Archive for September, 2009

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the future of banking

Wednesday, September 30th, 2009

Martin Wolf looks at the future of finance and does not like what he sees.

What entered the crisis was, we now know, an ill-managed, irresponsible, highly concentrated and undercapitalised financial sector, riddled with conflicts of interest and benefiting from implicit state guarantees. What is emerging is a slightly better capitalised financial sector, but one even more concentrated and benefiting from explicit state guarantees. This is not progress: it has to mean still more and bigger crises in the years ahead. ….

[W]here we are now is intolerable. Today’s concentrations of state-insured private wealth and power must surely go. At present, the official sector believes tighter regulation, particularly higher capital requirements, can contain these risks. But this is likely to fail. If it does, we will need to be radical. Yet narrow banking would still not be enough. We would need to rule out quasi-banking. Otherwise, we would soon return to the world of fragility and bail-outs. Funds that replace banks would have to pass the risks directly on to the outside investors.

Martin Wolf, “Why narrow banking alone is not the finance solution”, Financial Times, 30 September 2009.

“Narrow banking” forces banks to hold assets as safe and liquid as their liabilities. Normally these would be government bonds. Such 100 percent reserve banking would effectively eliminate monetary policy, an attribute seen by some proponents as an advantage. One proponent is Mr Wolf’s colleague, John Kay, who has written a pamphlet on the subject: Narrow Banking: The reform of banking regulation.

Boston University economists Christophe Chamley and Laurence J. Kotlikoff have a less radical reform proposal, one that they call “limited purpose banking” .

Banks should be allowed to initiate only conforming, i.e., government-approved, AAA-rated mortgages and business loans. These would be long-term, fixed-rate loans with 20 per cent-down and payments below 25 per cent of income. ….

Once approved [by the Federal Financial Authority], the banks would bundle and sell “their” loans within mutual funds.

… [B]ank runs wouldn’t arise. …. Why? Because banks would bear zero risk. Mutual fund owners would bear risk, but not the banks. And these lenders would know they were buying government-approved AAA-rated loans, not Bear Stearns‘ CDOs.

This limited purpose banking is a modern version of narrow banking proposed by Frank Knight, Henry Simons, and Irving Fisher. Banks would hold deposits, cash checks, wire money, originate loans, and market mutual funds, including money market funds with no guarantee of par value redemption.

Christophe Chamley and Laurence J. Kotlikoff, “Putting An End to Financial Crises”, Financial Times Economists’ Forum, 27 January 2009.

Another name for the proposed reform might be “conservative banking” – no more bank loans to NINJAs (no income, no job, no assets)! The essay on “limited purpose banking” can also be downloaded here. Martin Wolf provides a link to the Chamley/Kotlikoff proposal, but does not really discuss it.

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The World Economic Forum looks at universal pensions

Tuesday, September 29th, 2009

A new report on pensions and health care, from the World Economic Forum, acknowledges – in a chapter devoted to promotion of private pensions – the need for universal, noncontributory pensions. The report points out also that fiscal incentives (tax breaks) for retirement saving benefit higher-income households and strain the public finances, creating an impression that universal pensions are too costly.

In low-income countries, it may be difficult to bring the informal sector into contributory pension schemes. With the breakdown of family support networks, a strengthening of non-contributory public safety nets may also be required. The most effective safety nets are flat, universal old-age benefits which are paid to all residents. Their cost can be partly recovered and their progressivity further enhanced via tax systems and other forms of claw back.

[snip]

Financial incentives to save for retirement may benefit mainly higher-income households, while fuelling a perception that public pension safety nets are too costly.
• New Zealand eliminated the tax incentives for occupational pension arrangements in the mid-1980s as they were deemed to benefit mainly higher-income workers.
• Only a few low-income countries (such as Botswana, Namibia, Mauritius and Nepal) have succeeded in establishing a universal pension for all elderly resident citizens.

Chiemi Hayashi, Heli Olkkonen, Bernd Jan Sikken and Juan Yermo, Transforming Pensions and Healthcare in a Rapidly Ageing World (World Economic Forum, Geneva, 2009), p. 37.

I was pleased to see universal pensions mentioned in a positive light, despite the absence of any serious discussion of their usefulness or feasibility. There are glaring problems as well with the description of universal pensions – brief as it is. First, benefits that are ‘clawed back’ are not universal. Second, why assume universal pensions are relevant only for low-income countries? New Zealand, after all, provides all residents with a flat, universal pension, and has done so almost continuously since 1940. Third, low-income countries with universal pensions – in addition to the three mentioned in the report – include Kiribati, Somoa, Brunei, Kosovo and Bolivia.

The statement that tax incentives crowd out universal pensions is very true, but would have benefited from illustration with the cases of Australia and South Africa. In each country, universal pensions would be fiscally less costly than the current system of means-tested pensions for the masses plus tax incentives for retirement saving by higher-income households.

Thanks to Michael Littlewood for the pointer.

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Robert Shiller on financial innovation

Monday, September 28th, 2009

Many financial reformers would like to simplify investment instruments, arguing that their complexity contributed to the 2008 financial crisis. Yale University economist Robert Shiller believes that such thinking is wrong and feels strongly that consumers would benefit from complex financial products. He argues that, just as there is no need to understand the design of a lap-top computer in order to use it, neither is there any need to understand the design of a financial instrument in order to purchase it. Regulators should therefore focus on achieving trust, since it is lack of trust, not complex products, that causes financial markets to crash.

The advance of civilisation has brought immense new complexity to the devices we use every day … including automatic on-off lighting, communications and data processing devices. People do not need to understand the complexity of these devices, which have been engineered to be simple to operate. ….

[F]inancial products have not advanced as much. We are still mostly investing in plain vanilla products such as shares in corporations or ordinary nominal bonds, products that have not changed fundamentally in centuries.

Why have financial products remained mostly so simple? I believe the problem is trust. People are much more likely to buy some new electronic device such as a laptop than a sophisticated new financial product. ….

Unfortunately, people do not trust some good innovations that could protect them better. [One example is] the innovations in mortgages in recent years (involving such things as option-adjustable rate mortgages) …. I have proposed the idea of “continuous workout mortgages”, motivated by basic principles of risk management. The privately issued mortgage would protect against exigencies such as recessions or drops in home prices. ….

[Other examples are] “the target-date fund (also called life-cycle fund) that invests money for people’s retirement in a way that is specifically tailored for people their age” and “retirement annuities that include protections against potential risks”. ….

Regulatory agencies need to be given a stronger mission of encouraging innovation. They must hire enough qualified staff to understand the complexity of the innovative process and talk to innovators ….

Robert Shiller, “In defence of financial innovation”, Financial Times, 28 September 2009.

Professor Shiller is author of Irrational Exuberance and The New Financial Order: Risk in the 21st Century (2nd edition, 2005). For an earlier column on the same subject, see

Robert J. Shiller, “Has Financial Innovation Been Discredited?”, Project Syndicate, March 2008.

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human organ donations

Sunday, September 27th, 2009

Each year thousands die waiting for an organ transplant – a kidney, heart, liver or lung that can mean the difference between life and death.

When Steven P. Jobs, Apple’s chief executive, appeared in public recently for the first time in months, he revealed that he had received a liver transplant from the victim of a car crash. “I wouldn’t be here without such generosity,” Mr. Jobs said, adding that he hoped that many people would become organ donors.

With the help of a little behavioral economics, it is possible to make that hope a reality. ….

In the world of traditional economics, it shouldn’t matter whether you use an opt-in or opt-out system [for organ donation]. So long as the costs of registering as a donor or a nondonor are low, the results should be similar. But many findings of behavioral economics show that tiny disparities in such rules can make a big difference. ….

Consider the difference in consent rates between two similar countries, Austria and Germany. In Germany, which uses an opt-in system, only 12 percent give their consent; in Austria, which uses opt-out, nearly everyone (99 percent) does.

Richard H. Thaler, “Economic View: Opting in vs. Opting Out”, New York Times, 27 September 2009.

An alternative way to eliminate excess demand for human organs is to use the price system – sell organs to the highest bidder, and allow direct purchase from donors and their families. This almost never happens today, and is roundly condemned when it does happen. Mr Jobs received a liver transplant not because of his considerable wealth, but rather because he was the sickest person on the waiting list.

Chicago economist Richard Thaler in his column today explains that people reject a market solution to shortages for two reasons. “First, they object to the possibility of rich people buying their way to the front of the line. …. Second, they object to incentives that would induce the poor to sell their kidneys.” I would add that many object also to incentives that would induce poor (or greedy) persons to sell organs of their deceased loved ones.

In the case of organ transplantation, decisions of who will live and who will die are not left to the market. Instead, they are made by medical experts – committees that some in the US refer to as “death panels”.

In the US health care debate, a serious anomaly exists. Why is rationing of human organs by ability to pay universally condemned, whereas rationing of medical care the same way is widely accepted? Why is it ethical for a wealthy person to pay to avoid a queue for heart surgery whereas it is unethical for her to pay for privileged access to a heart transplant? I have not seen a convincing explanation, but will keep an open mind.

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paying to save trees

Friday, September 25th, 2009

This week’s Economist has a long article on “reducing emissions from deforestation and degradation” (REDD). If REDD is to work, co-operation from forest dwellers is essential. The best and perhaps only way to obtain full co-operation is to pay them. A number of experimental projects along these lines are underway. The Economist discusses one of them, located in the south-eastern corner of the Brazilian state of Amazonas.

Novo Aripuanã is the site of a novel response to [the threat of deforestation]: the Juma Sustainable Development Reserve, an area of 600,000 hectares (1.2m acres) bordered by two highways. This is a nature reserve with an unusual twist: local people will be paid to prevent the trees from being cut down. Each family in the area has been issued with a debit card. Regular inspections will ensure that the trees are still standing: as long as they are, families will have 50 reais ($28) a month credited to their accounts.

These funds come from the rich world, where governments and companies that cannot reduce their own emissions cheaply are prepared to pay others to reduce emissions on their behalf (as “carbon offsets”). Not cutting down trees in endangered areas prevents emissions that would otherwise have occurred, which gives untouched forest huge financial value—and provides people who live in the forest with an incentive to preserve it.

This idea is known as “avoided deforestation” or “reducing emissions from deforestation and degradation” (REDD). At the moment REDD is not so much a plan as a collection of proposals and some working schemes, like Juma. The fate of the forests in Brazil, Indonesia, the Philippines and elsewhere around the world could hang on the success of this approach. But there will need to be substantial international commitments to reduce global emissions to create demand for the carbon offsets that REDD schemes can provide. This means a lot hangs on a deal being struck in December in Copenhagen, where countries will meet to negotiate a new climate treaty.

“Paying to save trees: Last gasp for the forest”, The Economist, 26 September 2009.

Preventing deforestation is important for the climate agenda because “carbon emissions from deforestation account for some 18% of global greenhouse-gas emissions, more than all the world’s trains, cars, lorries, aeroplanes and ships combined”. This informative essay is – for The Economist – exceptionally long, and worth reading in its entirety.

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Richard Posner becomes a Keynesian

Friday, September 25th, 2009

Judge Posner, the prolific conservative writer who co-blogs with Chicago economist Gary Becker, read Keynes and saw the light. This surprising transformation speaks volumes about Posner’s intellectual honesty.

Until last September, when the banking industry came crashing down and depression loomed for the first time in my lifetime, I had never thought to read The General Theory of Employment, Interest, and Money, despite my interest in economics. ….  I had heard that it was a very difficult book, which I assumed meant it was heavily mathematical; and that Keynes was an old-fashioned liberal, who believed in controlling business ups and downs through heavy-handed fiscal policy (taxing, borrowing, spending); and that the book had been refuted by Milton Friedman, though he admired Keynes’s earlier work on monetarism. ….

We have learned since September that the present generation of economists has not figured out how the economy works. The vast majority of them were blindsided by the housing bubble and the ensuing banking crisis; and misjudged the gravity of the economic downturn that resulted; and were perplexed by the inability of orthodox monetary policy administered by the Federal Reserve to prevent such a steep downturn; and could not agree on what, if anything, the government should do to halt it and put the economy on the road to recovery. ….

Baffled by the profession’s disarray, I decided I had better read The General Theory. Having done so, I have concluded that, despite its antiquity, it is the best guide we have to the crisis.  ….

Keynes’s masterpiece is many things, but “outdated” it is not. So I will let a contrite Gregory Mankiw, writing in November 2008 in The New York Times, amid a collapsing economy, have the last word: “If you were going to turn to only one economist to understand the problems facing the economy, there is little doubt that the economist would be John Maynard Keynes. Although Keynes died more than a half-century ago, his diagnosis of recessions and depressions remains the foundation of modern macroeconomics. His insights go a long way toward explaining the challenges we now confront. . . . Keynes wrote, ‘Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slave of some defunct economist.’ In 2008, no defunct economist is more prominent than Keynes himself.”

Richard Posner, “How I Became a Keynesian: Second Thoughts in the Middle of a Crisis”, The New Republic, 23 September 2009.

Richard A. Posner is a judge on the U.S. Court of Appeals for the Seventh Circuit and a senior lecturer at the University of Chicago Law School. Gregory Mankiw is a professor at Harvard and author of a best-selling economics textbook.

HT to Greg Mankiw.

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Krugman on Keynes

Thursday, September 24th, 2009

“At research seminars, people don’t take Keynesian theorising seriously anymore; the audience starts to whisper and giggle to one another.” So declared Robert Lucas of the University of Chicago, writing in 1980. At the time, Lucas was arguably the world’s most influential macroeconomist; the influence of John Maynard Keynes, the British economist whose theory of recessions dominated economic policy for a generation after the Second World War, seemed to be virtually at an end.

But Keynes, it turns out, is having the last giggle. Lucas’s “rational expectations” theory of booms and slumps has shown itself to be completely useless in the current world crisis. Not only does it offer no guide for action, but it more or less asserts that market economies cannot possibly experience the kind of problems they are, in fact, experiencing. Keynesian economics, on the other hand, which was created precisely to make sense of times like these, looks better than ever.

Paul Krugman, “Keynes: The Return of the Master by Robert Skidelsky”, The Observer, 30 August 2009.

Paul Krugman is reviewing Robert Skidelsky’s latest book.

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health and life expectancy

Thursday, September 24th, 2009

Much of the increased life expectancy … has come from gains in prevention, cleaner living rather than better medicine. …. Who lives in unwashed woolens –and woolens do not wash well– will itch and scratch. So hands were dirty, and the great mistake was failure to wash before eating. This is why those religious groups that prescribed washing –the Jews, the Muslims– had lower disease and death rates; which did not always count to their advantage. People were easily persuaded that if fewer Jews died, it was because they had poisoned Christian wells.

David S. Landes, The Wealth and Poverty of Nations (Norton, New York, 1998), p. xviii.

Recycled from the 2003 Thought du Jour archive.

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the near-elderly in the US and Europe

Thursday, September 24th, 2009

In 1975, Americans and Europeans who reached the age of 50 could expect to live an additional 27 years. By 2005 life expectancy at age 50 increased to 31 years in the USA, compared to 32.5 years in Europe. A Rand Corporation study examines this gap, comparing the health of the near-elderly in the US with that of the near-elderly in Europe.

Except for current smoking status, [50-55 year old] Americans look worse [than Europeans] in terms of health. Several of the differences are quite large. For instance, Americans are about twice as likely to have hypertension, twice as likely to be obese, twice as likely to have diabetes, and nearly 50% more likely to have ever smoked, As we demonstrate latter, these differences are unlikely to be explained by differences in diagnosis or reporting. For example, the prevalence of stroke is twice as low in Europe as in the U.S., a condition which rarely goes undiagnosed. ….

We have demonstrated that differences in observed disease prevalence can almost entirely account for [the longevity gap between the US and Europe] …. In this sense, the international longevity gap appears much easier to explain than, for instance, the racial or socioeconomic longevity gaps, which are not well explained by health differences. ….

The gap in health and longevity has obvious private costs to the citizens suffering from disease. There are also significant public finance consequences, to the tune of $17,800 in per capita medical costs, and net public finance costs of roughly five thousand dollars per capita. Gradual transitions of US cohorts towards European levels could generate large fiscal benefits. In the long-run, medical expenditures may fall by $1.1 trillion on a present value basis.

Pierre-Carl Michaud, Dana Goldman, Darius Lakdawalla, Adam Gailey and Yuhui Zheng, “International Differences in Longevity and Health and their Economic Consequences”, Netspar Discussion Paper 06/2009-021 (June 2009).

Available also as NBER Working Paper No. 15235 (August 2009).

Gaps in life expectancy are related to gaps in health – hardly an earth-shaking conclusion. A more interesting question is ‘What accounts for gaps in health?’. On this, the authors admit “Further research is needed”.

Another crucial question the authors ignore “due to data limitations” is “whether trends of chronic disease have spread more rapidly in the US”. In other words, did a health gap exist in 1975, when life expectancy at age 50 was the same in the US and Europe?

The authors assume that any health gap was at least smaller in the past, justifying this assumption by examining OECD data on per capita tobacco consumption (1975-2005) and obesity rates (1978-2005). These data refer to the entire adult population (15+), so it is not clear how they relate to the health of the near-elderly. For what it is worth, in the mid-1970s both smoking and obesity were more common in the US than in Europe. US adults now consume less tobacco per capita than European adults, but the gap in adult obesity rates has widened.

My frustration with this study is that the modeling is static, not  dynamic. It fails to address the extent to which changes in life expectancy gaps might be related to changes in health gaps. On this, further research is definitely needed.

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Brad DeLong on Cuba’s human development

Wednesday, September 23rd, 2009

The hideously depressing thing is that Cuba under Batista– Cuba in 1957–was a developed country. Cuba in 1957 had lower infant mortality than France, Belgium, West Germany, Israel, Japan, Austria, Italy, Spain, and Portugal. Cuba in 1957 had doctors and nurses: as many doctors and nurses per capita as the Netherlands, and more than Britain or Finland. Cuba in 1957 had as many vehicles per capita as Uruguay, Italy, or Portugal. Cuba in 1957 had 45 TVs per 1000 people–fifth highest in the world. Cuba today has fewer telephones per capita than it had TVs in 1957.

You take a look at the standard Human Development Indicator variables–GDP per capita, infant mortality, education–and you try to throw together an HDI for Cuba in the late 1950s, and you come out in the range of Japan, Ireland, Italy, Spain, Israel. Today? Today the UN puts Cuba’s HDI in the range of Lithuania, Trinidad, and Mexico. (And Carmelo Mesa- Lago thinks the UN’s calculations are seriously flawed: that Cuba’s right HDI peers today are places like China, Tunisia, Iran, and South Africa.)

Thus I don’t understand lefties who talk about the achievements of the Cuban Revolution: “…to have better health care, housing, education, and general social relations than virtually all other comparably developed countries.” Yes, Cuba today has a GDP per capita level roughly that of– is “comparably developed”–Bolivia or Honduras or Zimbabwe, but given where Cuba was in 1957 we ought to be talking about how it is as developed as Italy or Spain.

Brad DeLong, “Let’s Get Even More Depressed About Cuba”, 14 May 2003.

This post generated some interesting comments. Here is one interchange:

Give over. Cuba in 1957 was a developed narcostate. When you compare it with Italy and Spain, are you really suggesting that Italy and Spain would have developed to where they are today if their only industries had been basic agriculture, plus the provision of cocaine and casino services to Germany and France?

Posted by: dsquared on May 14, 2003 11:15 PM

Well Monte Carlo hasn’t done too badly, D^2. But I suppose it doesn’t have the agriculture.

Posted by: Matthew on May 15, 2003 04:40 AM

Recycled from the Thought du Jour 2003 archive.

Brad DeLong on Cuba’s human development

The hideously depressing thing is that Cuba under Batista– Cuba in 1957–was a developed country. Cuba
in 1957 had lower infant mortality than France, Belgium, West Germany, Israel, Japan, Austria, Italy,
Spain, and Portugal. Cuba in 1957 had doctors and nurses: as many doctors and nurses per capita as the
Netherlands, and more than Britain or Finland. Cuba in 1957 had as many vehicles per capita as Uruguay,
Italy, or Portugal. Cuba in 1957 had 45 TVs per 1000 people–fifth highest in the world. Cuba today has
fewer telephones per capita than it had TVs in 1957.

You take a look at the standard Human Development Indicator variables–GDP per capita, infant
mortality, education–and you try to throw together an HDI for Cuba in the late 1950s, and you come out
in the range of Japan, Ireland, Italy, Spain, Israel. Today? Today the UN puts Cuba’s HDI in the range
of Lithuania, Trinidad, and Mexico. (And Carmelo Mesa- Lago thinks the UN’s calculations are seriously
flawed: that Cuba’s right HDI peers today are places like China, Tunisia, Iran, and South Africa.)

Thus I don’t understand lefties who talk about the achievements of the Cuban Revolution: “…to have
better health care, housing, education, and general social relations than virtually all other
comparably developed countries.” Yes, Cuba today has a GDP per capita level roughly that of– is
“comparably developed”–Bolivia or Honduras or Zimbabwe, but given where Cuba was in 1957 we ought to
be talking about how it is as developed as Italy or Spain.

Brad DeLong, “Let’s Get Even More Depressed About Cuba”, 14 May 2003.

http://www.j-bradford-delong.net/movable_type/2003_archives/001473.html

The comments this post generated are especially interesting. Here is one interchange:

Give over. Cuba in 1957 was a developed narcostate. When you compare it with Italy and Spain, are you
really suggesting that Italy and Spain would have developed to where they are today if their only
industries had been basic agriculture, plus the provision of cocaine and casino services to Germany and
France?

Posted by: dsquared on May 14, 2003 11:15 PM

Well Monte Carlo hasn’t done too badly, D^2. But I suppose it doesn’t have the agriculture.

Posted by: Matthew on May 15, 2003 04:40 AM

Recycled from the Thought du Jour 2003 archive.

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Posted in Development Economics | 2 Comments »

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