David R. Henderson  

John Cochrane's Talk at Hoover: His Version

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"Socialists Won Over By War"... Cognitive Hubris...

On Tuesday, I posted my notes from John Cochrane's December 3 talk at Hoover. When he saw my notes, John sent me his talk and gave me permission to reprint it. Here it is.

Comments at "Restoring Robust Economic Growth in America" Conference
Hoover Institution, Stanford University, December 2 2011
John H. Cochrane

It's a pleasure and honor to be here, especially next to such distinguished panelists.

John Raisian suggested I do something simple and easy for the panel, like cover all the troubles in Europe and the US and how to fix them. In 10 minutes. So let's go on a quick tour of Europe first.

In case you're not reading the papers, we're in financial crisis 3.0, a run on European banks stemming from their sovereign debt losses.

This is not high finance. European banks have been failing on sovereign debt since Edward III stiffed the Perruzzi in 1353. This is not a "multiple equilibrium," a run of self-confirming expectations. People are simply getting out of the way of sovereign default, since it's pretty clear that governments are at the end of the bailout rope.

By dutiful application of bad ideas and wishful thinking, the Europeans have turned a simple sovereign restructuring into a currency crisis, a fiscal crisis, a banking crisis, and now a political crisis. They could have had a lovely currency union without fiscal union. The meter in Paris measures length. The Euro in Frankfurt measures value. And sovereigns default, just like companies. They could do what George Schulz beautifully called the "simple obvious" things, and return to the kind of strong growth that would let them pay off large debts. Alas, the ECB is full in, both buying debt and lending to banks who buy debt, so now a sharp euro inflation - which is just a more damaging and wider sovereign default -- seems like the most likely outcome.

How did we get here? Financial crises are runs. No run, no "crisis." People just lose money as in the tech bust. (Let me quickly plug here Darrell Duffie's "Failure Mechanics of Dealer Banks." This wonderful article explains exactly how our financial crisis was a run in dealer banks.)

For nearly 100 years we have tried to stop runs with government guarantees--deposit insurance, generous lender of last resort, and bailouts. That patch leads to huge moral hazard. Giving a banker a bailout guarantee is like giving a teenager keys to the car and a case of whisky. So, we appoint regulators who are supposed to stop the banks from taking risks, in a hopeless arms race against smart MBAs, lawyers and lobbyists who try to get around the regulation, and though we allow-nay, we encourage and subsidize--expansion of run-prone assets.

In Dodd-Frank, the US simply doubled down our bets on this regime. The colossal failure of Europe's regulators to deal with something so simple and transparent as looming sovereign risk hints you how well it will work. (European banks have all along been allowed to hold sovereign debt at face value, with zero capital requirement. It's perfectly safe, right?)

The guarantee/regulate/bailout regime ends eventually, when the needed bailouts exceed governments' fiscal resources. That's where Europe is now.

And the US is not immune. Sooner or later markets will question the tens of trillions of our government's guarantees, on top of already unsustainable deficits.

What financial system will we reconstruct from the ashes? The only possible answer seems to me, to go back to the beginning. We'll have to reconstruct a financial system purged of run-prone assets, and the pretense that nobody holds risk. Don't subsidize short-term debt with a tax shield and regulatory preference; tax it; or ban it for anything close to "too big to fail." Fix the contractual flaws that make shadow bank liabilities prone to runs.

Here we are in a golden moment, because technology can circumvent all the standard objections. It is said that people need liquid assets, and banks must borrow short and lend long to provide such assets. But now, you could pay for coffee with an electronic transfer of mutual fund shares. The fund could hold stocks, or mortgage backed securities. Nobody ever ran on a (floating-NAV) mutual fund. With instant communication, liquidity need no longer coincide with fixed value and first-come first-served guarantees.

We also now have interest-paying reserves. The government can supply as many liquid assets as anyone wants with no inflation. We can live the Friedman rule.

Short-term debt is the key to government crises. Greece is not in trouble because it can't borrow one year's deficits. It's in trouble because it can't roll over existing debt. Governments can be financed by coupon-only bonds with no principal repayment, thereby eliminating rollover risk and crises. The new European treaty, along with wishing governments would mend their spending ways, should at least insist on long-maturity debt.

You may say this is radical. But the guarantee/regulate/bailout regime will soon be gone. There really is no choice. The only reason to keep the old regime is to keep the subsidies and bailouts coming. Which of course is what the banks want.

On to the US.

Why are we stagnating? I don't know. I don't think anyone knows, really. That's why we're here at this fascinating conference.

Nothing on the conventional macro policy agenda reflects a clue why we're stagnating. Score policy by whether its implicit diagnosis of the problem makes any sense.

The "jobs" bill. Even if there were a ghost of a chance of building new roads and schools in less than two years, do we have 9% unemployment because we stopped spending on roads & schools? No. Do we have 9% unemployment because we fired lots of state workers? No.

Taxing the rich is the new hot idea. But do we have 9% unemployment-of anything but tax lawyers and lobbyists--because the capital gains rate is too low? Besides, in this room we know that total marginal rates matter, not just average Federal income taxes of Warren Buffet. Greg Mankiw figured his marginal tax rate at 93% including Federal, state, local, and estate taxes. And even he forgot about sales, excise, and corporate taxes. Is 93% too low, and the cause of unemployment?

The Fed is debating QE3. Or is it 5? And promising zero interest rates all the way to the third year of the Malia Obama administration. All to lower long rates 10 basis points through some segmented-market magic. But do we really have 9% unemployment because 3% mortgages with 3% inflation are strangling the economy from lack of credit? Or because the market is screaming for 3 year bonds, but Treasury issued at 10 years instead? Or because $1.5 trillion of excess reserves aren't enough to mediate transactons?

I posed this question to a somewhat dovish Federal Reserve bank president recently. He answered succinctly, "Aggregate demand is inadequate. We fill it. " Really? That's at least coherent. I read the same model as an undergraduate. But as a diagnosis, it seems an awfully simplistic uni-causal, uni-dimensional view of prosperity. Medieval doctors had three humors, not just one.

Of course in some sense we are still suffering the impact of the 2008 financial crisis. Reinhart and Rogoff are endlessly quoted that recessions following financial crises are longer. But why? That observation could just mean that policy responses to financial crises are particularly wrongheaded.

In sum, the patient is having a heart attack. The doctors debating whether to give him a double espresso vs. a nip of brandy. And most likely, the espresso is decaf and the brandy watered.

So what if this really is not a "macro" problem? What if this is Lee Ohanian's 1937-not about money, short term interest rates, taxes, inadequately stimulating (!) deficits, but a disease of tax rates, social programs that pay people not to work, and a "war on business." Perhaps this is the beginning of eurosclerosis. (See Bob Lucas's brilliant Millman lecture for a chilling exposition of this view).

If so , the problem is heart disease. If so, macro tools cannot help. If so, the answer is "Get out of the way."

People hate this answer. They want to know "what would you do?" What's the bold new plan? What's the big new idea? Where is the new Keynes? They want FDR, jutting his chin out, leading us from the fear of fear itself.

Alas, the microeconomy is a garden, not an army. It grows with property rights, rule of law, simple and non distorting taxes, transparent rules-based regulations, a functional education system; all of George's "simple obvious steps," not the Big Plan for the political campaign of a Great Leader. You need to weed a garden, not just pour on the latest fertilizer. Our garden is full of weeds. Yes, it was full of weeds before, but at least we know that pulling the weeds helps.

Or maybe not. This conference, and our fellow economists, are chock full of brilliant new ideas both macro and micro. But how do we apply new ideas? Here I think we economists are often a bit arrogant. The step from "wow my last paper is cool" to "the government should spend a trillion dollars on my idea" seems to take about 15 minutes. 10 in Cambridge.

Compare the scientific evidence on fiscal stimulus to that on global warming. Even if you're a skeptic on global warming, it's clear that compared to global warming, our evidence for stimulus--including coherent theory and decisive empirical work--is on the level of "hey, it's pretty hot outside." And compared to mortgage modification plans, strange "unconventional" monetary policy, the latest creative fix-the-banks plan, and huge labor market interventions, even stimulus is well-documented.

There are new ideas and great new ideas. But there are also bad new ideas, lots of warmed over bad old ideas, and good ideas that happen to be wrong. We don't know which is which. If we apply anything like the standards we would demand of anyone else's trillion-dollar government policy to our new ideas, the result for policy, now, must again be, stick with what works and the stuff we know is broken and get out of the way.

But keep working on those new ideas.


Comments and Sharing





COMMENTS (15 to date)
Liam McDonald writes:

I really liked that speech, David. Especially the part; a disease of tax rates, social programs that pay people not to work, and a "war on business."

It really does feel that way too. I recently got into a debate about Wal-Mart is evil with some well meaning people and used my best DRH argument of what's wrong with being successful.

Andreas writes:

This was great, as one has come to expect from Mr Cochrane. Is it possible to put a link up to Mr Lucas' lecture? I only managed to find the slides. Thank you in advance.

ajb writes:

His discussion of QE seems perfunctory as you've noted. Could you get him to comment more on the Sumnerian version of the story? It's not totally unicausal and boosting inflation/nominal gdp seems a better fix to the AD problem than just spending.

ajb writes:

One way in which I've observed that low inflation has hurt the housing market is that people who become underwater can't refinance even if they've been paying steadily. Surely we're better off in a world in which nominal prices are higher but the relative price of houses falls. With low nominal inflation it's clear that there's a lot of stickiness in both housing and labor markets that's hard to deal with. Furthermore, it encourages government intervention in ways that don't deal with the problem and even make the stickiness worse. A stronger QE much earlier would have preempted some of these moves.

Bill Woolsey writes:

If nominal GDP were at the trend growth path of the great moderation, and still real output and employment were 10% below, then I would agree that the problem is due to a drop in productive capacity.

Perhaps it was that increase in the minimum wage. Maybe it is the expectations of mandatory health benefits for low skilled workers. Maybe firms are really worried that carbon emissions will be penalized and that greatly reduces the productivity of unskilled workers.

When Cochrane just ignores that, and instead sees monetary policy as solely a matter of interest rates, then he proves that he just doesn't understand macroeconomics.

What is the implicit argument--one he doesn't bother to make? It is that if the problem were low nominal expenditure, then nominal wages and prices would be on a 14% lower growth path too. Because if quantity supplied is greater than quantity demanded, prices fall, and that includes labor.

Also, mutual funds did have runs. To the degree that the model of runs makes that impossible, there is a problem with the model.

Sadly, it looks like the real problem is each person thinks they can avoid risk of loss by selling at the peak. It is certainly crazed for anyone to imagine that the system avoids risk because everyone can sell at the peak.

Anyway, the idea that mutual funds don't face runs would require that they say, "break the buck?, Is that a surprise? It happens all the time."

The notion that everyone can have all the liquidity because reserves pay interest, and at the same time, governments should never lend short is a blatant contradiction.

The proposal would be to have the government borrow by creating interest bearing monetary liabilities. These are even shorter than Treasury bills. If there is a loss of confidence in the government, funding more of the national debt with reserve balances simply removes an additional step from inflationary default.

Bruce Cleaver writes:

"Medieval doctors had three humors, not just one."

That is an awe-inspiring putdown.

Keith writes:

To both John Cochrane and David Henderson.

Thank you for making this available. Excellent talk.

Costard writes:

ajb -- homeowners would certainly be better off if their debt were simply inflated away. Whether the unemployed, underemployed and retired would be better off if their savings were inflated away, well, that's a different question. But is anybody better off with a government that promises everything and accomplishes nothing? How much of this stickiness in the housing market is due to the misplaced hope that either a federal rescue is in the works, or that hyperinflation is due any minute?

Bill -- "Because if quantity supplied is greater than quantity demanded, prices fall, and that includes labor." If this were true, we would not be confronting surpluses in labor, housing, etc. Clearly this is not a system in equilibrium, which was more or less Cochrane's point. I don't see the relevance of recent economic numbers; fiscal and monetary policy have dominated the landscape since '08. We would have had severe deflation but for the actions of a very determined congress, treasury and reserve - so how on earth can you claim that nominal price stability is somehow indicative of the underlying economy?

marris writes:

Milliman lecture slides (no video)

http://www.econ.washington.edu/news/millimansl.pdf

marris writes:

@Bill Woolsey

I think the mutual fund idea is that redemptions are done equity-sell-style rather than fixed value style. If everyone wanted to get out of the mutual fund, the value would drop to zero, but it would not be the contractual default thing that arises in a bank run.

GIVCO writes:

Thanks for posting this. But I do want to credit one of my favorite writers.

Giving a banker a bailout guarantee is like giving a teenager keys to the car and a case of whisky. John Conchrane

Giving money and power to government is like giving whiskey and car keys to teenage boys. P. J. O'Rourke

Seth writes:

Very enjoyable.

"Is 93% too low, and the cause of unemployment?"
No. But it may be too high and a cause unemployment.

"Reinhart and Rogoff are endlessly quoted that recessions following financial crises are longer. But why? That observation could just mean that policy responses to financial crises are particularly wrongheaded."

Bing-freaking-O!

Duncan writes:

Very good. I could have sworn there were four humors, though.

Bryan Willman writes:

I vote for "dutiful application of bad ideas and wishful thinking" as the put-down of the month.

Abe writes:

I wish Cochrane would write a bit more... and by "write more", I mean in blog/op-ed format. I feel like we only hear from him every six months or so - and yet I always find his insight fascinating (and mostly correct).

[spelling of Cochrane's name corrected--Econlib Ed.]

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