How is Inequality Holding Back the Recovery?

Feb 4, 2013Mike Konczal

Is inequality holding back our weak recovery? Joe Stiglitz argues it is, while Paul Krugman argues it is not. John Judis summarizes the debate at The New RepublicI want to rephrase the question and focus specifically on the two most relevant policy points.

Taxes: Stiglitz argues, "[T]he weakness of the middle class is holding back tax receipts, especially because those at the top are so adroit in avoiding taxes and in getting Washington to give them tax breaks." 
 
Right now our federal government's tax structure is progressive, while state and local taxes are regressive. Meanwhile, the federal government can borrow at cheap rates and run a large deficit without a problem, while state budgets are constrained and need to be balanced. As a result, large cuts and layoffs at the state and local level have counteracted much of the federal government's stimulus that comes from running a larger deficit. Indeed, Stiglitz's point that inequality makes it harder to fund education is a real life battle: we are currently seeing education funding by state and local governments collapsing in real-time.
 
Here's a chart on how regressive state and local taxes are from the Institute on Taxation & Economic Policy:

When it comes to state and local taxes, the top 1 percent pays 6.4 percent, the middle 20 percent pays 9.7, while the poorest 20 percent of families pay 10.9 percent. This isn't counting user fees, though a CEO with 300 times the income of a worker probably doesn't get 300 times as many drivers' licenses.
 
So, all things being equal, less inequality would mean less revenue for the federal government and more for state and local governments. Since a good plan for boosting demand would entail the federal government collecting less revenue (an extension of the payroll tax cut would have boosted demand) and state and local governments collecting more revenue and thus facing less austerity, less inequality would net provide more stimulus. I doubt it would matter that much, though it's an empirical matter on just how much it would provide.
 
Spending: The other debate has to do with the marginal propensity to consume. Evidence does find the rich are less likely to spend money on consumption than everyone else, and in a liquidity trap this matters. Steve Waldman at Interfluidity has a larger theory on why it has mattered over the past decades, but I want to focus on the complicating, narrow issue of wealth inequality.
 
A graph by Amir Sufi, using Federal Reserve data, shows a collapse in the median net worth of households, and his research and others finds that this is a driver of the collapse in demand:

Meanwhile, precautionary savings are still a problem.
 
So, all things being equal, what happens if we decrease inequality in a balance-sheet recession? I see two changes running in opposite directions. You could see an increase in spending by the median household, as they have a higher propensity to spend, plus more income could relieve their balance-sheet constraints. However, if more middle-class households have more of the country's income, they may save it even more aggressively; this would amplify the Paradox of Thrift and make the recession worse in the short term. It's not clear which of these effects would dominate over the other.
 
One way to deal with this is to boost net wealth while keeping incomes consistent, via debt forgiveness or reform our legal mechanisms like bankruptcy so they can handle allocating these losses, though that doesn't seem to be in the cards.
 
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Is inequality holding back our weak recovery? Joe Stiglitz argues it is, while Paul Krugman argues it is not. John Judis summarizes the debate at The New RepublicI want to rephrase the question and focus specifically on the two most relevant policy points.

Taxes: Stiglitz argues, "[T]he weakness of the middle class is holding back tax receipts, especially because those at the top are so adroit in avoiding taxes and in getting Washington to give them tax breaks." 
 
Right now our federal government's tax structure is progressive, while state and local taxes are regressive. Meanwhile, the federal government can borrow at cheap rates and run a large deficit without a problem, while state budgets are constrained and need to be balanced. As a result, large cuts and layoffs at the state and local level have counteracted much of the federal government's stimulus that comes from running a larger deficit. Indeed, Stiglitz's point that inequality makes it harder to fund education is a real life battle: we are currently seeing education funding by state and local governments collapsing in real-time.
 
Here's a chart on how regressive state and local taxes are from the Institute on Taxation & Economic Policy:

When it comes to state and local taxes, the top 1 percent pays 6.4 percent, the middle 20 percent pays 9.7, while the poorest 20 percent of families pay 10.9 percent. This isn't counting user fees, though a CEO with 300 times the income of a worker probably doesn't get 300 times as many drivers' licenses.
 
So, all things being equal, less inequality would mean less revenue for the federal government and more for state and local governments. Since a good plan for boosting demand would entail the federal government collecting less revenue (an extension of the payroll tax cut would have boosted demand) and state and local governments collecting more revenue and thus facing less austerity, less inequality would net provide more stimulus. I doubt it would matter that much, though it's an empirical matter on just how much it would provide.
 
Spending: The other debate has to do with the marginal propensity to consume. Evidence does find the rich are less likely to spend money on consumption than everyone else, and in a liquidity trap this matters. Steve Waldman at Interfluidity has a larger theory on why it has mattered over the past decades, but I want to focus on the complicating, narrow issue of wealth inequality.
 
A graph by Amir Sufi, using Federal Reserve data, shows a collapse in the median net worth of households, and his research and others finds that this is a driver of the collapse in demand:

Meanwhile, precautionary savings are still a problem.
 
So, all things being equal, what happens if we decrease inequality in a balance-sheet recession? I see two changes running in opposite directions. You could see an increase in spending by the median household, as they have a higher propensity to spend, plus more income could relieve their balance-sheet constraints. However, if more middle-class households have more of the country's income, they may save it even more aggressively; this would amplify the Paradox of Thrift and make the recession worse in the short term. It's not clear which of these effects would dominate over the other.
 
One way to deal with this is to boost net wealth while keeping incomes consistent, via debt forgiveness or reform our legal mechanisms like bankruptcy so they can handle allocating these losses, though that doesn't seem to be in the cards.
 
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The Bad GDP Report is a Warning Not to Create Another Roosevelt Recession

Jan 31, 2013David B. Woolner

President Obama should begin his second term much like the first and demand stimulus to bolster a sagging economy.

The only real capital of a nation is its natural resources and its human beings. So long as we take care of and make the most of both of them, we shall survive as a strong nation, a successful nation and a progressive nation—whether or not the bookkeepers say other kinds of budgets are from time to time out of balance.

President Obama should begin his second term much like the first and demand stimulus to bolster a sagging economy.

The only real capital of a nation is its natural resources and its human beings. So long as we take care of and make the most of both of them, we shall survive as a strong nation, a successful nation and a progressive nation—whether or not the bookkeepers say other kinds of budgets are from time to time out of balance.

This capital structure—natural resources and human beings—has to be maintained at all times. The plant has to be kept up and new capital put in year by year to meet increasing needs. If we skimp on that capital, if we exhaust our natural resources and weaken the capacity of our human beings, then we shall go the way of all weak nations. —Franklin D. Roosevelt, 1938

In a somewhat surprising announcement, the Commerce Department noted yesterday that the U.S. economy actually shrank in the fourth quarter of last year, contracting by 0.1 percent. This sharp decline from the 3.1 percent growth rate posted in the previous quarter has not as yet lead to widespread fears that the United States is about to enter another recession, but given that much of the cause of the decline can be attributed to cuts in government spending, some economists worry that this news is but a harbinger of things to come. We are, after all, facing another government-manufactured showdown on March 1, as well as a possible government shut down near the end of March when the stopgap measure financing the federal government expires. Then there is the expected fight over raising the federal debt ceiling, which could lead the U.S. to default on its debts.

Most economists agree that the uncertainty brought about by the dysfunctional nature of Washington is having a negative effect on the economy. But we hear little about the direct effects that cuts in government spending have had on job growth. How many Americans, for example, are aware that one of the primary drivers of our persistently high unemployment rate is the sharp decline in public sector employment—the massive layoffs of teachers, firefighters, police officers, and other public sector employees over the past two years? We might also ask how many Americans recognize that one of the primary ways President Obama managed to stop the downward economic spiral at the start of his first term was through the funding of public sector jobs via the stimulus funds that were channeled to state and local governments. Indeed, it was the expiration of that federal support, and Congress’s refusal to support the president’s modest request for additional federal dollars to support state and local governments in his jobs bill, that initiated the recent public sector decline.

Now at the start of President Obama’s second term, with the U.S. economy still in a very fragile state, we are reminded once again of the direct link between government spending and jobs. For it was the deep cuts in federal defense spending that helped push the economy into negative territory in the past quarter.

One would assume, in the face of such economic realities, that Congress would support the type of modest spending proposals President Obama put forward in the American Jobs Act. But rather than provide funding for the employment of teachers, firefighters, police officers, and the like, rather than put hard-pressed Americans to work rebuilding our dismal infrastructure (now rated 23rd in the world), Congress would rather engage in another endless round of bickering about the perils of deficit spending. Once again heeding the siren song of the deficit hawks, those soothsayers of doom who insist that without an immediate and massive reduction in the level of federal spending we face an imminent economic collapse.

Interestingly, roughly three-quarters of a century ago President Roosevelt faced a similar argument at the start of his second term. Thanks to the stimulus spending of the New Deal, the U.S. economy had been growing at an average annual rate of over 11 percent. Fearing inflation, his more conservative economic advisors, like Treasury Secretary Henry Morgenthau, urged the president to cut spending, balance the budget, and tighten the money supply. But the U.S. economy—which had seen the largest drop in the unemployment rate in history—was still fragile, and the results of the spending cuts were a disaster. Unemployment shot up, industrial production declined, and the country soon found itself in the midst of a recession.

Thankfully, FDR quickly reversed course, and his re-instigation of the essentially Keynesian economic policies (counter-cyclical deficit spending) he had been following since the start of his tenure as president soon turned the U.S. economy around. But the cost to the American people and to FDR’s political fortunes was high. Millions lost their jobs unnecessarily, and the president took a real beating in the 1938 midterm elections, rendering his social and economic reform agenda much more difficult to accomplish.

President Obama, who is fond of history, might do well to study what happened to FDR in 1937. At the very least he should not give up on his demand that Congress provide a modest level of support for further federal spending on behalf of state and local governments. He should also insist on further federal spending on infrastructure. As FDR once said, these measures do not represent wasteful spending; they represent an investment in the American people, an investment in what he liked to call “human capital.” Human capital whose health and well being was not only critical for the present but also for the future. Indeed, FDR insisted that:

Before we can think straight as a nation, we have to consider, in addition to the old kind, a new kind of government balance sheet—a long-range sheet which shows survival values for our population and for our democratic way of living, balanced against what we have paid for them. Judged by that test—history's test—I venture to say that the long-range budget of the present Administration of our government has been in the black and not in the red.

Let us hope that the president and Congress will take heed of this lesson. For, like FDR, they too will one day have to pass the test of history.

David Woolner is a Senior Fellow and Hyde Park Resident Historian for the Roosevelt Institute. He is currently writing a book entitled Cordell Hull, Anthony Eden and the Search for Anglo-American Cooperation, 1933-1938.

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Morning Joe vs. the Barbell

Jan 29, 2013Mike Konczal

Paul Krugman was on Morning Joe yesterday, where he was peppered with questions about why he and other liberal economists aren't obsessed with long-term debt as a more pressing, or at least equally pressing, problem compared to mass unemployment. Joe Scarborough wrote a follow-up editorial implying that Krugman's opinion is isolated among economists without citing any actual economists. In response, Joe Weisenthal created a list of economists of varying backgrounds and political persuasions who agree with Krugman.

The segment focused on the idea that the only way to do stimulus is if we also do long-term cuts at the same time.

Some quotes to give a feel:

Joe Scarborough, 8m20s: "Medicare, Medicaid, health care costs, the defense budget, long-term drivers of a long-term debt... I say you can do two things at the same time."

Ed Rendel, 12m23s, 15m49s: "I don't think any of these things are mutually exclusive... I think we can [invest in infrastructure] while at the same time taking care of the long-term... Simpson-Bowles said we can do both. We can stretch out our debt reduction over a course of time and at the same time do some things that will spur the economy."

Joe Scarborough: "Won't that send a good message to the markets if we say, 'Hey listen, here's the deal. We are going to take care of what we have to do in the short term to get people back to work, but in the long term we are taking care of the long-term structure'?"

This is often referred to as a "barbell strategy" (from a Peter Orzag column). Do stimulus, do long-term deficit reduction, but only if you can do them together. As mentioned by the panelists, this is part of several bipartisan debt reduction strategies. Here's Domenici-Rivlin's Restoring America's Future Plan: "First, we must recover from the deep recession that has thrown millions out of work... Second, we must take immediate steps to reduce the unsustainable debt... These two challenges must be addressed at the same time, not sequentially."

It's weird that nobody on Morning Joe seems to understand the obvious problems with this strategy, so let's make a list.

1. There is no solid economic argument for this. There may be political arguments, as in that's the only way to build a coalition to get legislation through a partisan Congress, but they are just that, political. There's no decent economic argument for why if stimulus is a good idea, and long-term deficit reduction is a good idea, that you need to do both at the same time.

Scarborough's argument that "this would send a good message to the markets" implies that interest rates are a constraint, when instead they've been at ultra-low rates. It also seems to imply that additional stimulus would send the markets into a panic. It is true that if we passed a stimulus program interest rates could rise, but this would reflect the market thinking things were getting better, not worse.

2. The political argument for this is also weak, if only because it was the operative strategy over the past several years and didn't work. President Obama just tried to get some $225 billion dollars in stimulus in the fiscal cliff and looked to be willing to accept cuts in the inflation adjustments for Social Security as part of the package. Republicans turned this down. This stimulus was first proposed a year earlier in his American Jobs Act, which, as he told Congress, would be paid for by offsetting long-term budgets. This was dead on arrival.

And it is easy to see why. You can probably get some agreement on the content of a stimulus package, but to get a agreement on long-term deficit reduction, you would need the GOP to accept some new revenues or clarify what it wants on social insurance. It won't do the first outside constructed scenarios like the fiscal cliff and the latter has yet to happen.

3. As for the short term, alleviating unemployment is the most responsible budget action even though it increases the short-term deficit. Austerity is likely to give us a higher debt-to-GDP problem if it causes a double-dip recession. Our current deficit is so large because so many people are not working; more economic activity would mean more things to tax and fewer stablizers like unemployment insurance to pay for.

As Delong and Summers argue, additional fiscal stimulus in a depressed economy can largely offset its own costs. Or as John Maynard Keynes said in 1933, "It is the burden of unemployment and the decline in the national income which are upsetting the Budget. Look after the unemployment, and the Budget will look after itself."

4. As for the part of the budget that won't take care of itself, President Obama fought an ugly and costly battle to bend the cost curve of health care, in which he was accused of everything from creating death panels to looting benefits of seniors in order to pass them out to his army of Takers. Since he's already paid that price, why wouldn't he wait and see how well Medicare cost saving techniques work?

Maybe it's just me, but I find the "if you want to see full employment again, immediately dismantle some social insurance" to be like a form of ransom. Meanwhile millions of people are suffering needlessly as a result of the lack of action.

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Paul Krugman was on Morning Joe yesterday, where he was peppered with questions about why he and other liberal economists aren't obsessed with long-term debt as a more pressing, or at least equally pressing, problem compared to mass unemployment. Joe Scarborough wrote a follow-up editorial implying that Krugman's opinion is isolated among economists without citing any actual economists. In response, Joe Weisenthal created a list of economists of varying backgrounds and political persuasions who agree with Krugman.

The segment focused on the idea that the only way to do stimulus is if we also do long-term cuts at the same time.

Some quotes to give a feel:

Joe Scarborough, 8m20s: "Medicare, Medicaid, health care costs, the defense budget, long-term drivers of a long-term debt... I say you can do two things at the same time."

Ed Rendel, 12m23s, 15m49s: "I don't think any of these things are mutually exclusive... I think we can [invest in infrastructure] while at the same time taking care of the long-term... Simpson-Bowles said we can do both. We can stretch out our debt reduction over a course of time and at the same time do some things that will spur the economy."

Joe Scarborough: "Won't that send a good message to the markets if we say, 'Hey listen, here's the deal. We are going to take care of what we have to do in the short term to get people back to work, but in the long term we are taking care of the long-term structure'?"

This is often referred to as a "barbell strategy" (from a Peter Orzag column). Do stimulus, do long-term deficit reduction, but only if you can do them together. As mentioned by the panelists, this is part of several bipartisan debt reduction strategies. Here's Domenici-Rivlin's Restoring America's Future Plan: "First, we must recover from the deep recession that has thrown millions out of work... Second, we must take immediate steps to reduce the unsustainable debt... These two challenges must be addressed at the same time, not sequentially."

It's weird that nobody on Morning Joe seems to understand the obvious problems with this strategy, so let's make a list.

1. There is no solid economic argument for this. There may be political arguments, as in that's the only way to build a coalition to get legislation through a partisan Congress, but they are just that, political. There's no decent economic argument for why if stimulus is a good idea, and long-term deficit reduction is a good idea, that you need to do both at the same time.

Scarborough's argument that "this would send a good message to the markets" implies that interest rates are a constraint, when instead they've been at ultra-low rates. It also seems to imply that additional stimulus would send the markets into a panic. It is true that if we passed a stimulus program interest rates could rise, but this would reflect the market thinking things were getting better, not worse.

2. The political argument for this is also weak, if only because it was the operative strategy over the past several years and didn't work. President Obama just tried to get some $225 billion dollars in stimulus in the fiscal cliff and looked to be willing to accept cuts in the inflation adjustments for Social Security as part of the package. Republicans turned this down. This stimulus was first proposed a year earlier in his American Jobs Act, which, as he told Congress, would be paid for by offsetting long-term budgets. This was dead on arrival.

And it is easy to see why. You can probably get some agreement on the content of a stimulus package, but to get a agreement on long-term deficit reduction, you would need the GOP to accept some new revenues or clarify what it wants on social insurance. It won't do the first outside constructed scenarios like the fiscal cliff and the latter has yet to happen.

3. As for the short term, alleviating unemployment is the most responsible budget action even though it increases the short-term deficit. Austerity is likely to give us a higher debt-to-GDP problem if it causes a double-dip recession. Our current deficit is so large because so many people are not working; more economic activity would mean more things to tax and fewer stablizers like unemployment insurance to pay for.

As Delong and Summers argue, additional fiscal stimulus in a depressed economy can largely offset its own costs. Or as John Maynard Keynes said in 1933, "It is the burden of unemployment and the decline in the national income which are upsetting the Budget. Look after the unemployment, and the Budget will look after itself."

4. As for the part of the budget that won't take care of itself, President Obama fought an ugly and costly battle to bend the cost curve of health care, in which he was accused of everything from creating death panels to looting benefits of seniors in order to pass them out to his army of Takers. Since he's already paid that price, why wouldn't he wait and see how well Medicare cost saving techniques work?

Maybe it's just me, but I find the "if you want to see full employment again, immediately dismantle some social insurance" to be like a form of ransom. Meanwhile millions of people are suffering needlessly as a result of the lack of action.

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Live at Bloomberg View, on The Federal Reserve Transcripts

Jan 28, 2013Mike Konczal

I have a new article at Bloomberg View, titled The Fed Is More Out of It Than You Thought It Was. It's about the recently released Federal Reserve transcripts from 2007, and what they say about where the Fed was and wasn't looking when it came to weakness in the economy. It's also implicitly about coverage of the economic crisis that are overtly focused on the financial sector, relevant again in all the new TARP retrospectives that are out there. I hope you check it out.

I have a new article at Bloomberg View, titled The Fed Is More Out of It Than You Thought It Was. It's about the recently released Federal Reserve transcripts from 2007, and what they say about where the Fed was and wasn't looking when it came to weakness in the economy. It's also implicitly about coverage of the economic crisis that are overtly focused on the financial sector, relevant again in all the new TARP retrospectives that are out there. I hope you check it out.

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The Inaugural Address and a Vision of America

Jan 28, 2013Bo Cutter

President Obama's second inaugural had soaring language but fell short of a transformational vision of the future.

President Obama's second inaugural had soaring language but fell short of a transformational vision of the future.

Inaugural addresses are poetry and vision. They are not about governing and programs. Judged this way, President Obama's second inaugural speech was wonderful poetry. The president excels at these big set pieces and he delivers them magnificently. In these moments he is magnetic, and it would take a very crabbed spirit not to acknowledge this. To quote Newt Gingrich, it was a good speech. But the vision of America in the speech is disappointing -- not because it is wrong, but because it isn't sufficiently penetrating and insightful. It is far too incomplete. It does not rise to the quality of his mind or of his poetry.

Some thoughts about the president's speech itself before expanding on my concerns about the president's vision:

The headline instant analysis of the speech all said this was a defiantly progressive statement. Maybe history will see it that way, but I doubt it. This was a very, very conventional restatement of progressive thought and values. It can only be thought of as some sort of signature statement because of how far toward the right debate in Washington shifted after the arrival of the Tea Party.  

I'm not a "progressive" in today's terms, but nevertheless I'd argue that the values the president emphasized have become conventional because they are right. And after a completely unedifying and at times ugly presidential campaign, and then a really dispiriting congressional lame duck session, some of these values needed to be reasserted. We do face problems requiring government and collective action, as the president discussed. The nation is not divided neatly into givers and takers as Governor Romney believes. Equal opportunity for every American ought not to be a question we debate. And even in the middle of a bitter immigration dispute about who are or can become Americans, we have to act decently. We ought to be able to resolve our immigration problem without seemingly taking delight in making good and decent men and women miserable, even if they are here "illegally."

I even found the president's statement of support for Medicaid, Medicare, and Social Security completely traditional and unexceptional. The statement that "The commitments we make to each other – through Medicare, and Medicaid, and Social Security – these things do not sap our initiative; they strengthen us" is hardly a call to the barricades. Who out there expected the president, after winning a second term, to say anything differently? Who put the odds very high above zero that the president would suddenly acknowledge that Paul Ryan was right after all?

And I'm delighted that the president finally returned to climate change -- although it is very, very late. I'll acknowledge a high degree of self-interest here. I chair Resources for the Future, a 65-year-old economic think tank that is one of the world's leading centers of thought on climate, energy, and the environment. I believe there are more and less effective ways to approach climate and environmental issues, but I think the problems are real and have to be addressed. It is depressing that much of the Republican Party -- once again never missing a chance to miss a chance -- has decided, immediately after the president's speech, that the whole climate issue is a ruse, part of a deviously clever plot by the president to expand the regulatory state. I guess I'm glad for the human species that there are climate deniers like Holman Jenkins and George Will who are so awesomely smart that with 1,000 words and a few anecdotes they can disprove a quarter century of climate science. But I don't take a word of any of this as serious commentary. Since we are, right now, trashing the planet, I hope forging a long-term creative approach to this central question is how the president chooses to be transformational.

But this brings me to the incompleteness of the president's vision. America is a great deal more -- and is entering times more challenging -- than today's conventional progressive vision suggests or the president said in his speech. I'd underline three subjects the president left out: change, business and economic growth, and our decentralized society.

To start with, we are facing immense simultaneous changes in our economy, the world economy, technology, the diversity of our population, the nature of work, and our environment. Any vision you choose to have about America has to be put in the context of these changes.

But we are experiencing a very low rate of economic growth, and we cannot cope with these big changes unless our economic growth rate rises. The only way that can really happen is through business and the private sector. We have the most dynamic and innovative private sector in the world. Unless it stays that way, as a nation we won't be able to afford all of that collective action the president wants. However, the president never mentions the private sector and it seems conspicuously excluded from his insistence that we have to work together. To have the only mention of the private sector focus exclusively on rules and regulations just isn't remotely appropriate.

More broadly, we have the richest and most diverse civil society in the world, strong state and local governments, and an ethos that is insistently individualistic and decentralized. These are mostly strengths. Big government and big companies really do have a strong tendency to take all of the air out of the room, to homogenize everything, and to relentlessly oppose innovation and change. It is our decentralization and diversity that makes us a uniquely dynamic nation.

We are a very complicated mosaic and much more of it should be celebrated than the president chose to in his speech. I wish he had put his insistence on the timeless quality of the values he underlined in the context both of the need to retain the dynamism of American society and the American economy and in the context of the immense changes we are facing. How to keep these values fresh in the midst of the changes we have to navigate -- that's a topic made for a second inaugural.

Finally, a brief specific point. The president said, "[W]e reject the belief that America must choose between caring for the generation that built this country and investing in the generation that will build its future." Great. But that's exactly the choice we are making now, and there is no sign we are changing. Our national government is already mostly about defense, transfer payments to the elderly, and the cost of our (growing) debt. On current trends we will spend all of our tax revenues on those three functions in the year 2020. And the president's speech was decidedly lukewarm about resolving the state of our fiscal health. If I were in the generation that "will build America's future," I'd be gratified by the sentiment and all, but I'd worry a lot more about the numbers.

Roosevelt Institute Senior Fellow Bo Cutter is formerly a managing partner of Warburg Pincus, a major global private equity firm. Recently, he served as the leader of President Obama’s Office of Management and Budget (OMB) transition team. He has also served in senior roles in the White Houses of two Democratic Presidents.

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No, the 90 Percent Debt Threshold Hasn't Been Proven

Jan 28, 2013Mike Konczal

The deficit hawks at the Washington Post editorial board are worried. They are worried that the deficit is falling and the debt-to-GDP ratio is leveling off as a result of the numerous cuts and tax increases implemented over the past two years. Liberals know this and are starting to push back, either claiming that the deficit is coming down too quickly or arguing that the main medium-term deficit issues are taken care of and we should focus more on unemployment and other non-budget issues while implementing Obamacare reforms well. The CBPP has been leading the charge on this, noting various levels at which debt as a percent of GDP would level off in the following graphic:

The editorial focuses on the debt-to-GDP ratio leveling out too close to a 90 percent threshold. The writers also claim that there is a well-defined and well-established 90 percent threshold over which our economy will suffer. They write, "The CBPP analysis assumes steady economic growth and no war. If that’s even slightly off, debt-to-GDP could keep rising — and stick dangerously near the 90 percent mark that economists regard as a threat to sustainable economic growth." This 90 percent threshold was proposed by Carmen Reinhart and Kenneth Rogoff in their 2010 article "Growth in a Time of Debt" (GITD). They found that economies with public debt over 90 percent of debt-to-GDP grew more slowly than other countries.

It's always tough to figure out where consensus among economists lies. But economists don't "regard" the 90 percent mark as definitive; in fact, this study and its claim have never even been peer reviewed by an economics journal. [1]

I don't bring this up because something that's peer reviewed should automatically be accepted as definitive, or that credentials are everything, or that only Very Serious Economics matter. (That's a bad rule in general, and as an economics blogger that would be a doubly insane claim.) I bring it up only because the public should understand that the 90 percent threshold couldn't survive peer review for a very important reason: It's impossible to seperate the cause and effect here given the evidence collected. Policymakers and deficit hawks should reconsider if they're running under the assumption that this is a well-established rule.

Remember that growth that is suprisingly slow will increase the debt-to-GDP ratio relative to expectations by definition. And periods of slower growth will lead to higher debt levels. That doesn't mean that those debt loads caused the slower growth -- in these cases it would be just the opposite. Reinhart and Rogoff present no techniques, tools or theory to break this problem down and determine what is the cause and what is the effect in this debt versus GDP relationship.

As John Irons and Josh Bivens of EPI noted in their review of the GITD paper (my bold):

First, the theory that governs the relation between debt and growth suggests strongly that causality runs more firmly from slower growth to higher debt loads. Slow economic growth, and especially growth that is slower than policy makers’ expectations, will lead to higher levels of debt as revenues fall and as automatic-stabilizer spending increases... Importantly, the timing matters. Persistent slow growth will yield high debt levels, and will thus mechanically yield to contemporaneous combinations of high debt and slow growth...

In short, the statistical evidence strongly suggests that the causality runs from growth to debt, and not the reverse. Given that theory and preliminary investigation agree in this case, it seems clear that the GITD analysis—which looks only at contemporaneous levels of debt and growth—is much more likely to capture causal relationships running from slow growth to high debt. This means there is very little reason for policy makers to think that there is a high-debt threshold that acts to slow growth.

As one economist wrote me in an email, "it is likely unpublishable in a top journal due to the fact that they have not developed any techniques to tease out causality in what are suggestive but non-conclusive correlations. For this work to be the *one* thing that politicians decide to take from economics is horrible."

You can think that lower debt is better than higher debt ratios. You can be worried about interest payments, even though those are at a 30-year low and projected to go back to historical averages. But there isn't a great reason to believe that that leveling out at 80 versus 90 percent of GDP matters that much when we have mass unemployment, low interest rates, and inflation in check. Growth matters just as much as GDP for this calculation, and it's a terrible deal if we sacrifice either immediate growth or long-term investments in an attempt to bring down this debt-to-GDP ratio. There isn't good evidence that the levels matter that much if the plan works, and it is likely the plan won't work. Weakening growth is likely to balloon that deficit as well.

It's important to get a sense of where the deficit hawks will focus next because, if it is true that the deficit wars are coming to an end, all those giant deficit hawk groups are still funded through the apocalypse. Their mission will be that of Peter Venkman in Ghostbusters: "Type something, will you? We're paying for this stuff." How will they keep busy and justify their taxpayer-subsidized funding? We may have just gotten an important glimpse.

[1] According to their C.V.s, it's been published in the May 2010 issue of the American Economic Review, which is a special non-reviewed "papers and proceedings" issue.

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The deficit hawks at the Washington Post editorial board are worried. They are worried that the deficit is falling and the debt-to-GDP ratio is leveling off as a result of the numerous cuts and tax increases implemented over the past two years. Liberals know this and are starting to push back, either claiming that the deficit is coming down too quickly or arguing that the main medium-term deficit issues are taken care of and we should focus more on unemployment and other non-budget issues while implementing Obamacare reforms well. The CBPP has been leading the charge on this, noting various levels at which debt as a percent of GDP would level off in the following graphic:

The editorial focuses on the debt-to-GDP ratio leveling out too close to a 90 percent threshold. The writers also claim that there is a well-defined and well-established 90 percent threshold over which our economy will suffer. They write, "The CBPP analysis assumes steady economic growth and no war. If that’s even slightly off, debt-to-GDP could keep rising — and stick dangerously near the 90 percent mark that economists regard as a threat to sustainable economic growth." This 90 percent threshold was proposed by Carmen Reinhart and Kenneth Rogoff in their 2010 article "Growth in a Time of Debt" (GITD). They found that economies with public debt over 90 percent of debt-to-GDP grew more slowly than other countries.

It's always tough to figure out where consensus among economists lies. But economists don't "regard" the 90 percent mark as definitive; in fact, this study and its claim have never even been peer reviewed by an economics journal. [1]

I don't bring this up because something that's peer reviewed should automatically be accepted as definitive, or that credentials are everything, or that only Very Serious Economics matter. (That's a bad rule in general, and as an economics blogger that would be a doubly insane claim.) I bring it up only because the public should understand that the 90 percent threshold couldn't survive peer review for a very important reason: It's impossible to seperate the cause and effect here given the evidence collected. Policymakers and deficit hawks should reconsider if they're running under the assumption that this is a well-established rule.

Remember that growth that is suprisingly slow will increase the debt-to-GDP ratio relative to expectations by definition. And periods of slower growth will lead to higher debt levels. That doesn't mean that those debt loads caused the slower growth -- in these cases it would be just the opposite. Reinhart and Rogoff present no techniques, tools or theory to break this problem down and determine what is the cause and what is the effect in this debt versus GDP relationship.

As John Irons and Josh Bivens of EPI noted in their review of the GITD paper (my bold):

First, the theory that governs the relation between debt and growth suggests strongly that causality runs more firmly from slower growth to higher debt loads. Slow economic growth, and especially growth that is slower than policy makers’ expectations, will lead to higher levels of debt as revenues fall and as automatic-stabilizer spending increases... Importantly, the timing matters. Persistent slow growth will yield high debt levels, and will thus mechanically yield to contemporaneous combinations of high debt and slow growth...

In short, the statistical evidence strongly suggests that the causality runs from growth to debt, and not the reverse. Given that theory and preliminary investigation agree in this case, it seems clear that the GITD analysis—which looks only at contemporaneous levels of debt and growth—is much more likely to capture causal relationships running from slow growth to high debt. This means there is very little reason for policy makers to think that there is a high-debt threshold that acts to slow growth.

As one economist wrote me in an email, "it is likely unpublishable in a top journal due to the fact that they have not developed any techniques to tease out causality in what are suggestive but non-conclusive correlations. For this work to be the *one* thing that politicians decide to take from economics is horrible."

You can think that lower debt is better than higher debt ratios. You can be worried about interest payments, even though those are at a 30-year low and projected to go back to historical averages. But there isn't a great reason to believe that that leveling out at 80 versus 90 percent of GDP matters that much when we have mass unemployment, low interest rates, and inflation in check. Growth matters just as much as GDP for this calculation, and it's a terrible deal if we sacrifice either immediate growth or long-term investments in an attempt to bring down this debt-to-GDP ratio. There isn't good evidence that the levels matter that much if the plan works, and it is likely the plan won't work. Weakening growth is likely to balloon that deficit as well.

It's important to get a sense of where the deficit hawks will focus next because, if it is true that the deficit wars are coming to an end, all those giant deficit hawk groups are still funded through the apocalypse. Their mission will be that of Peter Venkman in Ghostbusters: "Type something, will you? We're paying for this stuff." How will they keep busy and justify their taxpayer-subsidized funding? We may have just gotten an important glimpse.

[1] According to their C.V.s, it's been published in the May 2010 issue of the American Economic Review, which is a special non-reviewed "papers and proceedings" issue.

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Obama’s Second Inaugural Should Reject the “Job Creators” Vision of Capitalism

Jan 18, 2013John Paul Rollert

Now is the time to articulate a vision of capitalism that doesn't rely on the Visible Hand.

An inaugural address finds presidents at their most philosophical. Policy prescriptions are neither expected nor desired, and the solemnity of the occasion lends itself to reflection.

Now is the time to articulate a vision of capitalism that doesn't rely on the Visible Hand.

An inaugural address finds presidents at their most philosophical. Policy prescriptions are neither expected nor desired, and the solemnity of the occasion lends itself to reflection.

But a second inaugural address differs from the first in one important way, for it must respond to recent history. A newly installed president, without any real responsibility for the larger events that saw his election, can indulge in hopeful prophecy, but a re-elected president owns the immediate past. It, and not his address, is prologue to a second term, and so, especially in troubled times, his speech must take shape around present challenges.

The financial crisis cast a long shadow over President Obama’s first term.  Yet in his battle to deliver the economy from a steep financial downturn, he stumbled into a war of sorts over how capitalism works. This is a conflict the president would no doubt have rather avoided—the presidency is challenging enough without having to convince a substantial portion of the electorate that your aim is not to subvert capitalism but to save it from itself. However, the deep disagreement over how the crisis came about, much less how it might be resolved, made an ideological debate over the very nature of capitalism all but unavoidable.

What exactly is the nub of the disagreement? During the election, everything Republicans believed to be wrong with the president’s approach to economic policy was epitomized by the “You didn’t build that” remark. The remark came amid off-the-cuff comments President Obama made at a campaign rally in July. A first-time listener might be forgiven for mistaking the endlessly disputed that, but a review of the transcript clearly shows it refers to public infrastructure—roads, bridges, educational institutions, and the like—that is necessary, if not sufficient, for a private enterprise to thrive.

At the time, some Republicans tried to twist the remark to suggest that Obama believed that business owners don’t actually have a hand in building their own businesses, a contention that was not implausible so much as incoherent. However, shrewder observers insisted that the significance of the remark lay beyond its plain meaning. “It’s an explanation,” Paul Ryan declared in a campaign stop at the site of the remark. “It tells us why our economy is not growing like it should. It tells us the mindset that he’s using to lead our government. It tells us that he believes in a government-centered society and a government-driven economy.” For Ryan and others, it suggested that President Obama rejected the “job creators” vision of economic development favored by Republicans, or what one might call the Visible Hand theory of capitalism.

This theory finds its first and most formidable expression in the work of Joseph Schumpeter, the mid-20th century Austrian economist who cast the entrepreneur as the action hero of economic growth. As far back as Adam Smith, economists had regarded the serene stasis of perfect competition as a kind of endpoint for capitalism. But Schumpeter believed this ideal blinded them not only to the chaotic reality of capitalism but to the revolutionary power of instability to pull or, more accurately, yank an economy ahead.

“Economic progress, in capitalist society, means turmoil,” he declared in his classic work Capitalism, Socialism, and Democracy. The system “is incessantly being revolutionized from within by new enterprise, i.e., by the intrusion of new commodities or new methods of production or new commercial opportunities into the industrial structure.” The people who fomented such destabilizing changes were Schumpeter’s entrepreneurs. Their efforts constituted a “distinct economic function,” one that gave rise to new possibilities in the capitalist order even as they foreclosed old ones.

Especially in Schumpeter’s early writings, the entrepreneurial class embodies the Visible Hand of capitalism. In his first book, The Theory of Economic Development, Schumpeter celebrates the entrepreneur as a “man of action,” a larger than life individual whose keen intellect, swashbuckling spirit, and stubborn irreverence toward the commercial status quo made his activity “the greatest and most splendid element that economic life offers to the observer.”

But though he never yielded pride of place in Schumpeter’s system, the entrepreneur evolved from a class of superman, distinct and identifiable, to a spirit of sorts that animated capitalism. That evolution is captured by the very way in which Schumpeter emphasized the impact of the entrepreneur. Early on he terms it “creative construction” before changing to the always-capitalized “Creative Destruction,” a subtle revision that prized the secondary consequences of entrepreneurial endeavors over their self-conscious aims.

The shift in emphasis coincided with a greater awareness by Schumpeter of what he called the “cultural performance” of capitalism, its tendency to subvert traditional ways of life and undermine social cohesion. “[O]ne may care less for the efficiency of the capitalist process in producing economic and cultural values,” he candidly admitted, “than for the kind of human beings that it turns out and then leaves to their own devices, free to a make a mess of their lives.”

Ayn Rand’s radical individualism made her the natural person to adopt Schumpeter’s vision and relieve it of its social qualms. Though she never acknowledged her debt to Schumpeter, Rand also locates the engine of capitalism in an “exceptional minority who lift the whole of a free society to the level of their own achievements.”

This passage comes from What Is Capitalism?, an essay published in 1965, 15 years after Schumpeter’s death. In it, Rand provides an eye-opening description of the just deserts implied by her vision of capitalism:

The man at the top of the intellectual pyramid contributes the most to all those below him, but gets nothing except his material payment, receiving no intellectual bonus from others to add to the value of his time. The man at the bottom who, left to himself, would starve in his hopeless ineptitude, contributes nothing to those above him, but receives the bonus of all their brains.

In other words, to the victors can’t go spoils enough.

Rand’s ethics of achievement, together with Schumpeter’s opinion of the essential place of the entrepreneur, provide the Visible Hand its moral license and theoretical integrity. In the 2012 campaign, it found an impassioned spokesman in Paul Ryan, whose speech at the Republican National Convention was a celebration of this vision. “With tax fairness and regulatory reform,” he pledged, “we'll put government back on the side of the men and women who create jobs, and the men and women who need jobs.”

Yet even among those sympathetic to the Republican ticket, the unavoidable elitism of the Visible Hand left some feeling cold. “In Ryan’s intellectual bubble, there are job creators and entrepreneurs on one side and parasites on the other,” wrote Scott Galupo of The American Conservative the morning after Ryan’s speech. “There is no account of the vast gray expanse of janitors, waitresses, hotel front-desk clerks, nurses, highway maintenance workers, airport baggage handlers and taxi-drivers. They work hard, but at the end of the day, what can they be said to have ‘built’?”  

The answer, of course, is nothing—at least nothing essential to economic development. What so struck Adam Smith about the commercial system he described, “the assistance and co-operation of many thousands,” is entirely taken for granted. The daily labors of a nation are a mere fait accompli to the executive decisions of a few.

Such a vision sits uncomfortably amid democratic values of equality, empathy, and the inherent dignity of the individual, but it becomes intolerable when the theory underpinning it becomes a pretense for naked privilege. Whatever the merits of Schumpeter’s theory of entrepreneurship, his “job creators” were a class defined by spirit, not tax status. To the degree that Republicans conflate the two, they make a travesty of Visible Hand.

An aristocracy of talents is no doubt preferable to the politics of plutocracy, but neither one is commensurate with a vision of capitalism that takes as its point of departure, and its final destination, a concern for the common good. President Obama recognizes this. “Ever since” the financial crisis began, he said in his most powerful speech of the 2012 campaign, “there has been a raging debate over the best way to restore growth and prosperity; balance and fairness.” This isn’t “just another political debate,” he continued. “This is the defining issue of our time.”

And it will only continue to be, what with the upcoming battles over the sequester and the debt ceiling in addition to ongoing debates over entitlement reform, budget deficits, and tax rates. President Obama’s second inaugural address provides him a unique opportunity to describe the challenges of a common capitalism and to put forward a vision of economic development that doesn’t see us waiting on the deliverance of an enlightened few, but one in which there is dignity and place for everyone to lend a hand. 

John Paul Rollert is an Adjunct Assistant Professor of Behavioral Science at the University of Chicago Booth School of Business.

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Are "Educational Services" Off-Setting the Reduced Number of Public Education Workers?

Jan 15, 2013Mike Konczal

One important reason the recovery has been so weak has been the collapse in the number of government employees, a decline that continues years after the recession has technically "ended." An important check on the economy, unemployment would be significant lower if there weren't 651,000 fewer government jobs since January 2009.

Education jobs are a large part of this decline. State and local education job together declined 224,700 since January 2009. These losses are entirely at the local level, with state-level education workers going up slightly over the time period. This is consistent with declining spending on public primary and secondary education broadly in the states, and a large increase in the number of young people attending higher educaiton.

But what if these public sector jobs are being replaced with private sector ones? Several people on twitter have noted that the number of "educational service" jobs have gone up quite significantly in the past several years, gaining 244,500 jobs since January 2009. What if they are replacing K-12 education workers? That would be a much different picture of how the public sector is evolving in the past several years.

Luckily, the CES has the ability to break out primary and secondary education workers from education services. Let's graph this out:

(The breakout is not seasonally adjusted, and education has large seasonal changes. As such, all these numbers are a 12-month moving average. The conclusions are robust to other specifications.)

As you can see, there's been a minimal increase in the number of private elementary and secondary school workers, on the order of an increase of 39,600, all relatively recent. The vast majority of the increase in education sector workers are working in postsecondary education. This is consistent with the large increase in post-secondary education we are seeing in this recession. The private sector isn't offsetting either the state and local level austerity imposed through the school system, nor is it, as far as I can see, offsetting the major disinvestments we are making in the education and opportunities of our young people.

 

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One important reason the recovery has been so weak has been the collapse in the number of government employees, a decline that continues years after the recession has technically "ended." An important check on the economy, unemployment would be significant lower if there weren't 651,000 fewer government jobs since January 2009.

Education jobs are a large part of this decline. State and local education job together declined 224,700 since January 2009. These losses are entirely at the local level, with state-level education workers going up slightly over the time period. This is consistent with declining spending on public primary and secondary education broadly in the states, and a large increase in the number of young people attending higher educaiton.

But what if these public sector jobs are being replaced with private sector ones? Several people on twitter have noted that the number of "educational service" jobs have gone up quite significantly in the past several years, gaining 244,500 jobs since January 2009. What if they are replacing K-12 education workers? That would be a much different picture of how the public sector is evolving in the past several years.

Luckily, the CES has the ability to break out different groups of educational services workers, so we can focus on primary and secondary education workers as well more post-secondary workers. Let's graph this out:

(The breakout is not seasonally adjusted, and education has large seasonal changes. As such, all these numbers are a 12-month moving average. The conclusions are robust to other specifications.)

As you can see, there's been a minimal increase in the number of private elementary and secondary school workers, on the order of an increase of 39,600, all relatively recent. The vast majority of the increase in education sector workers are working in postsecondary education. This is consistent with the large increase in post-secondary education we are seeing in this recession. The private sector isn't offsetting either the state and local level austerity imposed through the school system, nor is it, as far as I can see, offsetting the major disinvestments we are making in the education and opportunities of our young people.

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What Does the New Community Reinvestment Act (CRA) Paper Tell Us?

Dec 11, 2012Mike Konczal

There are two major, critical questions that show up in the literature surrounding the 1977 Community Reinvestment Act (CRA).

The first question is how much compliance with the CRA changes the portfolio of lending institutions. Do they lend more often and to riskier people, or do they lend the same but put more effort into finding candidates? The second question is how much did the CRA lead to the expansion of subprime lending during the housing bubble. Did the CRA have a significant role in the financial crisis?
 
There's a new paper on the CRA, Did the Community Reinvestment Act (CRA) Lead to Risky Lending?, by Agarwal, Benmelech, Bergman and Seru, h/t Tyler Cowen, with smart commentary already from Noah Smith. (This blog post will use the ungated October 2012 paper for quotes and analysis.) This is already being used as the basis for an "I told you so!" by the conservative press, which has tried to argue that the second question is most relevant. However, it is important to understand that this paper answers the first question, while, if anything, providing evidence against the conservative case for the second.
 
Where is the literature on these two questions? One starting point is the early 2009 research of two Federal Reserve economists, Neil Bhutta and Glenn B. Canner, also summarized in this Randy Kroszner speech. On the first question Kroszner summarizes research by the Federal Reserve, the latest being from 2000, arguing that "lending to lower-income individuals and communities has been nearly as profitable and performed similarly to other types of lending done by CRA-covered institutions." The CRA didn't cause changes to banks' portfolios, but instead required them to find better opportunities. More on this in a minute.
 
What about the second question? Here the Bhutta/Canner research notes that only six percent of higher-priced loans (their proxy for subprime loans) were extended by CRA-covered lenders to lower-income borrowers or CRA neighborhoods. 94 percent of these loans were either made by non-traditional banks not covered by the CRA (the "shadow banking system"), or not counted towards CRA credits. As Kroszner noted, "the very small share of all higher-priced loan originations that can reasonably be attributed to the CRA makes it hard to imagine how this law could have contributed in any meaningful way to the current subprime crisis."
 
How did those loans do? Here the research compared the performance of subprime and alt-A loans in neighborhoods right above and right below the CRA's income threshold, and found that there was no difference in how the loans performed. Hence the idea that a CRA-driven subprime bubble isn't found in the data. (The FCIC's final report, starting at page 219, has more on this and other research.)
 
So what does this new research do? It takes banks that were undergoing a normal examination to see if they were in compliance with the CRA, and thus under heightened regulatory scrunity, and compares their loan portfolios with banks that were not undergoing a CRA examination. It finds that the CRA exam increases loans 5 percent every quarter surrounding the event and those loans default 15 percent more often, under the idea that those banks were ramping up their loans to pass the CRA exam.
 
But this is question 1 territory. 94 percent of higher priced loans came outside CRA firms and outside CRA loans, and this research doesn't really change that. Since we are talking about regular mortgages - more on that in a second - that higher default isn't that scary. To put that in perspective, loans made in the quarter following the initiation of a CRA exam in a non-CRA tract are 8.3 percent more likely to be 90 days delinquent. That sounds scary, but it is an increase of 0.1, from 1.2 percent to 1.3 percent. In the CRA tract it is 33 percent more likely to default, going from 1.2 percent to 1.6 percent. FICO scores drop 7 points from 713.9 to 706.9. That's an increase I wouldn't want in my portfolio, but it is light-years away from 25%+ default rates, and very low FICO scores, on actual subprime.
 

This research, if anything, pushes against movement conservative CRA arguments. In light of the evidence in question 2, many conservatives argue that regulators used CRA to push down lending standards, which then impacted other firms. But this paper finds that extra loans aren't more likely to have higher interest rates, lower loan-to-value, or be balloon/interest-only/jumbo/buy-down mortgages, although there is a slight increase in undocumented loans. And their borrowers aren't more likely to have risky characteristics themselves. The authors conclude that "this pattern is consistent with banks’ strategic attempts to convince regulators that the loans they extend that meet CRA criteria are not overtly risky."

Read that again. The authors argue, from their empirical evidence, that regulators were trying to make sure these loans had high standards, and CRA banks tried to comply with that as best they could on the major, visible risks of their loans. This is the opposite argument made by people like John Carney, who believes the CRA "encourag[ed] lenders to adopt loose standards for mortgages." It also pushes against people like Peter Wallison, who, in his FCIC dissent, argued that CRA loans were more likely to have subprime characteristics or riskier borrowers in ways not captured by a higher-price variable. Not the case.

It also finds that loan volume and risk increases the most during 2004-2006, and points to the private securitization market as an important channel. This, along with characteristics above, pushes back against the idea that the CRA primed a subprime pump in the late 1990s and early 2000s, another favorite of movement conservative finance writers. If anything, banks undergoing CRA exams were caught up in the same mechanisms that were causing the housing bubble itself.

I'm not sure I buy all of the research. If CRA banks take on too many loans during examination, why wouldn't they just loan less afterwards, balancing out? The paper jumps to argue the opposite, as it is worried that "adjustment costs may cause banks to keep elevated lending rates even after the CRA exam is formally completed." This is meant to establish their results as a lower-bound, rather than an upper-bound. But really? They managed to ramp up their lending in enough time during this time. Either way it would throw a very different set of interpretations on their research. I'm interested in seeing how other researchers react to these problems. But for now these results don't change the way we approach the financial crisis.

 

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There are two major, critical questions that show up in the literature surrounding the 1977 Community Reinvestment Act (CRA).

The first question is how much compliance with the CRA changes the portfolio of lending institutions. Do they lend more often and to riskier people, or do they lend the same but put more effort into finding candidates? The second question is how much did the CRA lead to the expansion of subprime lending during the housing bubble. Did the CRA have a significant role in the financial crisis?
 
There's a new paper on the CRA, Did the Community Reinvestment Act (CRA) Lead to Risky Lending?, by Agarwal, Benmelech, Bergman and Seru, h/t Tyler Cowen, with smart commentary already from Noah Smith. (This blog post will use the ungated October 2012 paper for quotes and analysis.) This is already being used as the basis for an "I told you so!" by the conservative press, which has tried to argue that the second question is most relevant. However, it is important to understand that this paper answers the first question, while, if anything, providing evidence against the conservative case for the second.
 
Where is the literature on these two questions? One starting point is the early 2009 research of two Federal Reserve economists, Neil Bhutta and Glenn B. Canner, also summarized in this Randy Kroszner speech. On the first question Kroszner summarizes research by the Federal Reserve, the latest being from 2000, arguing that "lending to lower-income individuals and communities has been nearly as profitable and performed similarly to other types of lending done by CRA-covered institutions." The CRA didn't cause changes to banks' portfolios, but instead required them to find better opportunities. More on this in a minute.
 
What about the second question? Here the Bhutta/Canner research notes that only six percent of higher-priced loans (their proxy for subprime loans) were extended by CRA-covered lenders to lower-income borrowers or CRA neighborhoods. 94 percent of these loans were either made by non-traditional banks not covered by the CRA (the "shadow banking system"), or not counted towards CRA credits. As Kroszner noted, "the very small share of all higher-priced loan originations that can reasonably be attributed to the CRA makes it hard to imagine how this law could have contributed in any meaningful way to the current subprime crisis."
 
How did those loans do? Here the research compared the performance of subprime and alt-A loans in neighborhoods right above and right below the CRA's income threshold, and found that there was no difference in how the loans performed. Hence the idea that a CRA-driven subprime bubble isn't found in the data. (The FCIC's final report, starting at page 219, has more on this and other research.)
 
So what does this new research do? It takes banks that were undergoing a normal examination to see if they were in compliance with the CRA, and thus under heightened regulatory scrunity, and compares their loan portfolios with banks that were not undergoing a CRA examination. It finds that the CRA exam increases loans 5 percent every quarter surrounding the event and those loans default 15 percent more often, under the idea that those banks were ramping up their loans to pass the CRA exam.
 
But this is question 1 territory. 94 percent of higher priced loans came outside CRA firms and outside CRA loans, and this research doesn't really change that. Since we are talking about regular mortgages - more on that in a second - that higher default isn't that scary. To put that in perspective, loans made in the quarter following the initiation of a CRA exam in a non-CRA tract are 8.3 percent more likely to be 90 days delinquent. That sounds scary, but it is an increase of 0.1, from 1.2 percent to 1.3 percent. In the CRA tract it is 33 percent more likely to default, going from 1.2 percent to 1.6 percent. FICO scores drop 7 points from 713.9 to 706.9. That's an increase I wouldn't want in my portfolio, but it is light-years away from 25%+ default rates, and very low FICO scores, on actual subprime.
 

This research, if anything, pushes against movement conservative CRA arguments. In light of the evidence in question 2, many conservatives argue that regulators used CRA to push down lending standards, which then impacted other firms. But this paper finds that extra loans aren't more likely to have higher interest rates, lower loan-to-value, or be balloon/interest-only/jumbo/buy-down mortgages, although there is a slight increase in undocumented loans. And their borrowers aren't more likely to have risky characteristics themselves. The authors conclude that "this pattern is consistent with banks’ strategic attempts to convince regulators that the loans they extend that meet CRA criteria are not overtly risky."

Read that again. The authors argue, from their empirical evidence, that regulators were trying to make sure these loans had high standards, and CRA banks tried to comply with that as best they could on the major, visible risks of their loans. This is the opposite argument made by people like John Carney, who believes the CRA "encourag[ed] lenders to adopt loose standards for mortgages." It also pushes against people like Peter Wallison, who, in his FCIC dissent, argued that CRA loans were more likely to have subprime characteristics or riskier borrowers in ways not captured by a higher-price variable. Not the case.

It also finds that loan volume and risk increases the most during 2004-2006, and points to the private securitization market as an important channel. This, along with characteristics above, pushes back against the idea that the CRA primed a subprime pump in the late 1990s and early 2000s, another favorite of movement conservative finance writers. If anything, banks undergoing CRA exams were caught up in the same mechanisms that were causing the housing bubble itself.

I'm not sure I buy all of the research. If CRA banks take on too many loans during examination, why wouldn't they just loan less afterwards, balancing out? The paper jumps to argue the opposite, as it is worried that "adjustment costs may cause banks to keep elevated lending rates even after the CRA exam is formally completed." This is meant to establish their results as a lower-bound, rather than an upper-bound. But really? They managed to ramp up their lending in enough time during this time. Either way it would throw a very different set of interpretations on their research. I'm interested in seeing how other researchers react to these problems. But for now these results don't change the way we approach the financial crisis.

 

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Another Reason to Kill the Debt Ceiling: Conservative Think Tanks' Responses to Default

Dec 5, 2012Mike Konczal

House Republicans are looking to weaponize the debt ceiling again, while the Obama administration is trying to make removing the threat of default part of any agreement.

Here's one reason why the debt ceiling needs to go: the conservative intellectual infrastructure cheered on a potential default. I had imagined that there would be a good cop/bad cop dynamic to the right. Very conservative political leaders would be the bad cop, saying that they weren't afraid to default on the debt, while conservative think tanks would play a version of the good cop, warning of the dire consequences of a default for the economy if their bad cop friend didn't get his way.

For instance, here's bad cop Sen. Pat Toomey (R-PA) saying that the markets "would actually accept even a delay in interest payments on the Treasuries," especially "if it meant that Congress would right this ship, address this fiscal imbalance, and put us on a sustainable path, and that the bond market would rally if it saw we were making real progress towards this." Missing interest payments is fine; in fact, it is great for the country if it is used to pass the Ryan Plan.

Financial analysts, to put it mildly, disagreed. JP Morgan analysts wrote that "any delay in making a coupon or principal payment by Treasury would almost certainly have large systemic effects with long-term adverse consequences for Treasury finances and the US economy."

Here's where the think tanks are fascinating. You could image them saying "our partner Toomey is nuts, we can't control him, and you better do what he says or there's going to be real damage." But that's not what they did. It's best to split the work they did on the debt ceiling in two directions:

1. Technical Default Ain't No Thang. The first is arguing, like Toomey, that a "technical default" wouldn't matter, and in fact it could be a great thing if the Ryan Plan passed as a result. How did James Pethokoukis, then of Fortune and now of AEI, deal with a Moody's report arguing a "short-lived default" would hurt the economy? Pethokoukis: "I guess I would care more about what Moody’s had to say if a) they hadn’t missed the whole financial crisis, b) didn’t want to see higher taxes as part of any fiscal fix and c) if they made any economic sense." Default doesn't matter because Pethokoukis doesn't want taxes to go up, and there's no economic sense because of an interview he read in the Wall Street Journal.

Others went even further, arguing that the real defaulters are those who, umm, don't want to default on the debt. Here's the conservative think tank e21 with a staff editorial arguing that "policymakers need to stay focused on the real default issue: whether the terms of the debt limit increase this summer will be sufficiently tough to ensure that the nation’s debt-to-GDP ratio is stabilized and eventually sharply reduced." All these people who want a clean debt ceiling increase are causing the real default issue. As someone who used to do a lot of credit risk modeling, this is my favorite: "Indeed, those demanding the toughest concessions today actually have a strong pro-creditor bias." S&P disagreed with whoever wrote that editorial and increased the credit risk (downgraded) based on the threat of this technical default.

Heritage wrote a white paper saying that you could just "hold the debt limit in place, thereby forcing an immediate reduction in non-interest spending averaging about $125 billion each month," and that "refusing to raise the debt limit would not, in and of itself, cause the United States to default on its public debt." Dana Milbank noted that these kinds of shuffling plans would still leave the government short and likely cause a recession. Milbank: "Without borrowing, we’d have to cut Obama’s budget for 2012 by $1.5 trillion. That means even if we shut down the military and stopped writing Social Security checks, the government would still come up about $200 billion short." Cato also jumped in with the technical default crowd here.

But that was the reaction from the number-crunching analysts. What about the bosses?

2. Civilization Hangs in the Balance of the Debt Ceiling Fight. Here's the president of AEI, Arthur C. Brooks, in July 2011: "The battle over the debt ceiling...is not a political fight between Republicans and Democrats; it is a fight against 50-year trends toward statism...No one deserves our political support today unless he or she is willing to work for as long as it takes to win the moral fight to steer our nation back toward enterprise and self-governance."

Even better, the president of the Heritage Foundation, also in July 2011, compares Democrats to Japan during World War II and then argues: "We must win this fight. The debate over raising the debt limit seems complicated, but it is really very simple. Look beyond the myriad details of the awkward compromises, and you see an epic struggle between two opposing camps....Congress should not raise the debt limit without getting spending under control."

So the the conservative intellectual infrastructure, which consumes hundreds of millions of dollars a year, looked at the possibility of a debt default and determined it was both inconsequential and also the only way to stop statism in our lifetimes. No wonder the time period around the debt ceiling in 2011 was such a disaster for our economy, killing around 250,000 jobs that should have been created. There's no reason to assume all the same players won't play an even worse cop this time around.

There's no good reason for the debt ceiling, and now there are really bad consequences for its existence. Time to end it.

Follow or contact the Rortybomb blog:
  

House Republicans are looking to weaponize the debt ceiling again, while the Obama administration is trying to make removing the threat of default part of any agreement.

Here's one reason why the debt ceiling needs to go: the conservative intellectual infrastructure cheered on a potential default. I had imagined that there would be a good cop/bad cop dynamic to the right. Very conservative political leaders would be the bad cop, saying that they weren't afraid to default on the debt, while conservative think tanks would play a version of the good cop, warning of the dire consequences of a default for the economy if their bad cop friend didn't get his way.

For instance, here's bad cop Sen. Pat Toomey (R-PA) saying that the markets "would actually accept even a delay in interest payments on the Treasuries," especially "if it meant that Congress would right this ship, address this fiscal imbalance, and put us on a sustainable path, and that the bond market would rally if it saw we were making real progress towards this." Missing interest payments is fine; in fact, it is great for the country if it is used to pass the Ryan Plan.

Financial analysts, to put it mildly, disagreed. JP Morgan analysts wrote that "any delay in making a coupon or principal payment by Treasury would almost certainly have large systemic effects with long-term adverse consequences for Treasury finances and the US economy."

Here's where the think tanks are fascinating. You could image them saying "our partner Toomey is nuts, we can't control him, and you better do what he says or there's going to be real damage." But that's not what they did. It's best to split the work they did on the debt ceiling in two directions:

1. Technical Default Ain't No Thang. The first is arguing, like Toomey, that a "technical default" wouldn't matter, and in fact it could be a great thing if the Ryan Plan passed as a result. How did James Pethokoukis, then of Fortune and now of AEI, deal with a Moody's report arguing a "short-lived default" would hurt the economy? Pethokoukis: "I guess I would care more about what Moody’s had to say if a) they hadn’t missed the whole financial crisis, b) didn’t want to see higher taxes as part of any fiscal fix and c) if they made any economic sense." Default doesn't matter because Pethokoukis doesn't want taxes to go up, and there's no economic sense because of an interview he read in the Wall Street Journal.

Others went even further, arguing that the real defaulters are those who, umm, don't want to default on the debt. Here's the conservative think tank e21 with a staff editorial arguing that "policymakers need to stay focused on the real default issue: whether the terms of the debt limit increase this summer will be sufficiently tough to ensure that the nation’s debt-to-GDP ratio is stabilized and eventually sharply reduced." All these people who want a clean debt ceiling increase are causing the real default issue. As someone who used to do a lot of credit risk modeling, this is my favorite: "Indeed, those demanding the toughest concessions today actually have a strong pro-creditor bias." S&P disagreed with whoever wrote that editorial and increased the credit risk (downgraded) based on the threat of this technical default.

Heritage wrote a white paper saying that you could just "hold the debt limit in place, thereby forcing an immediate reduction in non-interest spending averaging about $125 billion each month," and that "refusing to raise the debt limit would not, in and of itself, cause the United States to default on its public debt." Dana Milbank noted that these kinds of shuffling plans would still leave the government short and likely cause a recession. Milbank: "Without borrowing, we’d have to cut Obama’s budget for 2012 by $1.5 trillion. That means even if we shut down the military and stopped writing Social Security checks, the government would still come up about $200 billion short." Cato also jumped in with the technical default crowd here.

But that was the reaction from the number-crunching analysts. What about the bosses?

2. Civilization Hangs in the Balance of the Debt Ceiling Fight. Here's the president of AEI, Arthur C. Brooks, in July 2011: "The battle over the debt ceiling...is not a political fight between Republicans and Democrats; it is a fight against 50-year trends toward statism...No one deserves our political support today unless he or she is willing to work for as long as it takes to win the moral fight to steer our nation back toward enterprise and self-governance."

Even better, the president of the Heritage Foundation, also in July 2011, compares Democrats to Japan during World War II and then argues: "We must win this fight. The debate over raising the debt limit seems complicated, but it is really very simple. Look beyond the myriad details of the awkward compromises, and you see an epic struggle between two opposing camps....Congress should not raise the debt limit without getting spending under control."

So the the conservative intellectual infrastructure, which consumes hundreds of millions of dollars a year, looked at the possibility of a debt default and determined it was both inconsequential and also the only way to stop statism in our lifetimes. No wonder the time period around the debt ceiling in 2011 was such a disaster for our economy, killing around 250,000 jobs that should have been created. There's no reason to assume all the same players won't play an even worse cop this time around.

There's no good reason for the debt ceiling, and now there are really bad consequences for its existence. Time to end it.

Follow or contact the Rortybomb blog:
  

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