In popular culture, there are “good” industries and “evil” industries.

Oil has held the most hated position of the evil list for generations and is likely to hold it until there is no more oil. Farming, once solidly on the good list, is moving to the evil list because its critics claim it uses too much water and its use of pesticides and herbicides hurt the environment.

Banking holds a special place on the bad list, having resided there for more than 2,000 years. Indeed, Dante had usurers condemned to the seventh of his nine circles of Hell.

Banks still exist because they serve a valuable purpose. They are intermediaries between huge numbers of savers and huge numbers of borrowers. As such, they dramatically increase the return to savers and, just as dramatically, reduce the cost to borrowers. We need banks. We need a well-functioning banking system.

Since the Lehman Brothers collapse, banks have become even more unpopular. They are blamed for the 2008 financial crisis and the terrible recession that accompanied the crisis. Much of that blame is undeserved.

Criminal bankers didn’t cause the Great Recession. Every industry has its criminals. Surely, there were criminal acts by bankers that went unpunished but they were small players on a big stage.

Banks are among America’s most heavily regulated industries. Beginning in the mid-1990s, the federal government, with bi-partisan agreement, set about to increase the percentage of the population that owned their own home. Their methods included incentivizing banks to loan to people who traditionally could not borrow. The incentives included rewards for cooperation and punishments for failure to cooperate. Banks had little choice.

Traditional lending standards existed for a reason. Many who borrowed under the new, more relaxed, standards eventually defaulted, contributing to declining real estate values and the Great Recession.

Consolidation of bank assets in ever fewer banks is the other culprit in the financial crash. For decades now, regulations on bank mergers have been incrementally relaxed, while bank operations have been increasingly regulated. Consolidation was not a stated purpose of the regulatory changes, but they have resulted in fewer banks.

The number of United States banks has collapsed from 14,400 in 1984’s first quarter to only 5,309 in 2015’s third quarter.

The decline in the number of banks has been accompanied by an increasing concentration of bank assets. Today, only five banks control almost half of all American Bank assets.

Bank failures have consequences. Big bank failures have big consequences. The government has decided that some banks are so large, and the consequences of their failure so onerous, that they cannot be allowed to fail. Those banks deemed too big to fail are bailed out. This results in terrible incentives.

When banks merge, they claim that they are diversifying and gaining economies of scale. Research is mixed on these topics. There is evidence that our largest banks are far above the cost-minimizing scale. There is also evidence that economies of scale persist throughout the size distribution. Similarly, there is evidence that banks merge with similar banks, achieving little diversification, and evidence that diversification persists through the size distribution.

The lack of consensus suggests that banks merge for other reasons. Market power and the too-big-to-fail option are prime suspects. The typical consumer and taxpayer does not benefit from these mergers. Market power allows banks to make excessive profits. Being too big to fail encourages banks to take excessive risks.

Banks did take excessive risks and we all paid a share of the costs.

Banks, being heavily regulated, have a huge incentive to try to influence their regulatory environment. Banks hire former regulators, providing an incentive for regulators to go easy on their potential future employers.

Our largest banks are heavy contributors to political campaigns and, as we’ve learned in the current presidential contests, they have found ways to directly support powerful politicians. So, we see lots of empty verbal abuse thrown at banks but little more.

What’s to be done?

• Higher capital requirements would reduce bank runs and stabilize our banking sector. Some economists recommend requiring reserves amounting to as much as 100 percent.
• A 100 percent tax on all assets over whatever is determined to be too big to fail would eliminate too-big-to-fail banks. This, in turn, would reduce banks’ incentives to take excessive risks.
• Private deposit insurance would reduce the influence of politicians and regulators, reducing the return to banks’ political spending. Banks would cut political spending.
• Limits on market share would slow the decline in bank numbers and reduce market power.
• Differential bank regulations based on asset size would further reduce the incentive for banks to merge. Small community banks have been critical contributors to local economies. We need more of them, not fewer.

A weak banking sector has contributed to the anemic recovery. A vigorous recovery needs a vigorous banking system, focused on economic growth rather than regulation. To achieve a vigorous banking system, we need to change bankers’ incentives. We need to move past demonizing to real reform.

The post Change bankers’ incentives to get big appeared first on Center for Economic Research and Forecasting.

“It’s no longer legal to say, ‘We don’t want African-Americans to live here,’ but you can say, ‘I’m going to make sure no one who makes less than two times the median income lives here,’” Jargowsky told me.

The above quote is from an Atlantic article on the resurrection of American slums.  I recommend the entire article.  It highlights the cycle that our slums have gone through over the past 25 years or so.

However, the quote succinctly tells a story that I’ve been trying to tell for the past 15 years.  California is now dominated by a wealthy elite, an elite that has molded policy to advance their preference.  Those preferences are all about the elite’s consumption.  They are nothing about opportunity for the less fortunate.

By implementing policies that limit opportunity, the elite are ossifying our society, limiting socioeconomic mobility.  The New York Times has an article on the correlation between a person’s parents’ income and their own.  Here’s the money quote:

I hear from people who say something like: I grew up poor, but I worked hard and I made it. If other people tried, they could, too. Bravo! Sure, there are extraordinary people who have overcome mind-boggling hurdles. But they’re like the N.B.A. centers with short parents.

Too true.

Bloomberg has noticed that our young people aren’t working summer jobs as much as they used to, but they get it all wrong.  Our young people aren’t lazy.  The decline in teen jobs is not exogenous, or an act of God.  Immigrants may be taking some traditionally teen jobs, but policy is the reason there aren’t enough to go around.

Each of these three articles highlights some results of policies optimized for the elite’s consumption rather than economic opportunity.  California, of course, is the nation’s forerunner in policy optimized for the elite.  The results are sometimes beautiful cities.  Santa Barbara, Monterey, and Malibu are excellent examples.  Just as often, the results are ugly cities.  Consider that San Bernardino has the second highest poverty rate among large U.S. cites, second only to Detroit.

The ugly results on people are not so obvious, but these three articles show that they are starting to become unavoidable.  Now, if people would take them as serious as a dead lion, we’d be getting someplace.

The post Ugly Outcomes of Elite Policy appeared first on Center for Economic Research and Forecasting.

I was shocked that almost everyone complained about increased bureaucracy and regulation.  For example, the farmer’s complaints included a “social responsibility” audit.  Even people who worked for quasi-government or government funded enterprises complained about new requirements.  Only the accountant was happy; regulation increases his business.

Complaints about regulation and bureaucracy are common.  I hear them all the time.  However, I’ve never seen such widespread complaints.  In a group of this size, I would expect maybe three people to complain about regulation, but at this meeting, it was practically universal.

This doesn’t bode well for the recovery.  However well intentioned, new broad-based regulatory requirements will serve as sand scattered throughout the gears of economic activity.  It creates additional costs–costs that are likely to exceed the benefits–and uncertainty.  This is exactly the opposite of what we need for robust growth.

It also doesn’t bode well for our forecast.  We have a very difficult time bringing this type of thing into our models.  It probably means that our models are a bit optimistic, and that is a bit scary.

The post Regulation appeared first on Center for Economic Research and Forecasting.

“The U.S. financial system remains fragile and banks subjected to additional economic stress might need as much as $76 billion in capital, according to the results of International Monetary Fund stress tests.”

We at CERF have been long concerned about the strength of our financial sector.  In fact I suspect that the IMF study may be understating the severity of the situation.  That would be a problem.  Ask the Japanese what a weak banking sector can do to an economy.  The weakness of their financial sector, and their failure to correct those weaknesses, were a significant contributor to their 20 years of economic malaise.

Failure to promptly deal with our weak financial sector can have similar consequences for us.  You may think the new financial regulation fixes our banks.  It doesn’t.  It creates a new regulatory environment but it does nothing to address the problems that are keeping our banks from fully participating in our economy, inadequate capital and bad assets on their books.

The post Yes, We Have to Fix the Banks appeared first on Center for Economic Research and Forecasting.

There is only one problem with DJ.  He doesn’t know squat about economics.  It’s not because I haven’t tried.  He refused to believe what I tried to share from my first economics class back in 69/70.  He’s refused to believe anything about economics that I’ve tried to teach him since.  DJ’s a communist, and he’s darn proud of it too, and he’s probably never going to learn, but I’m going to keep trying.

Which brings us to today’s topic.  DJ posted a link to this Robert Reich blog entry and a taunt on Facebook today.

In the blog, Reich correctly points out that inequality is a growing problem in America today.  Then, he starts getting things wrong, very wrong, basically coming to the conclusion that if we reduced managements’ incomes and increased workers’ incomes all would be well with the world.

I can’t believe that Reich really believes that if we just set a higher minimum wage and instituted a new maximum wage, we’d have prosperity for all.  It is well understood in economics that minimum wages increase unemployment and price ceilings create shortages.  Reich’s policy would cause output to fall, unemployment among lower-wage workers to dramatically increase, and management to move to someplace else, say Singapore or Hong Kong.

Inequality is problem, a serious problem and a growing problem.  The causes are a failed educational system, a completely inadequate safety net, and a lack of commitment to opportunity in far too many communities.

While returns to education have been increasing, our educational system has been declining.  The failure to prepare students for the workforce, particularly those who will not go to college, is paid for by the student.  It is paid for in lower income throughout their work life, and in more frequent and longer-lasting income interruptions.

Educational problems are not limited to k-12.  The rapid increase in the cost of a college degree is strong evidence that colleges and universities have managed to extract a significant portion of the gains to education, often leaving the student with debt that takes years to repay.  Too often that expensive, debt-funded, degree fails to provide the expected income, a result of a degree in a field with little market value or a program that lacked rigor.

The lack of an efficient safety net means that unemployed workers have an incentive to take the first available job offer.  That first job offer may be a perfect match, but it may not be.  The problem  is that without a safety net that would allow time for a search for a better match, or provide for geographic mobility, both  society and the worker are worse off.

Finally, communities limit opportunity in the service of quality of life, failing to recall that for many quality of life begins with opportunity.

The post It's Not All About Wages appeared first on Center for Economic Research and Forecasting.

Here are a few key findings:

• 2010 Q2 commitments only $1.9 billion, down 49 percent from 2010 Q1 and the lowest since 2003 Q3.
• 20101 first half commitments only $5.6 billion, down from $9.5 billion in the first half of 2009.
• 90 percent of United States survey respondents expect to see a decline in the number of venture capital firms in their country.
• A majority of respondents in China, India, and Brazil expect to see an increase in the number of venture capital firms in their country.

The pessimists cited unfavorable investment environments caused by economic uncertainty, increased regulatory uncertainty, increased taxes, decreased research spending, and problems in the exit markets.

This is a problem for the United States, and California in particular.  Our high-tech sector, supported by massive amounts of venture capital, has been one of our few relative strengths over the past decade, omitting real estate and finance for obvious reasons.  Given the continuing decline in manufacturing jobs, and the ongoing weaknesses in the real estate and finance sectors, it is hard to see the impetus for a strong rebound without vigorous venture capital activity.

The post Venture Capital Markets Look Grim appeared first on Center for Economic Research and Forecasting.

So it goes. Today’s political debate so often consists of empty slogans and name calling, with little no real discussion of the issues. Minds seem to be made up. Few people want any new information that challenges their views.

We were hired to assess the claims that AB32 would generate net-positive economic growth. The California Air Resources Board has said that AB32, the bill that would require California to reduce carbon emission back to 1990 levels, would create 10,000 jobs by 2020. To do this, we reviewed a few articles that supported the claims. We reviewed the evidence from some countries that are ahead of us in green house gas regulation. Finally, we reviewed the peer-review academic literature. We performed no primary research. We documented our conclusions.

We did not take a political stance as to the desirability of AB32. Assessing the risks of global warming is beyond our expertise. Deciding the appropriate expenses to incur to insure against those risks was beyond the scope of the project. Our research was specific and clear. Given that both advocates and opponents of greenhouse gas regulation claim that the opposing position will costs jobs, it was inevitable that some would be unhappy with our results.

So, what did we find? First, please recognize that the claim that AB32 would create net-positive economic growth is the same as saying something better than-a-free-lunch exists.

If that sounds too good to be true, it is. Evidence and theory indicate that some costs are unavoidable if we are to limit carbon emissions. That is: There is no free lunch, much less a better-than-free lunch. We also found that a refunded carbon tax minimizes costs. This is a tax where the tax is refunded against some other tax that distorts economic incentives. Income taxes are thought to distort incentives, and they would be an excellent candidate for the refund. This type of tax is widely accepted among economists as an efficient method of reducing an activity associated with negative externalities. If you want less of something, tax it.

As you move away from a pure rebated tax, costs tend to go up, particularly with command and control type regulation. In some cases, costs can be quite high, and we provided some examples. We concluded that command and control regulation, a significant component of AB32, could be very costly for California.

The debate over carbon emission regulation is a necessary debate. We should be discussing the risks associated with global warming. We should be discussing the appropriate amount to spend to insure against those risks. We should be discussing the most efficient ways to insure against those risks. Our work helps inform that debate, if anyone is listening.

The post We Call Them Like We See Them appeared first on Center for Economic Research and Forecasting.

The great French economist Leon Walras (1834-1910) showed that perfect markets result in an allocation of goods and services that can’t be improved on, in the sense that no one could be made better off without someone else being made worse off.

Of course, we don’t have completely unfettered markets. In fact, they have never existed. They will never exist. In particular, we economists like to talk about what we call negative externalities. These occur when I do something, but an unintended consequence is that it hurts you, and you have no recourse.

An example may make things clearer. Suppose I have a factory that spews out a deadly chemical, one that destroys all life downwind for ten miles. Obviously I’ve reduced the property values for the downwind property owners. (We’re simplifying here. There are many other issues.) There is no market for the damage I’ve done, and downwind landowners may not be able to afford to sue me, and there was a time when they would have likely lost such a case.

Society’s solution to the problem of negative externalities has been regulation. Until recently, the concept of negative externalities has been the rationale for most environmental regulation. Negative externalities’ victims have also been extended to include non-humans: flora, fauna, and “mother earth.”

Climate change regulation, though, is a bit different. In the first place, we don’t know how much of its justification, the claim of manmade global warming with long-term negative economic impacts, is accurate. Some, the “non-believers” completely deny the possibility of man-caused global warming. Others, “the believers” believe in man-caused global warming with a fervor that matches that of any religious zealot. Another group, me included, believes that manmade global warming is a possibility that should be considered as a factor in making long-term economic policy.

If manmade global warming was a certainty, you could reasonably argue that negative externalities justify regulation, the parties being hurt are just not yet born. That’s essentially what the believers are trying to say when they point to the imminent destruction of all life on earth.

However, once the existence of manmade global warming becomes a probability, it becomes an insurance question. This dramatically increases the level of complexity of the problem, and it dramatically complicates the political problem of reaching consensus about what to do.

So, proponents of climate-change regulation have tried to simplify the issue. One approach has been to turn everyone into believers, either by attempting to convince the skeptical—as it turns out by using gross exaggeration if necessary—or, failing conversion, excommunicating even the mildest skeptics from civil society.

Climate-change regulation proponents have also tried, with success, to use the novel argument that climate-change regulation is not only costless but will generate economic growth. The most enthusiastic proponents of this argument, California’s Governor Schwarzenegger among them, describe a utopian future of happy people enjoying previously-unknown prosperity in a pristine earthly heaven.

Sadly, this better-than-a-free-lunch deal is not likely to materialize. It is true that clever economists have constructed models where such an outcome is possible—models having to do with large-scale inefficiencies existing because of historical accident—but large-scale unrecognized opportunities are unlikely in today’s economy.

It is also true that some economists have found some evidence of small un-captured gains. I’ve participated in this literature. However, those gains are also unlikely to be of the scale necessary to achieve the promised new economic age. Indeed, most economists doubt their existence, arguing, reasonably, that the researchers failed to measure all of the relevant costs. Economists have a hard time believing that markets are so bad that unrecognized profitable opportunities exist in abundance.

Today, California is considering the repeal or postponement of its landmark global-warming regulation, AB32. Oddly, both sides are using the same argument. The forces arguing against the repeal of AB32 argue that the repeal will cost jobs. Those arguing for the repeal argue that failure to repeal will cost jobs.

They are both correct, and they can both prove it with their warring models, which brings us to our second great dead French economist.

Frederick Bastiat (1801-1850), not long before his death, wrote a piece What is Seen and What is Not Seen. In the essay, Bastiat gives the example of jobs created by breaking windows. The broken window creates work for the glazier, a multiplier is attached to that work, and it looks as if economic activity has increased. However, society is not better off. The problem is that we see, and account for, the work, but we do not see or count the costs associated with the initial destruction of capital.

So it is with California’s regulation. Proponents of the regulation have research to support their claim of job creation. The “green jobs” created by the regulation are seen and counted. The jobs lost to the regulation are not seen and are not counted.

The opponents of California’s regulation have estimated the jobs lost to the regulation, mostly a consequence of higher energy costs, but that research—the portion I’m aware of at least—has been criticized for ignoring the jobs created by the regulation. More importantly, they do not see the jobs that might be lost if global warming kills jobs. They only see, and show, the jobs lost to failure to repeal the regulation.

Creating jobs is easy; creating real economic growth is harder. Banning the use of any productivity-enhancing technology will create jobs, but this could occur at the cost of societal well being. We could achieve full employment by banning all agricultural technology created after the 17th century. There is no unemployment in a Malthusian economy. We’d all have “idyllic” jobs on the farm, yet this would in reality be back-breaking work. Many people would live on the edge of starvation. I don’t think anyone really wants that outcome. It is also easy to create subsidized jobs, even if those jobs add nothing to, or worse detract from, society’s well being.

Instead of jobs, the argument should focus on such things well being, consumption, income, probabilities, and the like. It is complicated by the uncertainty surrounding the theory of manmade global warming, and the uncertainty surrounding the economic impacts of any warming. But, the stakes are high. People’s lives will be changed. The debate deserves a higher-level of discourse than we’ve seen. Frenetic predictions of job losses or overly optimistic projections of employment created by a green economy will not do. Instead, let’s recognize the complexity of the issue and have a reasoned discussion.

This previously appeared at newgeography.com

The post Jobs, Environmental Regulation, and Dead French Economists appeared first on Center for Economic Research and Forecasting.

• Keep it simple. Simple regulation is cost-effective regulation. Simple regulation minimizes both regulatory costs to the government and compliance costs to the regulated firms, costs eventually borne by consumers or taxpayers. Complicated regulation invites lawsuits and encourages efforts to avoid the regulation.

• Regulate the smallest possible number of firms. Regulation is a market distortion and tends to limit innovation. Because of the September 2008 collapse, some people are not convinced of the benefits of financial innovation. This is unfortunate. Financial innovation is, on net, positive. Consider the Farmer who hedges against bad weather by using futures or the airlines that hedge against higher gasoline costs. We need to encourage financial innovation.

• Preserve incentives. We’ve all encountered either government monopolies or government regulated monopolies. The DMV, the Post Office, and utilities come to mind. We’ve also seen the innovation that followed the elimination of the phone monopoly. Bad regulation provides perverse incentives. Good regulation maintains incentives for quality, service, and innovation.

• Maximize market feedback. Markets have built in incentives that are beneficial to society. Where possible, we should allow that feedback to do its magic. It is the cost-effective way to preserve incentives.

• Minimize moral-hazard problems. Moral-hazard issues result from free or under-priced insurance. It is currently pervasive, and it is our single largest source of unnecessary systematic risk. The too-big-too-fail concept in particular has resulted in excessive risk taking, with disastrous results. Similarly, FDIC insurance was under-priced, as evidenced by the FDIC accelerating the collection of future premiums, and the results are self-evident.

• Minimize political influence. Political influence in economic matters is counterproductive. It is clear to me that the vast majority of political types are trying to optimize something other than economic activity or efficiency. Whether the political objective is maximizing the likelihood of reelection, rewarding supporters, or simply greedy corruption, we need to avoid the results.

• Regulation is not protection. Regulators often become partners with the regulated. Sometimes this is because the regulator expects to be eventually employed by the regulated. The regulator may have been employed by the regulated, or may become friends with the regulated, or may be corrupt and accept bribes. In all cases, we are ill served when the regulator is protecting the regulated.

• Regulation should not be adversarial. The purpose of regulation is not to punish the regulated. We have a legal system to provide punishment when it is needed. Adversarial regulation will encourage evasion. The best approach is arms-length, fair, and firm.

The post Bill’s Principles of Regulation appeared first on Center for Economic Research and Forecasting.

The problem with regulating capital ratios is that the capital ratio is not a sufficient measure of the firm’s risk. The firm’s risk is a function of both the capital ratio and the riskiness of the assets it holds, and that poses serious regulatory challenges.

A firm has a preferred risk profile. If you limit the capital ratio, the firm can achieve its target risk profile by increasing the riskiness of its assets. This means that if you want to regulate the riskiness of a firm using a capital ratio, you must also control the riskiness of its assets. No problem there.

Well, actually, there is a problem. Controlling the riskiness of a firm’s assets is impossible.

If regulation is to have any impact, the firm has a big financial interest in having riskier assets than the regulators would prefer—an interest that is only made larger by free (too-big-to-fail) or under-priced (FDIC) insurance—and the regulators have only a limited interest. Therefore, the firm will succeed in working around any constraints, and they will always be at least a step ahead of the regulators. The regulators are just no match for a determined firm with a big financial incentive.

Even if regulators could control the risk of firms’ assets, they still could not control the risk of the firm, because risk is dynamic, changing over time. In my banking days, we had a saying: In good times you don’t need capital; in bad times you will not have enough capital.

The problem is that in bad times, everything goes bad. We say the covariance goes to one. It may seem farfetched that a New York grocer, a Los Angeles realtor, and a Chicago lawyer would have economic prospects that were related, and that is true in most states of the world. This is the argument for geographic diversification. However, in a big event like we saw in September 2008 the grocer, the realtor, and the lawyer were all in the same boat. The probability of each of them failing to meet obligations has gone up, but more importantly, the probability of all of them defaulting has gone way up.

There must be a better way to regulate financial companies.

The post Regulating Capital Ratios Won’t Work appeared first on Center for Economic Research and Forecasting.