Inequality and the Fourth Estate

I have been slow to chime in on Thomas Piketty’s book, Capital in the 21st Century, but it is hard to ignore the chatter that the book has generated from those on all sides of the political spectrum. The book sheds welcome light on the topic of income and wealth inequality and it has rekindled a debate in the United States and Europe on an age-old question: Should we care if some individuals earn much more than others?

As individuals in a modern democracy we make social decisions about how much of each good to produce and consume through free trade in a market economy. The rules by which we trade with others are determined through democratic elections in which we give power to our representatives to transfer resources from one human being to another. And we interact with each other through conversations, free association and social media or through more organized forms of persuasion such as newspapers and television stations. 

As economists, we are sometimes justly accused by other social scientists of taking a narrow view of human nature. A human being, to the neoclassical economist, is a preference ordering over all possible actions that he or she may take over the course of a lifetime. That preference ordering is fixed at birth and swings into action at the age of consent, at which time each of us exercises our endowed ability to choose among competing alternatives to maximize our happiness. 

That, of course, is poppycock. The view of homo-economicus as a utility seeking machine is not to be found in Smith, who had a much richer view of human nature as evidenced by his “other book” on The Theory of Moral Sentiments. Nor is it to be found in John Stuart Mill’s eloquent defense of free speech in his essay On Liberty. Both of those eminent social scientists would, I am certain, have been open to the idea that our opinions are formed through rational argument with other human beings. Our preference orderings do determine our actions; but they are not preordained. Nature and nurture are equally important determinants of human action.

Politics and economics are two parts of a theory of social democracy. There is a third component of social theory which Thomas Carlyle referred to as the fourth estate. In Carlyle’s day that referred simply to the press. In the 21st century, it is any technology that promotes the spread of ideas.

Elections are not simple horse races between differing opinions, they are heavily influenced by advertising paid for by political machines that raise money from competing interest groups. The NY Daily News reported, in 2013, that a US Senate seat now costs $10.5 million to win. It is difficult for me to believe that this money is spent to endow potential voters with facts that they need in order to inform their own preexisting preference orderings over outcomes. Money buys votes by shaping opinion.

The power of money to influence elections suggests an answer to what is otherwise a perplexing question. Why are taxes on large estates currently set at such low rates? After all, we live in a democratic society in which the rules of the game are set by elected representatives in which every U.S. citizen gets one vote. Further, as Piketty reminds us, 1% of the U.S. population controls 30% of the wealth. Why don’t the 99%, as a matter of course, choose to confiscate wealth from the richest 1% of the population?

The conservative answer to that question is that “a rising tide lifts all boats”. According to that argument, a confiscatory estate tax would result in lower growth and all of us would be worse off. It is difficult to know if that proposition is right or wrong but the evidence from Scandinavian social democracies suggests that it is at least debatable. And for a substantial period of time following the end of WWII, growth did indeed benefit all parts of the income distribution. What Piketty has shown us, incontrovertibly I believe, is that since 1980 or thereabouts, it is only the rich and the very rich who have benefitted from growth. 

The rise of democratic institutions in nineteenth century England, was a response to the redistribution of wealth from landowners to the growing middle class that was created by the industrial revolution. Democracy was a safety valve that enabled the social cohesion necessary for everyone to thrive and it resulted in a massive redistribution of wealth from the landed aristocracy to the rest of society. That same safety valve will eventually lead to the enactment of a more comprehensive policy of redistribution as voters realize that there are limits to the argument that greed is good.

One can make moral arguments for or against the redistribution of income and wealth but at the end of the day those arguments only matter if they are persuasive to the average voter. In a democratic society, the power of money to influence public opinion can perhaps hold back the tide for another decade. Maybe it can hold back public opinion for two or more decades. But there will come a time when the average American realizes that the dream that his parents aspired to is no longer within his reach. And at that point, the enactment of a more comprehensive estate tax is inevitable.

Financial Policy

John Cochrane supports the case (forcefully made by Anat Admati) for higher capital requirements, citing excellent pieces by Pat Regnier at Time and Peter Coy at Business Week who explain exactly what this does and does not,  mean. I agree: we need banks to hold more capital.  But is that enough?

The following passages are extracts from my recent paper in the Manchester School on the role of the Financial Policy Committee as a guardian of financial stability.  I make the case that financial markets are inefficient because we cannot trade in markets that open before we are born. That fact is an important source of market incompleteness that I call the "absence of prenatal financial markets".
We all agree that financial crises occur. We disagree as to their cause. Some economists argue that markets are not only informationally efficient; they are also Pareto efficient. The boom and the bust are a consequence of the natural flow of knowledge acquisition in a capitalist economy. They are the price of progress. I disagree.

The distinction between informational efficiency and Pareto efficiency is often overlooked. I am quite ready to concede that financial markets are informationally efficient. It is hard to make a living trading stocks and most people don't do a very good job of it. But that does NOT mean that financial markets allocate capital efficiently to competing ends.
If booms and busts were the consequence of waves of innovation, we would expect to see large fluctuations in the earnings of companies. A wave of innovation would generate a wave of profits. But we would also expect to see those earnings capitalized into the market price of companies. The price earnings ratio of the market as a whole should remain approximately constant. That is not what we see and the Price Earnings ratio, in data, has swung between a low of 5 in 1919 and a high of 44 in 1998. 
Large fluctuations in price to earning (PE) ratios are prima fascia evidence that financial markets are inefficient. Those inefficiencies arise as a direct consequence of the absence of prenatal financial markets and they have huge consequences for human welfare. We need not and should not accept unemployment rates of 8% as normal. We can, and should, act to prevent the consequences of financial crashes before they occur.
Like Anat Admati, I support higher capital requirements for institutions that gamble with taxpayer money.  Like Miles Kimball, I do not think that will be enough. One solution that Miles and I have advocated is a Sovereign Wealth Fund that would actively trade a stock market index fund with the goal of stabilizing PE ratios.

How to Estimate Models with Indeterminacy

My coauthors, Vadim Khramov, Giovanni Nicolo and I, have recently completed a revision of our working paper, "Solving and Estimating Indeterminate DSGE Models".

Dynamic Stochastic General Equilibrium Models (DSGE) often have many equilibria. I have long argued that we should exploit that idea to explain real world phenomena. For example, multiple equilibrium models can help to explain why "animal spirits" drive real world markets (see my survey here).

In 2004, Thomas Lubik and Frank Schorfheide published an influential paper which applied that idea to US monetary policy.  A number of authors have taken up their method, but the technique they used is not very easy to apply in practice. Our paper shows how to solve and estimate models with indeterminate equilibria using readily available software packages such as Chris Sim's code Gensys, or the widely used Matlab based package Dynare.


TheTreasury and the Fed are at Loggerheads over QE

In my last post on QE, I quoted a paper by James Hamilton and Cynthia Wu that provides some empirical evidence for the importance of the asset composition of the Fed's balance sheet and its effect on the term structure of interest rates. They have posted their data online and it makes for interesting bedtime reading. 

Hamilton and Wu combined their data with evidence from the yield curve. They found that qualitative easing can be effective at the lower bound and that
... buying $400 billion in long-term maturities outright with newly created reserves, ... could reduce the 10-year rate by 13 basis points without raising short-term yields.
To construct these estimates, they used a theoretical model developed by Vayanos and Vila which assumes that there are investors who have a 'preferred habitat'.

The Hamilton Wu results are important. I ran some regressions of term premiums on bond supply by maturity, using their data, and I found the same orders of magnitude in the response of interest rates that they found. But there is an interesting sub-text to their analysis discussed in Section 8 of their paper. The Fed and the Treasury have been following conflicting policies. David Beckworth on his blog in 2012 makes the same point.

Quantitative Easing took place in three phases. QE1 from 11/08 to 03/10, QE2 from 11/10 to 06/11 and QE3 which is ongoing. Along with monetary expansion, the Fed attempted to refinance its portfolio by selling at the short end and buying at the long end of the yield curve. But at the same time, the Treasury was refinancing its own portfolio. The end result was that the Treasury restructuring completely swamped any effect of Fed operations at the long end of the yield curve.  

Figure 1
In Figure 1 I have broken down the System Open Market Account (SOMA) of Fed holdings of Treasuries by maturity as a percentage of all outstanding Treasuries, using the Hamilton Wu data set. The two vertical red lines are the beginning and end of the last recession and the vertical black line marks the collapse of Lehman Brothers.

There are two takeaways from Figure 1. First, the constancy of Fed holdings by maturity in the period leading up to the recession, and second, the dramatic change in this portfolio after the collapse of Lehmann Brothers. The big increase in Fed holdings at the long end is the result of 'operation twist'.

How big a player is the Fed in the Treasury markets? Leading up to the Great Recession, the Fed held 12% of all Treasuries with a maturity of two years or less, 3% of two to five year maturities, 1.5% of five to ten year maturities and 2% of maturities from ten to thirty years. Once the recession hit, Fed holdings of maturities shorter than two years plummeted, and longer maturities increased. 

But Figure 1 gives a misleading picture of Fed actions in response to the crisis since it divides SOMA holdings, chosen by the Fed, by total outstanding Treasury debt. There were two important changes going on during the recession. First, the Treasury dramatically changed the way it finances its deficit, substituting two to ten year bonds for shorter maturities. And second, the proportion of bonds held by the Fed fell dramatically.
Figure 2
In Figure 2, I illustrate the importance of the first point. This figure shows the percentage of all outstanding Treasuries, by maturity, as a percentage of total outstanding Treasury debt. After the collapse of Lehmann Brothers, the percentage of short denomination bonds plummeted. In their place, the Treasury sharply increased its issuance of two to ten year bonds. It is important to note that this Figure has nothing to do with any action by the Fed. It is a consequence of decisions by the Treasury to refinance its debt at longer maturities in the low interest rate environment that followed the collapse of Lehmann Brothers.

Figure 3

Figure 1 divides SOMA holdings by total Treasury debt outstanding. In contrast, in Figure 3 I divide Fed SOMA holdings by the Fed's holding of all maturities. This figure DOES reflect decisions made by the open market committee of the Fed. The Fed's holdings of short term bonds fell from 65% of its portfolio in 2007 to 25% in 2010. In contrast, holdings of two to five year bonds increased from 17% to 30%, five to ten year bonds increased from 6% to 26% and ten to thirty year bonds went from 12% to 19%. These are all percentages of the Fed's total Treasury holdings.
Figure 4
How successful was operation twist at changing the maturity structure of Treasury securities held by the public? In Figure 4, I break down Treasuries held by the public as a fraction of total debt outstanding. This figure shows that although the Fed switched its holdings from yields of three months to two years to yields in the two to ten year range (Figure 3) this operation was swamped, after November of 2008, by Treasury operations that increased the supply of maturities in the two to ten year range (Figure 4).  The end result was that the public ended up holding more of these two to ten year bonds in 2010 than before the recession hit.

Could we have a little coordination here guys?
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Footnote: The Hamilton Wu data have since been updated through January of 2011 but I haven't had time yet to update my figures using their revisions.