary to the conservative argument, the subsidy has been reduced to a small amount, if it still exists at all. I also think the focus on it is a distraction. My reasoning comes less from any single study but instead from the fact that the two primary yet opposite quantitative techniques for determining such a thing both tell the same exact story—a fact that I don’t think has been caught.

This post will be written for general readers, with the financial engineering in the footnotes. A TBTF subsidy just means that the largest firms are viewed by the markets as being safer than they should be. Since they have less credit risk, they have cheaper borrowing costs, and prices of their credit risks, as measured in CDS prices, will be lower.

So how would you go about answering whether a bank has a TBTF subsidy? There are two general quantitative approaches. The first would be to compare that bank to other, non-TBTF banks, controlling for characteristics, and see whether or not it has cheaper funding. The second would be to look at the fundamentals of that bank by itself, estimate its chances of failing, and compare it to the market’s estimates. These approaches are, as a matter of methodology, the opposite of each other [1]. Yet they tell the same story. Let’s take them in turn.

First Method - Compare a Firm to Other Firms

The first approach is to simply compare TBTF firms with other firms and see if they receive lower funding. How do you do this? You get a ton of data across many different types of banks and look at the interest rates those banks get. You assume that the chances of default are random but can change based on characteristics [2]. You then do a lot of statistical regressions while trying to control for relevant variables and see if this TBTF measure provides a lower funding cost. This is what the GAO did last year.

One major problem with this technique is that you have to control for important variables. Is TBTF a matter of the size of assets, the square of the size of assets, or just a $50 billion threshold? How do you control for risks of the firm? Given that all the information comes from comparisons across firms, the way you compare a TBTF firm with a medium-sized firm matters.

This is why you can end up with the GAO estimating 42 different models: they wanted to try all their variables. But which models are really the best? The graph below summarizes their results, where they found a major subsidy in the aftermath (dots below the line reflect models showing a subsidy) of the crisis that went back to near-zero later.

Second Method - Compare a Firm to Itself

Let’s do the exact opposite with the second approach. Instead of comparing across firms, let’s create a “structural” approach that looks at the specific structures of the bank, making an estimate of how likely it is to default [3]. We then compare that estimate with actual market prices of default estimates from credit default swaps. If there’s a TBTF subsidy, that means that our estimate of the price of a credit default swap will be higher than the actual price, since the market thinks a loss is less likely.

How do we do this? We look at the bank’s balance sheet and figure out how likely it is that the value of the firm will be less than the debt. We can even phrase it like an option, which means we can hand it to the physicists to put on their Black-Scholes goggles and find a way to price it [details at 4]. The IMF recently took a crack at using the second approach and comparing the estimate to actual CDS prices.

Here’s what they found, where a positive value means the predicted price is larger than the actual price:

Opposites Strengths, Weaknesses

These two approaches aren’t just the opposite of each other; they also have opposite weaknesses. Where under the first approach it’s not really clear whether or not you are controlling for size and risk well at any moment, the structural model is able to ignore these issues by simply looking at the TBTF firm itself. But structural models need CDS prices, which are often illiquid, introducing numerous pricing problems. The first approach includes the bond market, which is quite deep. The structural model requires a lot of financial engineering modeling assumptions, where the statistical approach requires virtually no assumptions. Let's take a second and chart that out:

Note again that the two approaches are the complete opposite of each other in theory, data, and relative merits, yet they both tell the same story. There was a subsidy that was real in the aftermath of the crisis but has been coming down and is now close to zero. What should we take away from this?

First, the mission isn’t done, but we are on the right path. Higher capital requirements, liquidity requirements, living wills, restructuring, derivatives clearing, and more are paying off, removing much of the concern that the markets believe we have permanent bailouts.

You’ll hear many stories about this subsidy, but they will get all their value from the 2009–2010 period. For those on the right who argued that this would become a permanent GSE regime, this isn’t the case. The only question is whether we will go further to fully eliminate it, not whether it will be a permanent feature.

Second, we should remember that this subsidy focus was always a distraction. If Lehman Brothers had collapsed with no chaos, we’d still have millions of foreclosures, a securitization and credit market designed to rip off unsuspecting consumers, and a system of enforcement that doesn’t hold people accountable. The subsidy is only one of the major problems we have to deal with.

In addition, this subsidy equaling zero doesn’t mean that we can ignore the issue. These models can’t tell the difference between a successful and an unsuccessful resolution. This conclusion just means there would be a credit loss, but doesn’t tell if bankruptcy is an option, or if a resolution is swift, certain, well-funded, and likely to create minimal chaos for the economy. Those are our bigger concerns, which aren’t the same question at all.

Third, rolling back major parts of Dodd-Frank, particularly when it comes to TBTF policy, is a bad idea. These results are fragile; it’s easy for us to return to 2010. It would be a shame to remove the policies that are actually working well.

 

[1] It’s not exactly “reduced-form versus structural”, but if you want to learn more about these two methods (and to confirm I’m not making this up) there’s an extensive literature on it.

[2] In the jargon, defaults are thought of as exogenous, with some characteristics making a random default more likely. This will become more apparent in the second approach, when we model the default as endogenous to the structure of the firm.

[3] Full disclosure, I used to work at Moody’s KMV, a pioneer in structural models. I bleed structural modeling; it is the best.

[4] Equity is worth the firm's assets minus debt, or zero if the assets are less than debt. This is the same exact payout as a call option; the equity of the firm is simply a call option on the firms' assets, with the debt as a strike price, and as such can be modeled and priced like an option.

(For those really wedded to the myth that shareholders "own" the firm, note that in the world of Black-Scholes it's just as true to say that debtholders "own" the firm, except they sell off a derivative on their ownership to someone else.)

Follow or contact the Rortybomb blog:
 
  

 

Is there a Too Big to Fail (TBTF) subsidy? If so, is it large, sustained, and institutionalized by Dodd-Frank, as many conservatives claim? Since this is always coming up in the discussion over financial reform, and especially since both those who think Dodd-Frank should be repealed and those who think it didn’t go anywhere near far enough have an incentive to argue for it, let me put out my marker.

I think the TBTF subsidy was real in the aftermath of the crisis, when it was an obvious policy to prevent a collapse of the financial system. But, contrary to the conservative argument, the subsidy has been reduced to a small amount, if it still exists at all. I also think the focus on it is a distraction. My reasoning comes less from any single study but instead from the fact that the two primary yet opposite quantitative techniques for determining such a thing both tell the same exact story—a fact that I don’t think has been caught.

This post will be written for general readers, with the financial engineering in the footnotes. A TBTF subsidy just means that the largest firms are viewed by the markets as being safer than they should be. Since they have less credit risk, they have cheaper borrowing costs, and prices of their credit risks, as measured in CDS prices, will be lower.

So how would you go about answering whether a bank has a TBTF subsidy? There are two general quantitative approaches. The first would be to compare that bank to other, non-TBTF banks, controlling for characteristics, and see whether or not it has cheaper funding. The second would be to look at the fundamentals of that bank by itself, estimate its chances of failing, and compare it to the market’s estimates. These approaches are, as a matter of methodology, the opposite of each other [1]. Yet they tell the same story. Let’s take them in turn.

First Method - Compare a Firm to Other Firms

The first approach is to simply compare TBTF firms with other firms and see if they receive lower funding. How do you do this? You get a ton of data across many different types of banks and look at the interest rates those banks get. You assume that the chances of default are random but can change based on characteristics [2]. You then do a lot of statistical regressions while trying to control for relevant variables and see if this TBTF measure provides a lower funding cost. This is what the GAO did last year.

One major problem with this technique is that you have to control for important variables. Is TBTF a matter of the size of assets, the square of the size of assets, or just a $50 billion threshold? How do you control for risks of the firm? Given that all the information comes from comparisons across firms, the way you compare a TBTF firm with a medium-sized firm matters.

This is why you can end up with the GAO estimating 42 different models: they wanted to try all their variables. But which models are really the best? The graph below summarizes their results, where they found a major subsidy in the aftermath (dots below the line reflect models showing a subsidy) of the crisis that went back to near-zero later.

Second Method - Compare a Firm to Itself

Let’s do the exact opposite with the second approach. Instead of comparing across firms, let’s create a “structural” approach that looks at the specific structures of the bank, making an estimate of how likely it is to default [3]. We then compare that estimate with actual market prices of default estimates from credit default swaps. If there’s a TBTF subsidy, that means that our estimate of the price of a credit default swap will be higher than the actual price, since the market thinks a loss is less likely.

How do we do this? We look at the bank’s balance sheet and figure out how likely it is that the value of the firm will be less than the debt. We can even phrase it like an option, which means we can hand it to the physicists to put on their Black-Scholes goggles and find a way to price it [details at 4]. The IMF recently took a crack at using the second approach and comparing the estimate to actual CDS prices.

Here’s what they found, where a positive value means the predicted price is larger than the actual price:

Opposites Strengths, Weaknesses

These two approaches aren’t just the opposite of each other; they also have opposite weaknesses. Where under the first approach it’s not really clear whether or not you are controlling for size and risk well at any moment, the structural model is able to ignore these issues by simply looking at the TBTF firm itself. But structural models need CDS prices, which are often illiquid, introducing numerous pricing problems. The first approach includes the bond market, which is quite deep. The structural model requires a lot of financial engineering modeling assumptions, where the statistical approach requires virtually no assumptions. Let's take a second and chart that out:

Note again that the two approaches are the complete opposite of each other in theory, data, and relative merits, yet they both tell the same story. There was a subsidy that was real in the aftermath of the crisis but has been coming down and is now close to zero. What should we take away from this?

First, the mission isn’t done, but we are on the right path. Higher capital requirements, liquidity requirements, living wills, restructuring, derivatives clearing, and more are paying off, removing much of the concern that the markets believe we have permanent bailouts.

You’ll hear many stories about this subsidy, but they will get all their value from the 2009–2010 period. For those on the right who argued that this would become a permanent GSE regime, this isn’t the case. The only question is whether we will go further to fully eliminate it, not whether it will be a permanent feature.

Second, we should remember that this subsidy focus was always a distraction. If Lehman Brothers had collapsed with no chaos, we’d still have millions of foreclosures, a securitization and credit market designed to rip off unsuspecting consumers, and a system of enforcement that doesn’t hold people accountable. The subsidy is only one of the major problems we have to deal with.

In addition, this subsidy equaling zero doesn’t mean that we can ignore the issue. These models can’t tell the difference between a successful and an unsuccessful resolution. This conclusion just means there would be a credit loss, but doesn’t tell if bankruptcy is an option, or if a resolution is swift, certain, well-funded, and likely to create minimal chaos for the economy. Those are our bigger concerns, which aren’t the same question at all.

Third, rolling back major parts of Dodd-Frank, particularly when it comes to TBTF policy, is a bad idea. These results are fragile; it’s easy for us to return to 2010. It would be a shame to remove the policies that are actually working well.

 

[1] It’s not exactly “reduced-form versus structural”, but if you want to learn more about these two methods (and to confirm I’m not making this up) there’s an extensive literature on it.

[2] In the jargon, defaults are thought of as exogenous, with some characteristics making a random default more likely. This will become more apparent in the second approach, when we model the default as endogenous to the structure of the firm.

[3] Full disclosure, I used to work at Moody’s KMV, a pioneer in structural models. I bleed structural modeling; it is the best.

[4] Equity is worth the firm's assets minus debt, or zero if the assets are less than debt. This is the same exact payout as a call option; the equity of the firm is simply a call option on the firms' assets, with the debt as a strike price, and as such can be modeled and priced like an option.

(For those really wedded to the myth that shareholders "own" the firm, note that in the world of Black-Scholes it's just as true to say that debtholders "own" the firm, except they sell off a derivative on their ownership to someone else.)

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Nothing Will Replace Public Higher-Education

May 29, 2015Mike Konczal

I have a piece at Rolling Stone, about how Yale's giant donation and the collapse of for-profit colleges under fraud charges both tell the same story: as we defund and privatize state public colleges there no set of good institutions which will fill the void left behind.

Three quick follow-up points. First, a technical one responding to something several people have brought up. I argue: "how much will Yale increase its enrollment numbers as a result of this [Schwarzman $150 million donation]? We can make a good guess: zero. Yale's freshman enrollment this past year [is] virtually the same as in 2003."

Yale's enrollment has not only been flat since 2003 but since around the 1970s, even though the number of students being educated overall has doubled over those 40 years. Some people have noted that there are plans by fall 2017 to increase Yale's enrollment 15 percent. It's true, though those plans have been in the works since before the financial crisis and have been significantly delayed, and are unrelated to the Schwarzman donation. The point very much stands.

Some thought this point was a cheap shot, but I think it is crucial to get out there in the debate. Private non-profits pick and choose strategically how to expand enrollment to fufill their private goals, and that's great. But their goals do not line up with the public one of ensuring that all who qualify has access to quality, affordable higher education, and they certainly won't step up as that system is pulled back.

Second, the for-profit stories are crazy. I need to be writing more about them, but keep an eye on their implosion, and what it means for privatization and running all government services through for-profit actors. The Corinthian debt-strikers are worth watching as well - here's Annie Lowrey writing about them and Astra Taylor.

Third, two recommendations. Michelle Goldberg's long Nation piece on the inequality amplifying consequences of public disinvestment at the University of Arizona, which I link to, is fantastic, and very much worth your time. I also tried to get in this great column by Andrew Hartman on how conservatives used to value mass higher education as a basis of Western Civilization during the Culture Wars - Alan Bloom describing it as "a space between the intellectual wasteland he has left behind and the inevitable dreary professional training that awaits him after the baccalaureate" - but now have traded that battle for one of defunding and privatization, but it didn't make it. But check out my piece anyway!

Follow or contact the Rortybomb blog:
 
  

 

I have a piece at Rolling Stone, about how Yale's giant donation and the collapse of for-profit colleges under fraud charges both tell the same story: as we defund and privatize state public colleges there no set of good institutions which will fill the void left behind.

Three quick follow-up points. First, a technical one responding to something several people have brought up. I argue: "how much will Yale increase its enrollment numbers as a result of this [Schwarzman $150 million donation]? We can make a good guess: zero. Yale's freshman enrollment this past year [is] virtually the same as in 2003."

Yale's enrollment has not only been flat since 2003 but since around the 1970s, even though the number of students being educated overall has doubled over those 40 years. Some people have noted that there are plans by fall 2017 to increase Yale's enrollment 15 percent. It's true, though those plans have been in the works since before the financial crisis and have been significantly delayed, and are unrelated to the Schwarzman donation. The point very much stands.

Some thought this point was a cheap shot, but I think it is crucial to get out there in the debate. Private non-profits pick and choose strategically how to expand enrollment to fufill their private goals, and that's great. But their goals do not line up with the public one of ensuring that all who qualify has access to quality, affordable higher education, and they certainly won't step up as that system is pulled back.

Second, the for-profit stories are crazy. I need to be writing more about them, but keep an eye on their implosion, and what it means for privatization and running all government services through for-profit actors. The Corinthian debt-strikers are worth watching as well - here's Annie Lowrey writing about them and Astra Taylor.

Third, two recommendations. Michelle Goldberg's long Nation piece on the inequality amplifying consequences of public disinvestment at the University of Arizona, which I link to, is fantastic, and very much worth your time. I also tried to get in this great column by Andrew Hartman on how conservatives used to value mass higher education as a basis of Western Civilization during the Culture Wars - Alan Bloom describing it as "a space between the intellectual wasteland he has left behind and the inevitable dreary professional training that awaits him after the baccalaureate" - but now have traded that battle for one of defunding and privatization, but it didn't make it. But check out my piece anyway!

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Remember When Everyone Was Terrified About the Carry Trade? New Score.

May 27, 2015Mike Konczal

I have a piece in The Nation discussing the Death of Centrism. A lot of people are discussing why the economic discussion has shifted to the left in liberal circles, and one of the big reasons is that the specific predictions centrists (as a movement, not a temperament) made about the economy didn't pan out.

It's very difficult to convey how different the conversation was back then. Here's a 2010 op-ed by Peter Orszag arguing that "much more deficit reduction, enacted now, to take effect in two to three years" as well as "an improvement in the relationship between business and government" are both necessary to boost the short-term economy. (He also argues against QE2 because monetary expansion might help prevent a Grand Bargain on the budget.) When researching this piece, Josh Bivens reminded me the administration was freaking out in 2009 about how the "carry trade" could cause interest rates to spike at a moment's notice, an argument that seems ridiculous with rates so low six years later.

All the centrists got was a counterproductive spending cut, one the GOP immediately reneged, and none of their actual goals. And now their arguments are completely absent from the debate right now. I hope you check it out!

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I have a piece in The Nation discussing the Death of Centrism. A lot of people are discussing why the economic discussion has shifted to the left in liberal circles, and one of the big reasons is that the specific predictions centrists (as a movement, not a temperament) made about the economy didn't pan out.

It's very difficult to convey how different the conversation was back then. Here's a 2010 op-ed by Peter Orszag arguing that "much more deficit reduction, enacted now, to take effect in two to three years" as well as "an improvement in the relationship between business and government" are both necessary to boost the short-term economy. (He also argues against QE2 because monetary expansion might help prevent a Grand Bargain on the budget.) When researching this piece, Josh Bivens reminded me the administration was freaking out in 2009 about how the "carry trade" could cause interest rates to spike at a moment's notice, an argument that seems ridiculous with rates so low six years later.

All the centrists got was a counterproductive spending cut, one the GOP immediately reneged, and none of their actual goals. And now their arguments are completely absent from the debate right now. I hope you check it out!

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The Rules are What Matter for Inequality: Our New Report

May 12, 2015Mike Konczal

I’m very excited to announce the release of “Rewriting the Rules of the American Economy” (pdf report), Roosevelt Institute’s new inequality agenda report by Joe Stiglitz. I’m thrilled to be one of the co-authors, as I think this report really tells a compelling story about inequality and the challenges the economy faces.

Recently there’s been a lot of discussion about a “new” conventional wisdom (“a force to be reckoned with” according to one observer), one in which choices about the rules of the economy are a major driver of the outcomes we see. This is in contrast to the normal narrative about inequality we hear, one in which globalization, technology, or individual choices are the only important parts. I like to think this report is a major advancement in this discussion, bringing together the best recent research on this topic.

As we argue, inequality is not inevitable: it is a choice that we’ve made with the rules that structure our economy. Over the past 35 years, the rules, or the regulatory, legal and institutional frameworks, that make up the economy and condition the market have changed. These rules are a major driver of the income distribution we see, including runaway top incomes and weak or precarious income growth for most others. Crucially, however, these changes in the rules have not made our economy better off than we would be otherwise; in many cases we are weaker for these changes. We also now know that “deregulation” is, in fact, “reregulation”—that is, a new set of rules for governing the economy that favor a specific set of actors, and that there's no way out of these difficult choices. But what were these changes?

Financial deregulation exploded both the size of finance and its incomes, roughly doubling the share of finance in the top 1 percent. However, finance grew as a result of intermediating credit in a “shadow banking” sector, which led to disastrous results. It also grew from asset management, a field in which pay is often determined by luck and by fees driven by the increasing prevalence of opaque alternative investment vehicles like hedge funds. For all the resources it uses, finance is no more efficient than it was a century ago.

Corporate governance also radically changed during this period, led by public policy decisions. CEO pay fundamentally shifted toward a high pay model in the 1980s. The shareholder revolution also changed the nature of investment. We now see finance acting as a mechanism for getting money out of firms rather than into them; similarly, private firms are investing more than public firms. CEOs regularly use buybacks to hit earnings targets and say they’d rather hit accounting goals than invest long-term, indicating that short-termism is now a serious problem for investment and its positive spillovers.

High marginal tax rates were cut, but there’s no evidence that the high-end marginal tax rate has any effect on growth; cutting it does, however, raise the share of income the top 1 percent takes home. Low taxes don’t just make the equalizing effects of taxes weaker; they also mean that CEOs and other executives in the top 1 percent have more of an incentive to bargain aggressively with boards or seek opportunities for extracting rents, all zero-sum games for the economy. Lowering capital taxes showed no impact on higher investment, but a positive effect on increased capital payouts; capital income growth is one of the main drivers of inequality during this time period.

During this time, the Federal Reserve’s focus moved toward low and stable inflation at the cost of higher unemployment. Unemployment from weak Federal Reserve action rises the most for low-skilled and minority workers. Inequality generally doesn’t come down unless unemployment is below 6 percent, and this has become less of a priority.

The rules changed, or were not updated, for the labor market as well. Decreasing unionization has taken a toll on workers’ wages. Men’s inequality, in particular, has risen due to collapsing unionization rates. Women’s inequality has suffered due to a falling minimum wage, which went from 54 percent of the average hourly wage in the late 1960s to just 35 percent now. Labor market protections and institutions that give workers voice and power, in general, have not been updated for a new world of service and care work.

Though not an effective driver of lower crime rates, a dramatic turn toward mass and punitive incarceration has reduced the employment prospects for millions of Americans, especially people of color. In particular, there’s a dense web of discriminatory codes for those with a record, which pushes them toward second-class citizenship. One estimate finds 38,000 such punitive statutes, with most of them related to employment and having no end date.

Our institutions and rules haven’t been updated to fully facilitate women’s ability to participate in the labor force. As a result of gender discrimination in the workplace, lack of paid sick and family leave, and the unavailability of affordable child care, women’s participation in the U.S. labor force has declined over the past 15 years, while it increased in most other OECD countries.

Many people agree inequality is a challenge, but would say that this is all driven by technology and globalization. We discuss this at length in the report, but we don’t find these traditional stories either convincing, in the case of technology, or sufficient, in the case of globalization. Both of these forces are playing out, in quite similar ways, in other advanced countries, whose growth of inequality nowhere mirrors our own. Technology and globalization don’t fall from the sky, but instead are determined in important ways by rules and institutions. This is especially important in the era of free trade agreements, which are really managed trade agreements. These agreements are less about trade and more about the regulatory environment corporations face.

But rules matter even in these straightforward stories about supply and demand for labor. Advancements in search theory tell us that supply and demand, rather than strictly determining wages, instead place boundaries or endzones on where wages can go. What determines where wages fall within those boundaries is a whole host of economic rules, including bargaining power, institutions, and social conventions. Even in the strong version of these arguments, the rules matter.

This report describes what has happened, going far deeper than this summary here. It also has a policy agenda focused on both taming the top and growing the rest of the economy. Some may emphasize some pieces more than others; but no matter what this argument about the rules is what is missing in the current debates over the economy. I hope you get a chance to check out the report!

Follow or contact the Rortybomb blog:
 
  

 

I’m very excited to announce the release of “Rewriting the Rules of the American Economy” (pdf report), Roosevelt Institute’s new inequality agenda report by Joe Stiglitz. I’m thrilled to be one of the co-authors, as I think this report really tells a compelling story about inequality and the challenges the economy faces.

Recently there’s been a lot of discussion about a “new” conventional wisdom (“a force to be reckoned with” according to one observer), one in which choices about the rules of the economy are a major driver of the outcomes we see. This is in contrast to the normal narrative about inequality we hear, one in which globalization, technology, or individual choices are the only important parts. I like to think this report is a major advancement in this discussion, bringing together the best recent research on this topic.

As we argue, inequality is not inevitable: it is a choice that we’ve made with the rules that structure our economy. Over the past 35 years, the rules, or the regulatory, legal and institutional frameworks, that make up the economy and condition the market have changed. These rules are a major driver of the income distribution we see, including runaway top incomes and weak or precarious income growth for most others. Crucially, however, these changes in the rules have not made our economy better off than we would be otherwise; in many cases we are weaker for these changes. We also now know that “deregulation” is, in fact, “reregulation”—that is, a new set of rules for governing the economy that favor a specific set of actors, and that there's no way out of these difficult choices. But what were these changes?

Financial deregulation exploded both the size of finance and its incomes, roughly doubling the share of finance in the top 1 percent. However, finance grew as a result of intermediating credit in a “shadow banking” sector, which led to disastrous results. It also grew from asset management, a field in which pay is often determined by luck and by fees driven by the increasing prevalence of opaque alternative investment vehicles like hedge funds. For all the resources it uses, finance is no more efficient than it was a century ago.

Corporate governance also radically changed during this period, led by public policy decisions. CEO pay fundamentally shifted toward a high pay model in the 1980s. The shareholder revolution also changed the nature of investment. We now see finance acting as a mechanism for getting money out of firms rather than into them; similarly, private firms are investing more than public firms. CEOs regularly use buybacks to hit earnings targets and say they’d rather hit accounting goals than invest long-term, indicating that short-termism is now a serious problem for investment and its positive spillovers.

High marginal tax rates were cut, but there’s no evidence that the high-end marginal tax rate has any effect on growth; cutting it does, however, raise the share of income the top 1 percent takes home. Low taxes don’t just make the equalizing effects of taxes weaker; they also mean that CEOs and other executives in the top 1 percent have more of an incentive to bargain aggressively with boards or seek opportunities for extracting rents, all zero-sum games for the economy. Lowering capital taxes showed no impact on higher investment, but a positive effect on increased capital payouts; capital income growth is one of the main drivers of inequality during this time period.

During this time, the Federal Reserve’s focus moved toward low and stable inflation at the cost of higher unemployment. Unemployment from weak Federal Reserve action rises the most for low-skilled and minority workers. Inequality generally doesn’t come down unless unemployment is below 6 percent, and this has become less of a priority.

The rules changed, or were not updated, for the labor market as well. Decreasing unionization has taken a toll on workers’ wages. Men’s inequality, in particular, has risen due to collapsing unionization rates. Women’s inequality has suffered due to a falling minimum wage, which went from 54 percent of the average hourly wage in the late 1960s to just 35 percent now. Labor market protections and institutions that give workers voice and power, in general, have not been updated for a new world of service and care work.

Though not an effective driver of lower crime rates, a dramatic turn toward mass and punitive incarceration has reduced the employment prospects for millions of Americans, especially people of color. In particular, there’s a dense web of discriminatory codes for those with a record, which pushes them toward second-class citizenship. One estimate finds 38,000 such punitive statutes, with most of them related to employment and having no end date.

Our institutions and rules haven’t been updated to fully facilitate women’s ability to participate in the labor force. As a result of gender discrimination in the workplace, lack of paid sick and family leave, and the unavailability of affordable child care, women’s participation in the U.S. labor force has declined over the past 15 years, while it increased in most other OECD countries.

Many people agree inequality is a challenge, but would say that this is all driven by technology and globalization. We discuss this at length in the report, but we don’t find these traditional stories either convincing, in the case of technology, or sufficient, in the case of globalization. Both of these forces are playing out, in quite similar ways, in other advanced countries, whose growth of inequality nowhere mirrors our own. Technology and globalization don’t fall from the sky, but instead are determined in important ways by rules and institutions. This is especially important in the era of free trade agreements, which are really managed trade agreements. These agreements are less about trade and more about the regulatory environment corporations face.

But rules matter even in these straightforward stories about supply and demand for labor. Advancements in search theory tell us that supply and demand, rather than strictly determining wages, instead place boundaries or endzones on where wages can go. What determines where wages fall within those boundaries is a whole host of economic rules, including bargaining power, institutions, and social conventions. Even in the strong version of these arguments, the rules matter.

This report describes what has happened, going far deeper than this summary here. It also has a policy agenda focused on both taming the top and growing the rest of the economy. Some may emphasize some pieces more than others; but no matter what this argument about the rules is what is missing in the current debates over the economy. I hope you get a chance to check out the report!

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Besides Failing Corporate Finance 101, Holtz-Eakin's Attack on Dodd-Frank Sets a Terrible Priority

May 8, 2015Mike Konczal

The American Action Forum jumps into the financial reform debate with a letter on the growth consequences of Dodd-Frank penned by its president, Douglas Holtz-Eakin. This letter is a bad analysis, immediately violating the first thing you learn in corporate finance: capital structure doesn’t dictate funding costs. But there’s a deeper context that makes this letter reckless and a bad development, and I hope they are willing to walk back part of it.

Why reckless? It’s important to understand the role people like Holtz-Eakin play in the conservative movement. It is less about providing analysis (which is good, because this is a bad analysis), and more about signaling priorities. What should be done about Dodd-Frank if the Republicans win in 2016? This letter signals a new front I haven’t seen before on the right: one focused on going after higher capital requirements. Worse, going after them as if they were, using that conservative trigger word, a “tax.” I think that is a terrible move with serious consequences, and if they are going to do it, they need to do better than this.

A Bad Analysis

Americans for Financial Reform and David Dayen give us a solid overview of what is lacking in this analysis. It contains no benefits, confuses one-time and ongoing costs, assumes all costs derive from the cost of capital rather than profits, and so on. I’m also pretty sure there’s an error in the calculations, which would reduce the estimate by a third; I’m waiting for a response from them on that [1].

But I want to focus on capital requirements. Holtz-Eakin argues that the Solow growth model “can be used to transform the roughly 2 percentage point rise in the leverage ratio of the banking sector” into “a rise in the effective tax rate.” Wait, the tax rate? “The banking sector responded to Dodd-Frank by holding more equity capital,” writes Holtz-Eakin, “thus require it to have greater earnings to meet the market rate of return – the same impact as raising taxes.” Higher capital requirements, in this argument, function just like a tax.

He concludes that a 2 percentage point rise in capital requirements, much like what we just had, increases the cost of capital somewhere between 2 and 2.5 percent. (I believe I understand that to be the argument, though the paper itself is quick and not cited to any body of research.)

This is wrong, full stop. The Holtz-Eakin argument is predicated on the idea that capital structure directly affects funding costs. But our baseline assumption should be that there is virtually no impact of capital requirements on cost of capital. Economics long ago debunked the notion that changes in aggregate funding mixes can have an effect on the value of a business itself, much less a widespread, durable, macroeconomic effect. This is a theorem they teach you in Corporate Finance 101: the Modigliani–Miller theorem. And this has been one of the most important arguments in financial reform, with Anat Admati being a particularly influential advocate of pointing this out.

Just step back and think about what Holtz-Eakin’s model means. If Congress passed a law requiring companies to fund themselves with half as much equity as they did before, would the economy experience a giant growth spurt from changing the aggregate funding mix? No, of course not. The price of capital would simply adjust with this new balance; funding with more equity means funding with less debt, though the business is still the same. Investors are not stupid; they respond to a changing funding mix by simply changing the prices accordingly. This is how markets are supposed to work.

Of course, the real world doesn’t work exactly like these abstract economic models. If there’s a hierarchy of financing options, which seems reasonable, then moving up or down that ladder can impose some costs. Doug Elliott from Brookings, for instance, writes quite a bit arguing that the idea that equity and higher capital requirement is costless is a dangerous “myth” of financial reform. (Here is Admati responding.)

So Elliott’s not on the costless side, but does he agree with Holtz-Eakin’s numbers? Not even remotely. According to Elliott’s estimate, the cost of the entirety of Dodd-Frank increases the cost of capital 0.28 percent, and the “low levels of economic costs found here strongly suggest that the benefits in terms of less frequent and less costly financial crisis would indeed outweigh the costs.”

As shown in the graphic above, a model of higher capital requirements by Kashyap, Stein, and Hanson put the estimate of a 2 percent capital increase at between 0.05 percent (driven by the tax effects) and 0.09 percent (driven by a large slippage of Modigliani-Miller they assume to get a high-end estimate). These are broadly in line with other estimates throughout the past several years. Even the most industry-driven estimates designed to weaken capital requirements don't remotely approach this 2.00+ percent increase.

(As a coincidence, Elliott did estimate what it would take to make the cost of capital rise Holtz-Eakin’s estimated 2 percent. In his view, it would be capital requirements on the order of 30 percent, which is the reach goal for some. But when you analyze Dodd-Frank and get numbers consistent with 30 percent capital ratios, you are probably doing it wrong.)

A Worse Priority

So the estimate is wrong in a fundamental way; but this is less about a specific analysis than it is about setting priorities for the conservative movement when it comes to Dodd-Frank. And if attacking capital requirements becomes a major priority for conservatives, that’s a worrying sign. When conservatives start calling things “taxes,” institutional forces go into play beyond the control of any specific person, and that’s dangerous for a successful reform with lots of support that is important for a better financial system.

A broad group of people has come together to argue for capital requirements. This includes important commentators across the spectrum, from Simon Johnson to John Cochrane to many others. And there’s good reason for this. The current capital requirement regime hits six birds with one stone: helping with solvency, balancing risk management, making resolution and the ending of Too Big to Fail more credible, preventing liquidity crises in shadow banking, right-sizing the scale and scope of the largest financial institutions, and macroeconomic prudential policy.

There are disagreements about specifics of what is the best way to do higher capital requirements—quite intense ones, actually. But there’s a broad consensus in favor of them. Having watched this from the beginning, this broad coalition is one of the most promising developments I’ve seen.

I’m excited to see the right go after Dodd-Frank. Is the argument that there’s too much accountability for consumers now, and we need to gut those regulators at the CFPB? Is it that derivatives regulations are too extensive, and we should build our future prosperity by letting a thousand AIGs bloom? Is it that there should be few, if any, consequences for firms that break the law or commit fraud? (As someone who is worried about over-policing, this is one area where I believe we are criminally under-policed.) Please, by all means, make these arguments.

But taking on capital requirements with this weak argument is a bad development. The financial market is not understudied, and though nobody has ever found anything like these results, and though it's clear Holtz-Eakin’s analysis doesn’t even engage with this other research, those who think the cost of capital requirements are low could be wrong. But to prove that, we’ll need an analysis far better than the one provided here. And until one has that, the responsible thing is to not unleash the conservative movement against reform that is doing good work and that should be advanced rather than dismantled.

 

[1] I’m pretty sure for “rL-C” in equation 11 he uses net income ($151.2bn) rather than EBIT ($218.7bn), though, from equation 9, “rL-C” should be pre-tax. However using the wrong number is the only way I can replicate the estimate he has. I’ll update this either way if they respond.

If I’m right this decreases Holtz-Eakins’ growth costs of regulations by about 30%, meaning that the economy will probably be skyrocketing any second now.

Follow or contact the Rortybomb blog:
 
  

 

The American Action Forum jumps into the financial reform debate with a letter on the growth consequences of Dodd-Frank penned by its president, Douglas Holtz-Eakin. This letter is a bad analysis, immediately violating the first thing you learn in corporate finance: capital structure doesn’t dictate funding costs. But there’s a deeper context that makes this letter reckless and a bad development, and I hope they are willing to walk back part of it.

Why reckless? It’s important to understand the role people like Holtz-Eakin play in the conservative movement. It is less about providing analysis (which is good, because this is a bad analysis), and more about signaling priorities. What should be done about Dodd-Frank if the Republicans win in 2016? This letter signals a new front I haven’t seen before on the right: one focused on going after higher capital requirements. Worse, going after them as if they were, using that conservative trigger word, a “tax.” I think that is a terrible move with serious consequences, and if they are going to do it, they need to do better than this.

A Bad Analysis

Americans for Financial Reform and David Dayen give us a solid overview of what is lacking in this analysis. It contains no benefits, confuses one-time and ongoing costs, assumes all costs derive from the cost of capital rather than profits, and so on. I’m also pretty sure there’s an error in the calculations, which would reduce the estimate by a third; I’m waiting for a response from them on that [1].

But I want to focus on capital requirements. Holtz-Eakin argues that the Solow growth model “can be used to transform the roughly 2 percentage point rise in the leverage ratio of the banking sector” into “a rise in the effective tax rate.” Wait, the tax rate? “The banking sector responded to Dodd-Frank by holding more equity capital,” writes Holtz-Eakin, “thus require it to have greater earnings to meet the market rate of return – the same impact as raising taxes.” Higher capital requirements, in this argument, function just like a tax.

He concludes that a 2 percentage point rise in capital requirements, much like what we just had, increases the cost of capital somewhere between 2 and 2.5 percent. (I believe I understand that to be the argument, though the paper itself is quick and not cited to any body of research.)

This is wrong, full stop. The Holtz-Eakin argument is predicated on the idea that capital structure directly affects funding costs. But our baseline assumption should be that there is virtually no impact of capital requirements on cost of capital. Economics long ago debunked the notion that changes in aggregate funding mixes can have an effect on the value of a business itself, much less a widespread, durable, macroeconomic effect. This is a theorem they teach you in Corporate Finance 101: the Modigliani–Miller theorem. And this has been one of the most important arguments in financial reform, with Anat Admati being a particularly influential advocate of pointing this out.

Just step back and think about what Holtz-Eakin’s model means. If Congress passed a law requiring companies to fund themselves with half as much equity as they did before, would the economy experience a giant growth spurt from changing the aggregate funding mix? No, of course not. The price of capital would simply adjust with this new balance; funding with more equity means funding with less debt, though the business is still the same. Investors are not stupid; they respond to a changing funding mix by simply changing the prices accordingly. This is how markets are supposed to work.

Of course, the real world doesn’t work exactly like these abstract economic models. If there’s a hierarchy of financing options, which seems reasonable, then moving up or down that ladder can impose some costs. Doug Elliott from Brookings, for instance, writes quite a bit arguing that the idea that equity and higher capital requirement is costless is a dangerous “myth” of financial reform. (Here is Admati responding.)

So Elliott’s not on the costless side, but does he agree with Holtz-Eakin’s numbers? Not even remotely. According to Elliott’s estimate, the cost of the entirety of Dodd-Frank increases the cost of capital 0.28 percent, and the “low levels of economic costs found here strongly suggest that the benefits in terms of less frequent and less costly financial crisis would indeed outweigh the costs.”

As shown in the graphic above, a model of higher capital requirements by Kashyap, Stein, and Hanson put the estimate of a 2 percent capital increase at between 0.05 percent (driven by the tax effects) and 0.09 percent (driven by a large slippage of Modigliani-Miller they assume to get a high-end estimate). These are broadly in line with other estimates throughout the past several years. Even the most industry-driven estimates designed to weaken capital requirements don't remotely approach this 2.00+ percent increase.

(As a coincidence, Elliott did estimate what it would take to make the cost of capital rise Holtz-Eakin’s estimated 2 percent. In his view, it would be capital requirements on the order of 30 percent, which is the reach goal for some. But when you analyze Dodd-Frank and get numbers consistent with 30 percent capital ratios, you are probably doing it wrong.)

A Worse Priority

So the estimate is wrong in a fundamental way; but this is less about a specific analysis than it is about setting priorities for the conservative movement when it comes to Dodd-Frank. And if attacking capital requirements becomes a major priority for conservatives, that’s a worrying sign. When conservatives start calling things “taxes,” institutional forces go into play beyond the control of any specific person, and that’s dangerous for a successful reform with lots of support that is important for a better financial system.

A broad group of people has come together to argue for capital requirements. This includes important commentators across the spectrum, from Simon Johnson to John Cochrane to many others. And there’s good reason for this. The current capital requirement regime hits six birds with one stone: helping with solvency, balancing risk management, making resolution and the ending of Too Big to Fail more credible, preventing liquidity crises in shadow banking, right-sizing the scale and scope of the largest financial institutions, and macroeconomic prudential policy.

There are disagreements about specifics of what is the best way to do higher capital requirements—quite intense ones, actually. But there’s a broad consensus in favor of them. Having watched this from the beginning, this broad coalition is one of the most promising developments I’ve seen.

I’m excited to see the right go after Dodd-Frank. Is the argument that there’s too much accountability for consumers now, and we need to gut those regulators at the CFPB? Is it that derivatives regulations are too extensive, and we should build our future prosperity by letting a thousand AIGs bloom? Is it that there should be few, if any, consequences for firms that break the law or commit fraud? (As someone who is worried about over-policing, this is one area where I believe we are criminally under-policed.) Please, by all means, make these arguments.

But taking on capital requirements with this weak argument is a bad development. The financial market is not understudied, and though nobody has ever found anything like these results, and though it's clear Holtz-Eakin’s analysis doesn’t even engage with this other research, those who think the cost of capital requirements are low could be wrong. But to prove that, we’ll need an analysis far better than the one provided here. And until one has that, the responsible thing is to not unleash the conservative movement against reform that is doing good work and that should be advanced rather than dismantled.

 

[1] I’m pretty sure for “rL-C” in equation 11 he uses net income ($151.2bn) rather than EBIT ($218.7bn), though, from equation 9, “rL-C” should be pre-tax. However using the wrong number is the only way I can replicate the estimate he has. I’ll update this either way if they respond.

If I’m right this decreases Holtz-Eakins’ growth costs of regulations by about 30%, meaning that the economy will probably be skyrocketing any second now.

Follow or contact the Rortybomb blog:
 
  

 

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