Josh Kosman on the Loopholes That Fuel Private Equity Buyouts

Jan 12, 2012Mike Konczal

kosman_paperback_launchAs a result of a series of attacks and counter-attacks on Republican presidential candidate Mitt Romney's work with Bain, there's been a lot of discussion about private equity, buyouts of firms, and their ultimate relation to the economy.

kosman_paperback_launchAs a result of a series of attacks and counter-attacks on Republican presidential candidate Mitt Romney's work with Bain, there's been a lot of discussion about private equity, buyouts of firms, and their ultimate relation to the economy. So far the discussion has been a back-and-forth on layoffs and "creative destruction," with very little on how laws and regulations structure the way private equity and buyouts happen in this country.

I interviewed Josh Kosman, author of The Buyout of America: How Private Equity Is Destroying Jobs and Killing the American Economy, on this topic. Bob Kuttner reviewed his book in May 2010, and Kosman was on Up with Chris Hayes last weekend. The interview has been edited for length.

Mike Konczal: What are private equity funds, and what do they do?

Josh Kosman: Private equity firms are mostly former Wall Street bankers who raise money to buy companies on credit. They used to be called leveraged buyout (LBO) firms, and when the first leveraged buyout boom went bust in the 1980s they regrouped and called themselves private equity.

The big difference between them and venture capitalist or hedge funds is that the companies that they buy borrow money to finance the acquisitions.

Private equity firms own more than 3,000 U.S. companies and employ roughly one out of every 10 Americans in the private workforce. This is just America, so it doesn't include companies or employees overseas. Some companies include HCA, the largest hospital chain, to Clear Channel, the largest radio station operator, to Dunkin' Donuts. They are in every industry.

MK: People coming to the defense of private equity from both the left-neoliberal and conservative spaces directly invoke or allude to "the market" as a natural, already existing thing. But a key progressive retort to this laissez-faire view of economics argues that all markets are deeply embedded in and constructed through legal, tax, and other regulatory government codes. Your research has found that, far from being natural, private equity exists largely due to issues with the tax code. Can you explain?

JK: The whole industry started in the mid-to-late 1970s. The original leveraged buyout firms saw that there were no laws against companies taking out loans to finance their own sales, like a mortgage. So when a private equity firms buys a company and puts 20 percent down, and the company puts down 80 percent, the company is responsible for repaying that.

Now the tax angle is that the company can take the interest it pays on its loans off of taxes. That reduces the tax rate of companies after they are acquired in LBOs by about half. Banks, also realizing this tax effect, were willing to finance these deals. At the time, you could also depreciate the assets of the company you were buying -- that's not true today.

They saw that you could buy a company through a leveraged buyout and radically reduce its tax rate. The company then could use those savings to pay off the increase in its debt loads. For every dollar that the company paid off in debt, your equity value rises by that same dollar, as long as the value of the company remains the same.

MK: So the business model is based on a capital structure and tax arbitrage?

JK: Yes. It's a transfer of wealth as well. It's taking the wealth of the company and transferring it to the private equity firm, as long as it can pay down its debt.  It think it is real - the very early firms targeted industries in predictable industries with reliable cash flows in which they by and large could handle this debt. As more went into this industry, it became very hard to speak to the original model. Now firms are taken over in very volatile industries. And they are taking on debts where they have to pay 15 times their cash flow over seven years -- they are way over-levered.

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MK: The most common argument for why Bain Capital and other private equity firms benefit the economy is that they are pursuing profits. They aren't in the business of directly "creating jobs" or "benefitting society," but those effects occur indirectly through the firms making as much money as they can.

But even here, "profits" -- how they exist, where they come from, and how they are timed -- have a crucial legal and regulatory function. A recent paper from the University of Chicago looking at private equity found that "a reasonable estimate of the value of lower taxes due to increased leverage for the 1980s might be 10 to 20 percent of firm value," which is value that comes from taxpayers to private equity as a result of the tax code. Can you talk more about this?

JK: That sounds about right. If you took away this deduction, you'd still have takeovers, but you'd have a lot less leverage and the buyer would be forced to really improve the company in order to make profits. I think that would be a great thing.

If you look at the dividends stuff that private equity firms do, and Bain is one of the worst offenders, if you increase the short-term earnings of a company you then use those new earnings to borrow more money. That money goes right back to the private equity firm in dividends, making it quite a quick profit. More importantly, most companies can't handle that debt load twice. Just as they are in a position to reduce debt, they are getting hit with maximum leverage again. It's very hard for companies to take that hit twice.

If you look at Ted Forstmann, an original private equity person who just passed away, he would rail against dividends in this manner -- borrowing money to pay out dividends. He was more interested in taking companies public and selling shares and paying down debts and collecting proceeds that way. I can respect that a lot more. The initial private equity model was that you would make money by reselling your company or taking it public, not by levering it a second time.

Private equity and buyouts started as a way to take advantage of tax gimmicks, not as a way of saying "we're going to turn around companies." And now it's out of control. I look at the 10 largest deals done in the 1990s, during ideal economic times, and in six cases it was clear that the company was worse off than if they never been acquired. Moody's just put out a report in December that looked at the 40 largest buyouts of this era and showed that their revenue was growing at 4 percent since their buyout, while comparable companies were growing at 14 percent.

In January -- so just in the past 12 days -- Hostess, the largest bakery in the country, just went bankrupt. Coach, the largest bus company, just went bankrupt. And Quizno's is about to go bankrupt. All of these were owned by private equity.

MK: This battle is part of a larger discussion of, in Henry Manne's phrase, "the market for corporate control." The tax code is set to overlever firms, which require increases in earnings to go toward debt payments instead of research and development, expansion, and other things that build the firm. What could we change to generate different outcomes?

JK: That's exactly right. Right after this goes on for a few years, you've starved your firm of human and operating capital. Five years later, when the private equity leaves, the company will collapse -- you can't starve a company for that long. This is what the history of private equity shows.

What I'd like to see Mitt Romney do is to show an example of a buyout that went well. The only success stories he's talking about on any level are venture capital investments -- Staples and Sports Authority. Personally I like venture capital, I think it provides a lot of value, but that's not what he did mostly, and that's not what these takeovers are about.

The big fix I'd encourage is an end to interest-tax deducibility for leveraged buyouts. The tax system encourages companies to borrow as much as they can. For certain industries, like telecom, these deductions might make a lot of sense. But it was never intended for financing leveraged buyouts. If you put a cap on this you would find buyouts and private equity firms that were much more focused on building companies.

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Jobs Numbers: The Good, the Bad, the Meh

Jan 6, 2012Mike Konczal

Some good news lurks in today's jobs numbers, but we're still a long way away from a real recovery.

Some good news lurks in today's jobs numbers, but we're still a long way away from a real recovery.

The new jobs numbers are out. Overall, 212,000 private sector jobs were created while 12,000 government jobs were lost, for a net total of 200,000 job gains. That loss, 12,000, is less than the average 23,000 government jobs that were lost per month in 2011, so it boosts the headline number. Yet 12,000 is still a lot to lose, especially when so many of those numbers come from education -- at least 9,000 local-level education jobs were cut.

Where's the good news? There were solid increases in weekly hours (+0.5%) and payroll (+0.7%), meaning employed people are getting more money in their pockets. With more money, they can spend more, which will employ other people and create a virtuous loop of spending and employment. This will help boost demand broadly and start to add some energy to a depressed economy. If sustained, it could help take the current jobs reports -- which are good but not enough to end the unemployment crisis we currently have -- and turn them into jobs numbers capable of bringing about a serious recovery.

But there's also an apparent queue for who will get jobs first. Right now we are seeing most job gains go to men and to those with higher education. Men have been gaining jobs over women across industries and occupations throughout 2011 -- and in the household survey women lost jobs last month. The employment-to-population ratio went down to 53 percent for women last month, bringing it to the lowest levels since 1988. The Roosevelt Institute will be doing additional research on this topic in 2012.

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What's on the horizon? Something needs to trigger these 200,000 jobs a month reports into the 250,000 to 400,000 range.  At the current rate, we won't see full employment until 2024. Something needs to kick in. One way this could happen is if household formation takes off in 2012. There's a shadow household inventory of adults living with parents and adults living with other adults who, in better times, would have moved out. Household formations would take stress off the terrible housing market, but is it likely to take off itself without a boost? I'll be following this argument throughout the year.

The other big way to put more gas in the economy's engine is through expanded fiscal and monetary policy. There's no sign from inflation or government borrowing rates that we've hit a danger zone in stimulating the economy, and there's plenty of slack in the short-term to put idle resources to work.

Mike Konczal is a Fellow at the Roosevelt Institute.

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Cordray's Recess Appointment Helps Implement a Law That Already Passed

Jan 4, 2012Mike Konczal

President Obama rightfully sidestepped a GOP that insists on dismantling a law that addresses some of the fundamental breakdowns of the crisis.

President Obama rightfully sidestepped a GOP that insists on dismantling a law that addresses some of the fundamental breakdowns of the crisis.

One way to think about how the Dodd-Frank Wall Street Reform and Consumer Protection Act goes about policing finance is that it levels the playing field of rules and regulations between bank and non-bank financial firms. In the lead up to the crisis, financial firms acted like "shadow banks" without having to follow the rules regular banks did. The legal and regulatory infrastructure that evolved since the Great Depression for regular banks was never extended to these new shadow banks.

This was especially true for consumer financial products, particularly home mortgages. There's a solid regulatory network for home mortgages in place when it comes to regular banks. However, when it came to subprime mortgages made through non-bank lenders, those rules didn't apply. Many financial regulators urged Federal Reserve Chairman Alan Greenspan to have the Fed start regulating subprime and leveling the regulatory playing field. So did the GAO and a HUD-Treasury task force. Greenspan wouldn’t. Hence Dodd-Frank's emphasis on reducing regulatory arbitrage by creating a special Bureau to consolidate consumer financial protection in one place.

But the Consumer Financial Protection Bureau (CFPB) needs a director in order to start working on reducing the uneven playing field. As a recent report noted, "[w]ithout a Director, the CFPB cannot fully supervise non‐bank financial institutions such as independent payday lenders, non‐bank mortgage lenders, non‐bank mortgage servicers, debt collectors, credit reporting agencies and private student lenders." Enter our dysfunctional Senate.

In early May of 2011, 44 Republican Senators signed onto a letter that requested three specific changes before they confirmed any nominee, "regardless of party affiliation," to head the CFPB. The changes included replacing "the single Director with a board to oversee the Bureau" and subjecting "the Bureau to the Congressional appropriations process."

Dodd-Frank, signed into law in July 2010, created a Consumer Financial Protection Bureau that had a single director and was consciously funded in a very specific way. In order for the CFPB to fully work, it needs an appointed director -- certain powers don't kick in otherwise. So in effect a minority of Republican Senators say that they won't allow an act of law to be fully implemented unless certain, crucial, parts of the law are overturned.

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People are correctly referring to this as a new nullification crisis (see also here). Brookings Scholar Thomas Mann notes that insisting "that a legitimately passed law be changed before allowing it to function with a director [is] a modern-day form of nullification. Same with the director of the Center for Medicare and Medicaid Services. There is nothing normal or routine about this. The Senate policing of non-cabinet appointments is sometimes more aggressive but the current practice goes well beyond that, more like pre-Civil War days than 20th century practice." This has also gone on with the NLRB and, in a way, went on with the debt ceiling battle. Eventually the administration needed to challenge this.

So it's great to see it recess appoint Richard Cordray as director. ThinkProgress outlines the initial legal analysis as to why Obama has the power to do this. Cordray will make a great director for the CFPB and the Bureau will continue to do the excellent work that it has already done.

It's a shame that more confirmations weren't pushed through with this window. A large number of financial regulator positions need to be filled, and even more judicial spots sit empty. In terms of building a longer-term, ascendent liberalism, it is essential to appoint people such as judges and nurture them to become strong leaders in the future.

It is uncertain whether this will shut down the confirmation process in the Senate, which may escalate tensions. If so, it will be a good time to reexamine how confirmations happen in the Senate more broadly. This is a part of government that was never meant to work the way it does now, and it is having serious consequences for the country.

Mike Konczal is a Fellow at the Roosevelt Institute.

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The Most Popular Post of 2011: Who are the 1% and What Do They Do for a Living?

Dec 23, 2011Mike Konczal

Editor's note: As the year comes to a close, New Deal 2.0 is highlighting our most read post from the year. Our regular posting schedule will resume in January. See you in 2012!

mike-konczal-newThere's good reason to focus on the top 1%: they're distorting our economy.

Look, a crazy anti-capitalist anarchist carrying a bizarre sign incompatible with the basic tenets of liberals:

Or not.

Editor's note: As the year comes to a close, New Deal 2.0 is highlighting our most read post from the year. Our regular posting schedule will resume in January. See you in 2012!

There's good reason to focus on the top 1%: they're distorting our economy.

Look, a crazy anti-capitalist anarchist carrying a bizarre sign incompatible with the basic tenets of liberals:

Or not.

A lot of emphasis is on the "99%" versus the "1%" in these protests. But who are the 1% and what do they do for a living? Are they all Wilt Chamberlains and Oprahs and other people taking part in the dynamism of the new economy? Nope. It's same as it ever was -- high-level management and the financial sector.

Suzy Khimm goes through the numbers here. I'm curious about occupations. I'll hand the mic off to "Jobs and Income Growth of Top Earners and the Causes of Changing Income Inequality: Evidence from U.S. Tax Return Data" by Bakija, Cole, and Heim. This is the latest and greatest report on occupations and inequality. Here's a chart of the occupations of the top 1%:

distribution_1_percent

Inequality has fractals. Let's go into the top 0.1% -- what do they look like? Here's the chart of the occupations of the top 0.1%, including capital gains:

It boils down to managers, executives, and people who work in finance. From the paper: "[o]ur findings suggest that the incomes of executives, managers, supervisors, and financial professionals can account for 60 percent of the increase in the share of national income going to the top percentile of the income distribution between 1979 and 2005."

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For fun, there are more than twice as many people listed as "Not working or deceased" than are in "arts, media, sports." For every elite sports player who earned a place at the top of the income pyramid due to technology changes and superstar, tournament-style labor markets that broadcast him across the globe, there are two trust fund babies.

The top 1% of managers and executives often means C-level employees, especially CEOs. And their earnings versus the average worker have skyrocketed in the past 30 years, so this shouldn't be surprising:

How has this evolved over time? Can we get a cross-section of that protest sign above?

Same candidates. There's a reason the protests ended up on Wall Street: The top 1% and top 0.1% comprises all the senior bosses and the financial sector.

One of the best things about Occupy Wall Street is that there is no chatter about Obama or Perry or whatever is the electoral political issue of the day. There are a lot of people rethinking things, discussing, learning, and conceptualizing the kinds of world they want to create. Since so much about inequality is a function of the legal structure known as a "corporation," I'd encourage you to check out Alex Gourevitch on how the corporate is structured in our laws.

The paper notes that stock market returns drive much of the manager's income. This is related to a process of financialization, something JW Mason has done a fantastic job outlining here. The "dominant ethos among managers today is that a business exists only to enrich its shareholders, including, of course, senior managers themselves," and this is done by paying out more in dividends that is earned in profits. Think of it as our-real-economy-as-ATM-machine, cashing out wealth during the good times and then leaving workers and the rest of the real economy to deal with the aftermath.

Both articles mention chapter 6 of Doug Henwood's Wall Street; anyone interested in how things have changed and where they need to go would be wise to check it out. It's even available for free pdf book download here.

There's good reason to focus on the top 1% instead of the top 10 or 50%. There is evidence that financial pay at this elite level is correlated with deregulation and the other legal changes that brought on the crisis. High-ranking senior corporate executives' pay has dwarfed workers' salaries, but is only a reward for engaging in shady financial engineering practices. These problems require a legal solution and thus they require a democratic challenge and a rethinking of how we want to structure our economy. Here's to the 99% and Occupy Wall Street helping get us there.

Mike Konczal is a Fellow at the Roosevelt Institute.

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Could We Redirect Tax Subsidies to Pay for Free College?

Dec 20, 2011Mike Konczal

Want a way to pay for free higher education? Take a look at all the tax breaks that ease the burden of student debt.

Want a way to pay for free higher education? Take a look at all the tax breaks that ease the burden of student debt.

Josh Eidelson has a great post at The Nation, "Fighting Privatization, Occupy Activists at CUNY and UC Kick Into High Gear," that dives into the battles currently being waged against the dismantling of public higher education. One of the Occupy movement's major objectives is combating the privatization of public higher education and its replacement with a debt-fueled economy of indenture.

While prepping a recent Occupy panel, Sarah Jaffe brought up how we subsidize student debt in a similar way to mortgage debt, that is, through allowing people to deduce the interest paid on this debt from taxes. According to Pew Charitable Trust's website subsidyscope, the deductibility of student loan interest alone costs taxpayers $1.4 billion dollars. Instead of taking $1.4 billion dollars and directly making college cheaper, students take out massive amounts of student loan debt and we alter the tax code to make that debt $1.4 billion dollars cheaper.

This is an example of what Suzanne Mettler calls "the submerged state," a pattern where the government has, as she says, "shunned the outright disbursing of benefits to individuals and families and favored instead less visible and more indirect incentives and subsidies, from tax breaks to payments for services to private companies. These submerged policies...obscure the role of government and exaggerate that of the market." Instead of directly providing public options, we subsidize the purchasing of private goods, often using the tax code.

Let's take the case of student debt and the tax code. How much would it cost to make public colleges and universities free? Rough estimates (quoting Jeffrey Sach's latest book) put the price of free public higher education at $15-$30 billion, which fits other estimates I've seen.

Now what are the costs of how we subsidize higher education through the tax code? There's already the $1.4 from the interest exemption. Also from subsidyscope, there's the exclusion of employer-provided educational assistance ($1.1 billion), exclusion of interest on student-loan bonds ($0.6 billion), exclusion of scholarship and fellowship income ($3.0 billion), exclusion of tax on earnings of qualified tuition programs: savings account programs ($0.6 billion), the HOPE tax credit ($5.4 billion), the Lifetime Learning tax credit ($5.5 billion), parental personal exemption for students age 19 or over ($3.4 billion), and state prepaid tuition plans ($1.75 billion). There's also the stimulus's American Opportunity Tax Credit ($14.4 billion) and some part of the deductibility of charitable contributions (education) ($4.9 billion).

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Even without the last two, that's $22.75 billion we are paying through the tax code to make college tuition and student debt more manageable. This amount is in the middle the range of the cost of just making public high education free. Now these aren't equivalent -- much of what is spent through the tax code will be biased more towards private and professional schools, which are more expensive. But this also isn't anywhere near the full extent we subsidize student debt (a government creation from 1965).

But there is a choice in how to provide mass higher education. We can either use resources to reduce the price of the good upfront -- make college free -- or to subsidize the purchase of the good -- here through the numerous hoops of the tax code. The amount of money we take from the tax code to try and make student debts and runaway tuition more bearable could be used instead to just provide free public colleges.

There are winners and losers in each case. When we subsidize through the tax code, people who are well off and pay more taxes benefit more. People who can afford support staff, such as accountants and lawyers, are also more likely to understand how to take maximum advantage of these benefits. These subsidies benefit private educational institutions over public ones, as they'll make private education feel more "natural" while obscuring the role of the government in setting up these markets. They give public college a nudge towards corporatization and privatization. Much of these subsidies are likely captured either by the higher education institutions themselves or the debt lenders. These subsidies will make tuition and debt easier to deal with, but providing colleges free as a public option would likely do far more to contain costs (also see here).

Most importantly, it breaks the link between citizenship and education. The subsidy approach replaces the claim to a necessary good to be full, participating citizens in our market economy with the claim of a consumer, whose claim is ultimately one of willingness to pay either through wealth or debt. The first kind is the place where progressives have the stronger argument about freedom, as opposed to those who see the market as the only source of freedom available.

Mike Konczal is a Fellow at the Roosevelt Institute.

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Amir Sufi on the Balance Sheet Recession and How to Address Household Debt

Dec 16, 2011Mike Konczal

money-globe-150I think that Amir Sufi (University of Chicago Booth School of Business) and Atif Mian (University of California, Berkeley) are doing the most interesting and important empirical work on what is going on with this Great Recession.

money-globe-150I think that Amir Sufi (University of Chicago Booth School of Business) and Atif Mian (University of California, Berkeley) are doing the most interesting and important empirical work on what is going on with this Great Recession. So I was excited to see that they just released two new papers on the subject, "What Explains High Unemployment? The Aggregate Demand Channel" and "Household Balance Sheets, Consumption, and the Economic Slump." Here's an editorial -- "How Household Debt Contributes to Unemployment" -- summarizing their research. They have used a lot of innovative methods and data sets in order to pinpoint the problem of the "household balance sheet" and housing debt overhang and its link to sluggish growth and employment. These papers have been covered in the blogosphere already (here's Paul KrugmanCalculated Risk and Kevin Drum all discussing it.) I was able to interview Amir Sufi about this research.

Mike Konczal: To get started, your papers, and much of the similar work on the matter, show how debt is impacting our slow recovery. In order for this to happen in an otherwise functioning economy, your model introduces three frictions.  Can you describe them?

Amir Sufi: From an academic perspective, most macroeconomics is done within a representative agent framework where all types of people are identical. What that means is that leverage can never really matter -- because it is one guy basically borrowing from himself.

So the first main ingredient in this paper -- and I think Eggertsson and Krugman have said this in the most straightforward way -- is that you have got to have some agents in the economy who are borrowers and some who are savers. For leverage to matter in an economic model, you are going to have to have heterogeneity among households in the model. From a practical point of view, when talking about the real world that's pretty obvious, but for the macroeconomic model you need to add that in.

The second ingredient is some shock that reduces the consumption of the borrowers very sharply. Both the Eggertsson/Krugman paper and another by Veronica Guerrieri and Guido Lorenzoni make the argument that the fundamental shock is to the ability of the borrowers to borrow -- they are forced to either default or massively pay back their debt burdens. In the context that I interpret it in the real world, it is the combination of the decline in house prices that took away the home equity channel, along with the collapse in credit card availability because of the financial crisis. Those are the big shocks that matter.

In my view, those two things are noncontroversial. Even when I present them to more right-leaning economists who don't believe frictions are so important, they're are willing to accept these assumptions. The third thing is trickier. The standard response of economists who don't believe in frictions is: fine, the consumption of these borrowers declines massively, but there's no reason the economy shouldn't equilibrate itself by the savers making up for the lost consumption. And what mediates that channel generally is the interest rate. When the borrowers reduce their consumption, the interest rate collapses -- it's like a positive shock to savings demand. At that point the savers, seeing the lower interest rate, should start buying cars, redoing their kitchens, and everything we think people do when there's lower interest rates.

What you need, and this is where the third thing, the zero-lower bound, comes in, is some friction that prevents the savers from making up the shortfall. And that's where the liquidity trap stuff really comes in. In order to get the savers to consume more, you need the interest rate to get really negative, but it can't get negative because of the zero-lower bound on nominal interest rates.

And then you get into all kinds of problems, like the Fisher debt-deflation stuff. The normal way you try to get real interest rates negative is through expected inflation, but the only way you can get expected inflation is if you force the current price level down, which is deflation. But the debt burdens are written in nominal terms. If you push the price level down, you get this vicious cycle where the borrowers cut their consumption by even more.

I want to add that the third ingredient -- the friction -- doesn't need to be the zero lower bound on nominal interest rates. But that is what has been articulated in the theory work most prominently.

MK: Reading much of the zero lower bounds literature now, it strikes me that it was a conversation among a handful of Princeton and New Keynesian academics when it first started. But looking at it now, it seems very obvious that the zero-lower bound creates a challenge. If right-leaning economists don't think the zero-lower bound is a friction, what do they think?

AS: I think that right-leaning economists don't deny that the zero lower bound could be a friction. I think the zero-lower bound does bother them, that they think it is a fundamental friction. I think where they'd disagree with Paul, and to an extent even I disagree with Paul, is that if you look at his model, the optimal policy in those models isn't necessarily fiscal stimulus, it is writing down the debts of borrowers. That's the number one policy that fixes the problem.

Gauti and Paul's model in particular has a tightened borrowing constraint on borrowers that pushes down their consumption, which in turn leads to zero lower bound problems. The quickest and most effective way in their model would be some type of transfer from the savers to the borrowers to offset this dramatic decline in consumption. Principle forgiveness is exactly such a transfer. Fiscal stimulus is a form of this transfer where we borrow from future generations to make up for the shortfall in demand. But it strikes me as much less direct and potentially more distortive than principle forgiveness.

I come from a finance micro background, so if I were to criticize the zero-lower bound literature, which I use, it is that fiscal stimulus doesn't fall so naturally out of it. Paul goes to lengths to argue against the argument "how can more debt solve a debt problem?" and explains it is because the borrowers are constrained, and there's some truth to that. But the fundamental problem in these models, what generates the zero-lower bound problem, is a sharp reduction in consumption by borrowers. Why not attack that problem head on? If you look at Rogoff's opinion against Krugman's, I think this is the main difference. They agree on the zero-lower bound nature of the problem, but have different tactics on how to fight it. I tend to agree with the view that directly targeting the household debt problem seems to make more sense than fiscal stimulus.

MK: Looking at these models, the real world implication is that a sharp drop in housing prices and a subsequent increase in debt-to-leverage should cause a decrease in consumption. But it isn't necessarily clear why this must be the case. Most of the papers don't develop this, often taking a debt limit as exogenous, though one could imagine people going about their spending decisions in much the same way before or after a housing crash. I was wondering if you have an answer for this.

AS: I think there's a few ways to think about it that we outline in our consumption paper. Why does the shock lead to such a strong reduction in consumption? One, and this is based on previous research, a lot of the consumption by the indebted households during the housing boom was being financed through home equity withdrawal. So just mechanically, consumption can't stay at the same path because they no longer have their homes to borrow against to finance consumption.

The second thing is that the deleveraging effect is real. The Survey of Consumer Finances shows that up until the 90th percentile of the distribution, as of 2007, made up around 65 percent of people's net worth. If you see a massive decline in the value of your home, it is kind of mechanical that if you are thinking about savings and retirement you'll think, "I was planning on having enough equity in my home when I retire that I could just borrow against it for the rest of my life. Now I don't, so I have to adjust my consumption path immediately."

The third thing comes from the credit supply channel. These guys can no longer refinance into lower rates, therefore their income in a relative sense goes down because they can't get these lower interest payments. Hence you'd see their relative consumption against those that can refinance decline. Also, the act of delinquency itself reduces consumption -- your credit score is shot, foreclosures have an effect on durable consumption. Regardless of what you think of the theory, the empirical evidence in our stuff is undeniable: highly indebted households see very sharp relative declines in spending.

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MK: A lot of the underwater mortgages in the country are in a handful of states. How well does your research deal with local conditions? Many of these places would have had a major housing construction boom too.

AS: We take on the local difference, and this is where our housing supply elasticity instrument becomes so critical. You are correct: if you unconditionally look at the high debt-to-income places, a lot of it is highly correlated with places that had construction booms and a lot of migration. To get rid of the construction and migration effects, we try to use exogenous variation in debt-to-income ratios that is driven by housing supply elasticity. This is a technique called "two-stage least squares." We regress the debt-income ratio on how hard it is to build in an area. The idea is that this instrument allows us to disentangle the effect of debt levels from construction and migration. The results after doing this are very strong. Any place that had a high debt-income ratio, whether or not it had a construction boom, is suffering massively now.

MK: A response to your argument is that the savings rate hasn't gone up that much. It's up, but lower than historical averages and has stayed pretty much in the 5 percent region. If your theory relies on people saving more, is this a problem?

AS: First, it is in some sense about the derivative. It might not be high historically, but it is high when compared to 2002 through 2007. Every single quarter since 2008, it's been higher than during the expansion preceding this recession.

But the more fundamental issue is that the savings rate is a very misleading number because it is endogenous. It's easiest to see this argument by looking at (1 - the savings rate), which is how much consumption you are doing out of your current income. It is true that consumption is not that much lower relative to total income than it has been historically. But of course that is a silly way of looking at it. The point is that consumption is way down, period. We don't care whether it low relative to current income.

Once you think about it this way, the problem with the savings rate becomes a lot more obvious. The right benchmark for judging whether consumption is low or savings is high is not relative to current income, it is relative to the consumption you had before the recession. When you say, "People don't seem to be consuming that much less as a fraction of their total income," I say, "Who cares?" The point is that their income is way lower precisely because of the recession. And their income is lower because everybody is consuming less. This is why the savings rate is kind of a silly number when talking about a deleveraging recession.

The right way to look at it is to say how much has consumption fallen since 2006. It has gone down tremendously! And that's prima facie evidence that consumers are deleveraging. People are earning less, because they are consuming less, which is the essence of the deleveraging argument.

Finally, you also have to take into account that interest rates are basically zero. If interest rates are zero, then people are really saving a huge amount of money, because they are saving 5 percent at a zero interest rate. You have to adjust for interest rates to determine whether or not savings rates are historically high.

MK: Another response to this model is that the debt-to-income ratios don't actually matter that much. What is really driving this is a wealth effect. People feel poorer from losing housing value, and thus they spend less. James Surowiecki just had a piece arguing against these balance sheet recession models in The New Yorker, "The Deleveraging Myth." Dean Baker from CEPR makes this argument as well.

AS: Well obviously I disagree 100 percent with that for both theoretical and empirical reasons. The theoretical reason is that housing should not be thought of in a pure wealth sense. We all have to consume housing going forward. And the value of my house going down is also the same value of the price of housing going down. The easiest way to imagine this is to picture a young couple that currently rents and will buy a house in the future. If housing prices decline, it is good for them because they can then more easily buy a house in the future. Clearly, this is not a negative wealth effect for the young couple.

MK: But as far as I understand it there are studies that find a wealth effect in housing.

AS: This is a semantic point on what you call it. I'm saying as an economist that if you call something a wealth effect, then it has nothing to do with borrowing constraints and debt levels, and that effect in theory should be zero. To the degree that we observe that when people's house prices go up they consume more, that's not a wealth effect -- that's a borrowing constraint being alleviated, and people borrowing against collateral that they couldn't before. Which is a very different thing, and it matters empirically. My own research on this topic shows definitively that people consume aggressively out of housing wealth because of borrowing constraints, not a simple wealth effect.

Here's why I fundamentally disagree with the "wealth effect" argument. Suppose you have an economy that looks like the U.S. before the recession, where you have an extremely skewed net wealth distribution. The wealth effect argument is that the response of the economy to house price declines would have been the same if you flattened that out versus if you had the polarization that we have now. And I disagree with that fundamentally, and that's what the research shows. The net wealth distribution matters. People who have very high debt-to-income ratios cut their spending very dramatically, and there is no way a pure wealth effect can explain the magnitude of the cut.

MK: How necessary is debt forgiveness?

AS: I'll say this: We are about four years into this mess, and we still don't have any sense what the elasticity of consumption would be with respect to principle forgiveness. The reason we don't have that estimate is that there's been no principle forgiveness government programs. Of all that has been allocated, there's been virtually nothing allocated to principle reduction to see if it works.

I'm not willing to come out and say principle forgiveness will solve all of our problems. But at the very least, shouldn't we have some basic idea of how responsive spending of highly indebted households would be to principle forgiveness? We've tried a ridiculous number of things in terms of government policy during this downturn: fiscal stimulus, homebuyer tax rebates, cash for clunkers, etc. Can't we at least give principle forgiveness a chance, even if it is on a very small scale?

MK: Any concluding remarks?

AS: The distribution of net wealth matters a lot. Let's suppose there's $100 of wealth in the economy and there's a hundred people. If everybody had $1 of wealth, and then there's a massive drop in house prices, my argument is that this recession wouldn't have been nearly as severe. It's because the five guys at the top have all of the $100 and are just lending to the other 95, that's why the recession is so severe when house prices collapse. Paul said this a few times on his blog, and he's usually very clear, but I don't think he's been clear enough on explaining this. These models on why deleveraging matters are all about the net wealth distribution. We shouldn't be surprised that this recession and the Great Depression were preceded by very large increases in wealth inequality. This is well documented during the 1920s and the 2000s. This is why I get a bit annoyed at the guys who are saying it's just a pure wealth effect, because it's something bigger than that.

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How Credit Collectors Have Reinvented the Debtors' Prison

Dec 14, 2011Mike Konczal

New tactics have an old ring to them and low-income debtors are falling prey.

New tactics have an old ring to them and low-income debtors are falling prey.

NPR just ran a story called "Unpaid Bills Land Some Debtors Behind Bars." As they report, "Here's how it happens: A company will often sell off its debt to a collection agency, generally called a creditor. That creditor files a lawsuit against the debtor requiring a court appearance. A notice to appear in court is supposed to be given to the debtor. If they fail to show up, a warrant is issued for their arrest." Marie Diamond has more.

This is increasingly common across the country. My colleagues Matt Stoller and Bryce Covert have both written about debtors being jailed for failure to appear in court. Debtors' prisons are illegal, and some point out that this is really jail for a summons problem, not a payment. But I haven't had a full vision of the practice until I read this excellent working paper by Lea Shepherd of Loyola Chicago law school, "Creditors Contempt" (h/t creditslips). Beyond laying out the problems with the current system, which gives a disproportionate amount of the coercive powers of the state to creditors, this paper also has implications for another topic I'm interested in -- the class bias of the submerged state.

The key here is something called in personam debt collection remedies. In an agrarian economy, it was relatively straight forward for creditors to order a sheriff to seize the property of a debtor. In rem actions, where a sheriff would go and seize property, would work just fine. But this became harder to do as time went on.

The debt collection market evolved in personam debt collection remedies. This in personam action has two goals: discovery and collection. The court orders the debtor to disclose information about his property, location of his assets, etc. to help creditors track down those assets. Then the court orders certain payments to be made, which allows for collection. This court order is enforced through the court's authority to hold debtors in contempt, which in turn is enforced through threats of imprisonment. Depending on the jurisdiction, contempt charges can be made against either the failure to show up for the discovery process or the failure to stick to the collection ordered.

So how does this go wrong? The most obvious way is that this in personam debt collection method -- which should be reserved for "extraordinary" situations -- is used regularly by today's collectors. Given that a debtor's liberty is at stake, it seems very important that there are strict rules for this practice and that these actions are used only when appropriate. But as Shepard finds, "in personam remedies are often initiated and executed on a high-volume basis and with a striking degree of informality."

Debtors who run into the law often don't understand the process; since the debt has often been resold multiple times, they may not even recognize the names of the plaintiffs. It is also problematic that debtors who don't show up for the summons are likely to be confused as to what they are being jailed for. They may think they are being jailed for nonpayment when they are actually being jailed for the failure to show up and not telling the court and creditors about their assets. It is in the interest of creditors to blur this distinction. Though debtors can often get out of jail by compliance, they may feel they need to pay off debts immediately to get out of jail instead. Debtors will be willing to make costly financial decisions, including using money that is legally protected from debt collectors, to get out of jail immediately. Indeed, many debtors are cash constrained and can't deal with even temporary incarceration due to the costs of work and family disruptions and will be willing to do anything to get out of jail.

In many jurisdictions, bail posted to get out of being jailed for contempt of the discovery process is used to pay creditors. Besides being a great deal for creditors -- as noted above, people often pay a huge economic penalty to get out of jail -- it functions as a de facto debtors' prison. As law professor Alan White described this process, "If, in effect, people are being incarcerated until they pay bail, and bail is being used to pay their debts, then they're being incarcerated to pay their debts." As the FTC noted, debtors being jailed for nonappearance "may be willing to pay the bail (and indirectly the judgement) using assets (such as Social Security payments) the law prohibits creditors from garnishing or otherwise obtaining to satisfy a judgement."

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Debtors can also be jailed for being in contempt of the court-ordered payment plan, an action that certainly seems like the debtor is being jailed for a failure to pay debts (see Alan White on this battle in Indiana here). This exacerbates the first problem -- as Shepard notes, "It may be easier to sue a debtor than to determine if she is a viable litigation target, and even judgement-proof debtors can tap 'last resort' payment sources, like exempt property, loans from family and friends, and fringe credit sources like payday lenders." This encourages creditors to go fishing for potential earnings in an area of the law that endangers the liberty and freedom of debtors.

What does this have to do with the submerged state? The government's method of providing benefits and protections through the tax code and legal channels disproportionately helps the most well-off, if only because they pay the most in taxes. But it also helps them because they can afford the necessary lawyers and support staff to take full private advantage of these rules. Let's look at an example Shepard provides:

Steven Lipman had fallen on hard times... Steven received a pension income of $525 per month... One creditor who obtained a judgment against Steven served him personally with notice of an in personam debt collection action...

After about a 20-minute wait, the creditor’s attorney called out Steven’s name and guided him into the hallway outside the courtroom, where five other debtors’ examinations were taking place. The creditor’s attorney asked Steven about what property he owned and the location of his bank account. Eventually, the attorney asked Steven how much money he could afford to pay each month. Steven felt flustered and wasn’t sure what to say. Feeling embarrassed about having defaulted in the first place, Steven agreed that he could pay $80 per month until the debt was paid off. Steven, unfortunately, couldn’t pay $80 per month...

[H]e hadn’t noticed that it included examples of exempt property -- various assets insulated from creditors’ collection efforts. The list included pension income, Social Security payments, a certain percentage of wage payments, veterans’ benefits, unemployment compensation, workers’ compensation, alimony and child support, and some personal property. Had Steven asserted his exemptions,  he would not have had to forfeit any of his money or property.

The creditor’s attorney didn’t tell him about the exemptions, and the judge never raised the issue. (Unless debtors affirmatively assert their exemption rights, judges may feel uncomfortable raising the topic. Otherwise, judges may be perceived as serving as debtors’ advocates -- not as disinterested adjudicators.)

Notice that Steven is paying 15 percent of his meager income to creditors, even though if he had known about the full protections he's entitled to under law he wouldn't have to pay anything. Cash constrained Steven presumably couldn't afford a lawyer -- but one can imagine a richer debtor making sure each and every exemption was accounted for.

These exemptions are there for serious reasons. As Shepard notes, "Courts have articulated exemption statutes’ broad and fundamental public policy goals: 1) to provide the debtor with enough money to survive, 2) to protect the debtor’s dignity, 3) to afford a means of financial rehabilitation, 4) to protect the family unit from impoverishment, and 5) to spread the burden of a debtor’s support from society to his creditors." With that in mind, why don't judges take an active role in protecting exempt property?

Requirements to appear in court are being overused and abused as a way of confusing debtors and forcing a strong hand on payments. This ultimately threatens the integrity of the entire debt collection system and the crucial protection of freedom and liberty.

Mike Konczal is a Fellow at the Roosevelt Institute.

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Why "Free Market" Foreclosures Destroy Communities as Effectively as Any Central Planner

Dec 6, 2011Mike Konczal

mike-konczal-newWhile central planners reshaped communities in their own image, mortgage servicers tear them apart to maximize their profits.

Today is National Day of Action on Foreclosures. Occupy Our Homes has created a list events at their site. Here's a great video on what is going on in Brooklyn, which shows the devastation happening there:

While central planners reshaped communities in their own image, mortgage servicers tear them apart to maximize their profits.

Today is National Day of Action on Foreclosures. Occupy Our Homes has created a list events at their site. Here's a great video on what is going on in Brooklyn, which shows the devastation happening there:

Between 1853 and 1869, Baron Haussmann tore down and rebuilt major parts of Paris according to principles of hygiene and circulation. He installed roads, sewers, and other public works and demolished neighborhoods, rebuilding them alongside modern technology. These neighborhoods became more stratified by class and function and more easily controlled by state forces.

A general critique of city planners like Haussman is that they rebuilt their cities in order to make it, in James Scott's phrase, seeable by the state. This reconstruction of Paris was focused on simplification, legibility, and centralized, managerial control, regardless of the local knowledge and practices destroyed in the recreation. Critiques like this extend across modernity, especially to those Americans like Robert Moses who built highways through major metropolitan areas.

Though Scott was looking towards models of embeddedness developed by those like Karl Polyani, most people who develop these critiques invoke Hayek and the price system of the market as the superior way of planning. The profit-motive of the price system coordinates information across a vast network of agents who will never know each other. This allows for the most efficient use of society's resources. By seeking out profit opportunities, individuals will coordinate the whole.

There have been millions of foreclosures over the past several years and there will be millions more in the next few years. They are reworking neighborhoods in much the same way Baron Haussmann once did -- but this time the process is driven by the free market of financial capital rationally seeking profit rather than a central planner dreaming about how to make a city "modern." How are the results?

The central agents in this story are mortgage servicers. Servicers are entities that accept payments from borrowers. They also handle mortgages that become distressed and are the entities responsible for modifying them. They are distinct from the company that lent out the money. With the vast majority of mortgages now having run through this relatively new servicing model, one created alongside the slicing-and-dicing model that took over consumer finance, this is the key type of entity responding to the profit motive in the mortgage payment market.

How do the mortgage servicers earn their profit? At their core, they respond to three principal-agent problems in their "Pooling and Service Agreement" contracts. As Adam Levitin and Tara Twomey argue convincingly:

[S]ervicers do not have a meaningful stake in the loan‘s performance; their compensation is not keyed to the return to investors. Second, the servicing industry's combination of two distinct business lines -- transaction processing and default management -- encourage servicers to underinvest in default management capabilities, leaving them with limited ability to mitigate losses. Servicers' monetary indifference to the performance of a loan only exacerbates this situation...

Servicers' incentives in managing individual loans do not track investors' interests. This creates three interrelated problems. First, servicers are incentivized to pad the costs of handling defaulted loans at the expense of investors and borrowers. Second, servicers are not incentivized to maximize the net present value of a loan, but are instead incentivized to drag out defaults until the point that the cost of advances exceeds the servicer‘s default income. In other words, servicers are incentivized to keep defaulted homeowners in a fee sweat box rather than moving to immediately foreclose on the loan. Third, servicers are incentivized to favor modifications that reduce interest rates rather than reduce principal, even if that raises the likelihood of redefault.

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Here's a chart from the National Consumer Law Center’s report "Why Servicers Foreclose When They Should Modify and Other Puzzles of Servicer Behavior" (pdf) by Diane E. Thompson that outlines the logic of how services handle mortgages in trouble:

To expand for a second on their incentives, they include:

Maximizing fees. As a result of the servicing "Pooling and Service Agreement" contracts, servicers have an incentive to push borrowers into default and keep them there. The fees associated with them go straight to the servicer. And if the loan goes into foreclosure, the servicer is paid first before the investor recoups any money. So fee pyramiding and/or loading a loan up with fees to the point where it becomes difficult for the borrower to pay and then foreclosing without modification -- a nightmare scenario for both the borrower and lender -- is fantastic for the servicing firm.

Making bad modifications. If debt goes bad, there should be a good-faith effort to successfully work it out and modify it before a foreclosure happens. As Lou Ranieri, the pioneer of the mortgage-backed security puts it, "You are almost always better off restructuring a loan in a crisis with a borrower than going to a foreclosure... If we keep letting these things go into foreclosure it’s a feedback loop where it will ultimately crush the consumer economy." Since servicers are paid as a percent of principal, they have an incentive to make modifications that increase principal and reduce interest rates, even if these loans aren't sustainable. This goes double if they have exposure to junior-lien debts.

Quick turnaround without proper legal attention. Since the system is designed for servicing to be a thin business model, there is no infrastructure, nor means by which investors can force one to be created, to handle a troubled housing market. Proper staffing is a sunk cost that isn't easily recouped. It shouldn't surprise us that informants are saying that:

20% of files with phantom referrals, approximately another 35% of files had some problems in them. Those problems varied, and included among others, an ARM that had improperly adjusted up, a failure to properly account for a borrower’s principal and interest payments, and a failure to properly attribute payments between pre-petition and post-petition that led the banks to try to collect pre-petition obligations they were not permitted to pursue.

These all add to fee income.

So this is the fruit of the private securitization market that is now running our mortgage markets. What I find fascinating is that the key things that are motivating servicers in their profit-maximizing don't aggregate widely-dispersed information in the way Hayek described in The Use of Knowledge in Society. They aren't signaling, or absorbing the signals of, relative prices of scarcity or substitution. They aren't reacting to an increase in the price of tin without having to care why it has increased, nor are they increasing the price of tin by selling less of it, influencing people they'll never meet.

As Thompson puts it, "How servicers get paid and for what is determined in large part by an interlocking set of tax, accounting, and contract rules." At their core, they are reacting to the laws we use to restructure debt in bankruptcy, the prioritization of multiple liens in distressed debt, REMIC tax law, standardized contracts with poor monitoring of agents, a lack of enforcement of foreclosure laws, and, most importantly, the ability to skim off the top. If you look at the chart of incentives for servicers above, none of them are really relevant to either taking in or sending out information about the mortgage market.

We shouldn't think of any of these things that force homeowners into bankruptcy as reflecting any marginal information about housing, homeowners' ability and willingness to pay, or the availability of capital. They are a combination of laws we've chosen for ourselves about the managing of private property in housing and debt and a standardized contract among a handful of big financial firms that have ended up in a vicious battle over monitoring of the servicers themselves. And that doesn't even get to the externalized costs of a foreclosure to the community. The model is driven not by an abstract invisible hand but by the very real laws and contracts in which they are embedded. When those laws and contracts are faulty -- as they are here -- no useful information or allocation happens.

Which is all to say, if we had a central planning team of Baron Haussmann, Robert Moses, Le Corbusier, and Lenin running the United States mortgage market, I can't imagine they'd do more damage to our neighborhoods and communities than Bank of America's servicing arm is currently doing.

Mike Konczal is a Fellow at the Roosevelt Institute.

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Frank Luntz and the Battle Over Economic Freedom

Dec 5, 2011Mike Konczal

Occupy Wall Street has some conservatives running scared, leaving a window of opportunity to change the dialogue on what freedom really means.

Occupy Wall Street has some conservatives running scared, leaving a window of opportunity to change the dialogue on what freedom really means.

Last week, Republican strategist and wordsmith Frank Luntz shared his concerns about the Occupy movement with a group of Republican governors in Florida. "I'm so scared of this anti-Wall Street effort. I'm frightened to death... They're having an impact on what the American people think of capitalism." Chris Moody wrote a must-read article on the matter, including the ten dos and don'ts that Luntz suggested to his audience.

As Seth Ackerman pointed out, there's an entire industry around Democrats and liberals trying to get an edge on Luntz with even more carefully polled wordplay. However, by talking directly about the power of the 1 percent over our lives, the broken political process, burdensome debts, and a collapsed labor market, the Occupy movement has gotten Luntz's attention in a few short months. As Ackerman puts it:

For twenty or thirty years, Democratic politicians... have been paying what must amount to billions of dollars by now to consultants, pollsters, and think tank gurus to tell them how to talk to the public about inequality in some way that might spark sustained public engagement... Then the Occupy movement comes along and after two and a half months shifts the national consciousness so palpably that Republican governors are scrambling to ask their Rasputins how capitalism can be defended to their constituents back in Peoria.

Luntz suggests 10 sets of words, phrases, and concepts to abandon and has some easily defended ones to use instead. "Jobs" and "entrepreneur" are out. "Careers" and "job creators" are in. Many people across the spectrum are noticing that Luntz is suggesting a retreat from the word "capitalism," but few reference where he wants to retreat to:

1. Don't say 'capitalism.'

"I'm trying to get that word removed and we're replacing it with either 'economic freedom' or 'free market,'" Luntz said. "The public...still prefers capitalism to socialism, but they think capitalism is immoral. And if we're seen as defenders of quote, Wall Street, end quote, we've got a problem."

Luntz suggests retreating to "economic freedom" as an easily defensible phrase conservatives can use to describe the economic status quo. This is astute, as there's been a long, 30-year conservative project to locate freedom in the laissez-faire marketplace.

It hasn't always been this way. Take this 1930 cartoon in the Chicago Defender, where economic freedom is seen as part of the right to unionize (click for larger image):

(Source: Foner, The Story of American Freedom.)

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Economic freedom as freedom from coercion was once a core part of progressive thought. Economic freedom as economic security was a central part of the New Deal and Roosevelt's four freedoms. And economic freedom as freedom from domination in the workplace is a central aspect of what unionization brings to the country. This was thought of as essential to the lives of the individuals and democracy itself -- as Samuel Gompers said, "Men and women cannot live during working hours under autocratic conditions, and instantly become sons and daughters of freedom as they step outside the shop gates."

This is on the minds of people I've talked with at various Occupy movements. Early on in Occupy Wall Street I went and asked 15 random people at Zucotti Park what "freedom" meant to them. Their answers invoked these earlier versions of economic freedom as essential aspects: “I think that freedom is your ability to carry out what you want to do. It’s not just about your social freedom, it is also about economic freedom." "Freedom is...when people can go to public universities and not have to go into debt. So not only so they can get the careers they want, but so they can be productive people in society." With the movement, we have an opportunity to change the dialogue.

Corey Robin's excellent essay in The Nation, "Reclaiming the Politics of Freedom," can act as a guide to why this is so important and what the roadmap toward changing it could look like. He says:

The secret of conservatism’s success -- as any reading of Reagan’s speeches and writings will attest -- has been to locate this notion of freedom in the market... We must confront this ideology head-on: not by temporizing about the riskiness or instability of the free market or by demonstrating that it (or its Republican stewards) cannot deliver growth but by mobilizing the most potent resource of the American vernacular against it. We must develop an argument that the market is a source of constraint and government an instrument of freedom. Without a strong government hand in the economy, men and women are at the mercy of their employer, who has the power to determine not only their wages, benefits and hours but also their lives and those of their families, on and off the job...

The politics of freedom does not dismiss the value or importance of state resources. But rather than conceiving of them as protections against the hazards of the market or indices of public compassion, it sees them as sources of power, as the tools and instruments of personal and collective advance. Armed with universal healthcare, unemployment benefits, public pensions and the like, I am less vulnerable to the coercions and castigations of an employer or partner. Not only do I have the option of leaving an oppressive situation; I can confront and change it -- for and by myself, for and with others. I am emboldened not to avoid risks but to take risks: to talk back and walk out, to engage in what John Stuart Mill called, in one of his lovelier phrases, “experiments in living.”...

That is why the politics of freedom refuses to view the state as the conservative does: as a constraint. Or as the welfare-state liberal does: as a distributive machine. Instead, it views the state the way the abolitionist, the trade unionist, the civil rights activist and the feminist do: as an instrument for disrupting the private life of power. The state, in other words, is the right hand to the left hand of social movement.

It will be challenging to square this idea of the state as a partner in economic freedom with the more anarchist-leaning tendencies of much of Occupy thought, but it's a debate worth having.

Mike Konczal is a Fellow at the Roosevelt Institute.

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The Fed Scrambles to Save Banks, Stalls on Unemployment

Nov 28, 2011Mike Konczal

Side-by-side, two worst case scenarios elicit very different reactions from the Federal Reserve.

Side-by-side, two worst case scenarios elicit very different reactions from the Federal Reserve.

I never congratulated Charles Evans, President of the Federal Reserve Bank of Chicago, for dissenting in the most recent FOMC meeting on behalf of the unemployed. ("Voting against the action was Charles L. Evans, who supported additional policy accommodation at this time.") I'm a big fan of the Evans Rule and am surprised inflation doves haven't been more vocal about it. As Goldman Sachs noted, "This was the first 'dovish' dissent since December 2007 (President Rosengren)." Given that unemployment has turned out to be worse than the Fed's projections at any time, it is about time that those who are worried about unemployment inside the Fed start making noise.

These first murmurs instead stand in contrast to the financial bailouts. Bloomberg just released a big story, based on its successful FOIA requests, that uncovered just how aggressive the Federal Reserve was with its emergency lender-of-last-resort powers. Kevin DrumMatthew Yglesias, and Paul Krugman argue that what is really shocking is how total the rescue and backing of the financial sector was while the real economy was left to rot. As Krugman puts it, "The real scandal isn’t so much that those banks got rescued as that the rest of the population didn’t."

Part of why the bailouts were packaged the way they were was because Lehman Brothers' bankruptcy went a lot worse than the Federal Reserve's expectations of how the collapse of a major investment bank would go. When the collapse went far worse than its expectations, it reacted with maximum force.

Is there an equivalent story for unemployment? I'll try to graph this using the FRB's Summary of Economic Projections. From its FAQ: "Economic projections are collected from each member of the Board of Governors and each Federal Reserve Bank president four times a year, in connection with the Federal Open Market Committee's usual two-day meetings (typically held in January, April, June, and November)... The unemployment rate is the average civilian unemployment rate in the fourth quarter of a year."

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Members of the Federal Reserve get together four times a year and project their expectations of unemployment for several years going forward. Below is that data plotted against the unemployment rate. Specifically, it has the average projected unemployment rate across the entire year and takes the average of the core tendencies that are reported as that rate. The actual unemployment is in bold red and projections from each point going forward are in shades of orange (click for larger image):

As you can see, there's no point in which unemployment was projected to be worse than it actually was. Especially in 2009-2010 -- the actual unemployment rate was significantly higher a year or two later. Here's a zoomed in view of the 09-11 range (click for larger image):

If we were to replace the FRB with a group of monkeys armed with darts, one would imagine that they would make at least a few projections above the actual rate of unemployment. It's funny -- the FRB tried to revise how bad unemployment is but doesn't revise it anywhere near enough to lower it to where the economy actually is.

So to recap: Lehman Brothers goes worse than the Federal Reserve's projection and the Fed goes to the most extreme lengths it can find to extend emergency lending. Every single unemployment number turns out to be worse than all of the Federal Reserve's projections, and it finds every excuse to look the other way. Only Charles Evans has the courage to say that we should let inflation go to 3 percent while unemployment is over 7 percent to catch up to trend growth. Amazing.

Mike Konczal is a Fellow at the Roosevelt Institute.

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