Pur Autre Vie

I'm not wrong, I'm just an asshole

Monday, September 01, 2014

Krugman and the Problem of the Rentiers

Krugman has a post up right now about the political economy of stimulus - that is, why elites support austerity instead of stimulus.  He ends up with the same puzzle I was writing about a little while ago.  Rich people would seem to gain tremendously from a run-up in asset prices, so what is their objection to expansionary monetary policy?

Anyway it's hardly a coincidence, my ideas are almost entirely generated by reading Krugman's blog and his columns (which is why you will recognize that I use a lot of his terminology).

Not Math Problems, Exactly

I've written in defense of taxis before, and I won't repeat my arguments here.  The short version is that if you want there to be a cheap way for people to travel around the city by car, you can't allow market entrants to replicate taxi service without being subject to comparable regulatory burdens.

But that's not the same thing as saying that the New York taxi system is perfect.  And in particular, research like this highlights how much room there is for improvement.  In short, it would be possible, using smartphone technology, to facilitate ride-sharing with the result that people would pay less and there would be fewer taxis on the road.

Of course, the politics are tricky - taxi medallions have surged in value in recent years, and the issue of jobs is always a sensitive one.  (And this research is indicative but far from exhaustive - we would need a more realistic assessment of the policy to draw robust conclusions.)  But this is exactly the kind of thing that a well-run society embraces, providing better service at lower cost to its citizens.  It's the kind of thing we have a right to demand in light of the monopoly granted to the medallion-owners.  You submit to the regulatory system, you get protection from Uber and Lyft (which I hope we will provide) - and in exchange, you obey the city's imperatives.  (The flip side, of course, is that if there is no regulatory protection, then there is no ability to issue imperatives, and we are left to the tender mercies of the market.)

Moving the Ribbon

A good society is one in which people subjectively experience fairness, safety, prosperity, meaningful human connections, beauty, ideas, and freedom of conscience.  (I'm probably forgetting some things, but you get the idea.)  In a later post I may take a closer look at what I mean by "subjectively," but for now just note that it raises some difficulties because people's subjective experiences don't map neatly onto objective metrics.

Most societies throughout most of history have failed to be good societies in such obvious ways that the problems (if not the solutions) have been easy to identify.  To some extent there is still low-hanging fruit in our society, but much less than in the past, and much less than in many other societies.  (This is one reason there are so many people who want to move here.)

So now we are beginning to face trickier questions about how to organize our society.  One way to think about it is that some kinds of scarcity are largely disappearing, but a lot of scarcity remains.

I'm being vague, so let me get to the point.  It is impossible to intervene directly in society to achieve good outcomes most of the time.  Basically this is only possible in very small groups, such as families and circles of friends.  When children are playing, a parent can intervene to generate a fair outcome.  When a friend experiences an unexpected setback (medical, professional, whatever), friends can step in with financial help.

But there are severe limitations to what can be done in these small-scale institutions.  They are totally inadequate to the task of operating a modern economy.  And of course, there is no guarantee that people will behave well.  William Gladstone was aghast when his brother proposed to marry a Unitarian (if memory serves), and threatened to boycott the proceedings.  (His father, the source of the family's wealth, intervened to compel him to accept his sister-in-law as part of the family.  William Gladstone's religious prejudices diminished over time, though more in his public life than his private life.)  Churches (and other religious congregations) are an effort to expand this circle of justice, but again they are far from perfect - even when their ideals are mostly right-minded, they achieve justice at a fairly high expense.

In a modern economy, people need to be able to interact with strangers on an anonymous basis, with trust that there is a high likelihood that promises will be kept and expectations honored.  And there are other, less market-oriented economies of scale that make it desirable to organize through the state rather than smaller units such as the family, the church, the tribe, etc.

But as I said, while you can make a direct intervention in your own family, your own social group, and even your own church or tribe, this kind of ad hoc justice is unavailable to the state.  It must perforce operate through procedures, and so the hunt is on for procedures that tend to achieve good outcomes.  (You might say, lacking the resources to tailor our policies to individual situations, we are forced to do our best to come up with off-the-rack designs that will work for as many people as possible, recognizing that off-the-rack clothes are never going to fit as well as tailored clothes.)  And at this point the appropriate degree of rigor to apply to the analysis is much lower than we might ideally like.  We are forced to make ghastly generalizations with totally inadequate evidence (or maybe a better way to put it is, totally inadequate capacity to process the available evidence).

And so we say things like, "The combination of a market economy, democratic government, and the rule of law is a hugely successful one."  And I think this is true.  But of course, it also appears to be hugely helpful for a society to be English-speaking, for reasons that aren't at all clear.  Famously, Weber thought that Protestantism was the key to progress.

At this point I want to make two observations.  The first is that when you are dealing in procedures designed to achieve a good outcome, it is not a sufficient objection that those procedures sometimes lead to bad outcomes, or that they can appear in some instances to be stupid.  These things are to be expected.  (As an example, people sometimes mock the fact that packages of nuts include a warning:  "CONTAINS NUTS."  This is a "stupid" policy that in fact is almost certainly a good one.  Try to formulate a policy that would exempt nut sellers from allergy warnings without causing problems far more serious than the absurdity of requiring this warning.  I doubt you can.)  A proper objection is along the lines of:  "We could adjust the procedures in such-and-such a way, with the result that we would achieve better outcomes on the whole, taking into account all of the relevant consequences."

This point is heightened by the severe scarcity that still characterizes our policymaking.  Most states' criminal codes probably contain no more than a few kilobytes of data.  In common law jurisdictions, you could expand that to include written court decisions, in which case you might have a few megabytes of data.  (Much of that data will be irrelevant, of course.)  And this is the basis on which we decide guilt and innocence, and mete out punishment, including in many states death, but in all states significant loss of liberty.  But this scarcity is necessary (or at least, almost certainly necessary):  we lack the institutional competence to adopt more fine-grained policies that take into account particular circumstances.  Instead we've added the capacity for ad hoc interventions such as jury nullification, leniency in sentencing, pardoning by the executive, etc.  I'm not saying we've done a perfect job, by any stretch, but the final result is very much a product of our limited capacity, and those limitations will probably not be significantly relieved however cheap processing power becomes.

Our response to this limited capacity is to adopt a mindset in which the procedures themselves come to carry independent moral force.  We expect people to obey the law and behave within social norms, and we don't think it is a sufficient defense that those laws or norms would, if they had been tailored to the specific situation, have yielded a different outcome.  If you break the law, you effectively take on "strict liability" for the consequences.  (That is, you will be punished if anything goes wrong, regardless of whether you should be held "responsible" in some metaphysical sense.  Responsibility attaches to you when you go outside the bounds of the law.)

I want to emphasize this point:  the procedure becomes the substance.  This is probably a necessary accommodation to our inability to pursue substantive justice at the level of the state.  Another way of putting it is that the citizen is expected to meet society halfway.  If society has made a good-faith effort to achieve justice, then it is the citizen's duty to conform himself to the framework established by society.  (In extreme enough circumstances, this duty disappears and rebellion or civil disobedience is justified.  Also, note that a good society will include safety valves so that it rarely asks people to make extraordinary efforts or sacrifices.)

(In Catch-22, there is a map of Italy with a ribbon on it, showing how far the ground troops have advanced.  The pilots and their crews watch it closely, because if the ground troops advance far enough, then the air corps won't be expected to provide bombing support.  A character laughs at their superstitious, pre-scientific obsession with the ribbon - he mocks them for thinking that the ribbon itself, and not the real-world situation it represents, is what matters.  At night someone surreptitiously moves the ribbon past the objective, and so the bombers are not sent out that day.  Just as the ribbon actually took on independent importance, so our procedures take on real-world substance.)

My second observation is that this tendency to turn the procedure into the substance can have an unfortunate deadening effect on thought.  What is in fact a regrettable accommodation is elevated to a matter of principle.  This is the objection to market fundamentalism.  Markets are just the sort of institution that we are forced to adopt as a pis aller; their justification is that everything else is even worse.  But market fundamentalists treat the "market outcome" as though it is some kind of unassailable moral criterion, so that it is enough to say of a policy that it is non-market and therefore must be rejected.  This elevation of procedure to substance and then to normative criterion is evidently highly seductive to some people.  (And so when I once argued that cost-benefit analysis is a good policy only if it leads to good outcomes, this was considered a controversial or incomprehensible claim to make - in fact, I was considered to have been bafflingly wrong, pig-headed in my insistence that cost-benefit analysis might possibly yield bad outcomes, something that my interlocutors regarded as impossible by definition.)

It is a subtle point I am making, because indeed as a policymaking matter we have to do roughly what the market fundamentalists suggest, and make markets the substance of our policy (that is, we must embrace markets and build our institutions around them, and we have to expect citizens to "meet us halfway" by deriving their income and most of their consumer goods from the market).  To put it another way, we lack the capacity to assess the market on a case-by-case basis, and so we generally regard it as sufficient to embrace the market unless presented with a good reason not to.  But we must do it with mental reservations and with a keen eye for situations in which we can profitably diverge from the market outcome.  And while we can and must expect citizens to be exposed to market forces, we need not regard the outcome as wholly just, and we would be prudent to include plenty of sheltered places, plenty of safety valves to prevent our necessary embrace of markets from turning into a source of grave injustice.  Market fundamentalists aren't on board with any of that.  They don't understand that markets are contingently useful.  As a result of the forces I've discussed, we've allowed market procedures to become operationally the substance of our policy; market fundamentalists think this means we've embraced them as our moral criterion.

I'll probably have more to say.  Basically I think these issues are very hard, and our "rational" approaches are subject to far more tradeoffs and intellectual shortcuts than we usually acknowledge.

Saturday, August 30, 2014

The End and its Aftermath

William Gladstone died on May 19, 1898.  The Prince of Wales served as a pallbearer.  Queen Victoria, who despised Gladstone, "telegraphed to the Prince of Wales to ask what was the precedent he had followed and whose advice he had taken in acting in such a capacity.  He rather splendidly replied that he knew of no precedent and had taken no advice."

And a final footnote.  Roy Jenkins (from whose Gladstone I have been quoting) writes of his grandson, also named William:  "When he was killed in France in April 1915, at the age of twenty-nine, he had been President of the Oxford Union and was currently Lord Lieutenant of Flintshire and Liberal member of Parliament for Kilmarnock Burghs."

Unbowed Until the End

Again quoting from Gladstone by Roy Jenkins.  But first, a little background.  Gladstone is at the very end of his parliamentary career.  What he had come to see as his life's work, Irish Home Rule, has been passed by the House of Commons but decisively rejected by the House of Lords.  Britain won't again consider the issue until forced to by the uprising of 1916, followed by the Irish Free State and the vituperative Irish Civil War of 1922, followed of course by decades of terrorism, assassinations, and religious and ethnic hatred; Ireland's seething hatred so deep-seated that the Republic remained neutral rather than joining the fight against Hitler; Gladstone thoroughly vindicated and his opponents utterly discredited, those vacuous pieces of shit.

So Home Rule is dead for a generation.  But while Gladstone is exhausted, he is not yet done.  A previous Conservative government had undertaken a massive ship-building campaign, motivating France and Russia to play catch-up.  Now two of those British warships have collided with each other, with much loss of life.  The unerring logic of imperialism now compels Britain to fund yet another massive expansion of its navy (this being the only appropriate response to a naval accident).  Here Jenkins quotes Sir Edward Hamilton, who was at one point Gladstone's private secretary but who by this point has risen into a greater role in politics (note, by way of additional background, that Gladstone was a notorious penny-pincher who had in the past successfully resisted military expenditures on the grounds of fiscal prudence):

He [that is, Gladstone] again and again said it was not a question of amount:  he would swallow any amount of expenditures, however reckless it might appear to be, for such purposes as converting all our ironclads into wooden ships on the assumption that naval policy has gone through a transformation, or (say) doubling the Education grant.  No.  It was a question of policy.  Russia and France had gone ahead with their ship-building, solely owing to our Naval programme of 1889 for which we had to thank the late Government; and now we were to 'go one better', thus directly challenging Europe in the race of armaments.  It was his conviction that this competitive action of ours would accelerate some great European catastrophe:  these vast armaments must lead to some flare-up - probably the absorption of small states and the break-up of Italy.  He could not be party to this.


 Now admittedly Gladstone's foresight was probably not quite so brilliant as this isolated passage might make it seem.  But Gladstone's imagination and willingness to stand against the tide are remarkable.  He is one of the greatest anti-imperialist politicians of all time, and the consequences he incurred are a cautionary tale (though also in some cases an inspiring example) for all modern politicians with an anti-imperialist tendency.

And by the way, it was this political battle over naval expenditures, and not the far more crushing Home Rule defeat, that formally ended his political career.  In other words, at the end of his political life and very nearly at the end of his lifespan, Gladstone persevered in his obstinate right-headedness, pushing hard against the political tides that were to sweep Britain into so much needless pain and loss of life.

The T Is Silent

First, a quick and amusing Gladstone update.  Then a more somber one.

I quote from Gladstone by Roy Jenkins, who recounts "the famous exchange many decades later of Lady Oxford (as Margot Tennant had then become) with the 'blonde bombshell' Jean Harlow, who persistently addressed her as 'Margotte,' until told:  'The t is silent in my name, Miss Harlow, as I presume in yours.'"

Wednesday, August 27, 2014

Gladstone, Gordon, Truman, MacArthur, and the Queen

One interesting aspect of Gladstone's career, of which I was unaware until reading Gladstone by Roy Jenkins, is the voluminous correspondence carried out between Gladstone (as Prime Minister) and Queen Victoria.  The letters are remarkably frank, though of course couched in polite, formal (you could even, with some justice, call it "Victorian") language.  The letters are striking in part because, as Jenkins notes, "Cowardice was not one of Gladstone's faults in dealing with the Queen."

I will reproduce an exchange that I find quite remarkable, but first a little background.  Britain had effectively gained control of Egypt following a successful military campaign that put the Gladstone government in good light.  But an uprising broke out in the southern part of what was then Egyptian territory (and is now Sudan), and an Egyptian army under English command was annihilated by the rebels.  Gladstone's government determined to withdraw from the contested territory, and to that end General Charles Gordon was sent to organize the withdrawal (a policy he opposed - his appointment was a bizarre result of feverish public opinion which should, as we shall see, have been resisted).

Instead of discharging his duties in accordance with his orders, General Gordon essentially attempted to put down the rebellion (I am fuzzy on the details).  His forces were soon surrounded and besieged, and the question of how to proceed was hotly debated within Gladstone's cabinet.  Gladstone was of the view that Gordon's predicament was the result of his own insubordination and that he should be left to his fate.  The public, however, took up Gordon's cause and strongly supported intervention on his behalf.  (Some in Gladstone's cabinet shared this view.)  Ultimately a relief expedition was organized, but it arrived too late - Gordon had been killed.

I will pause here to observe that there are striking similarities between the Gladstone/Gordon debacle and the Truman/MacArthur confrontation.   The relative firmness and adroitness with which Truman and his Congressional supporters resisted public opinion and put MacArthur in his place are to be admired.  In fairness to Gladstone, he was much distracted by his Irish legislation (not yet Home Rule, but rather a series of less drastic but still hotly debated measures) and had delegated the Gordon matter to a committee of his cabinet, which in turn handled it rather poorly.  On top of which, by the time Gordon's insubordination came to light, events had already spiraled largely beyond Gladstone's control, whereas Truman still had an opportunity for decisive action after MacArthur's disobedience.

But at any rate, Gordon was considered a hero and his death was blamed on Gladstone's government.  (That he had flagrantly disobeyed his orders and generally conducted himself like a madman was of no consequence.)  The queen (expressing the conservative/imperialist view to which she increasingly adhered in the later years of her reign) wrote to Gladstone (as quoted by Jenkins):

These news from Khartoum are frightful and to think that all this might have been prevented and many precious lives saved by earlier action is too fearful.
This rebuke was sent by unencrypted telegram, the equivalent of a postcard and therefore amounting to an open letter to Gladstone.

Gladstone replied, in private (again, as reported by Jenkins - note that the use of the third person is typical of Gladstone's correspondence):

Mr Gladstone has had the honour this day to receive Your Majesty's Telegram en clair [that is, unencrypted], relating to the deplorable intelligence received this day from Lord Wolseley, and stating that it is too fearful to consider that the fall of Khartoum might have been prevented and many precious lives saved by earlier action.

Mr Gladstone does not presume to estimate the means of judgement possessed by Your Majesty, but so far as his information and recollection at the moment go, he is not altogether able to follow the conclusion which Your Majesty has been pleased thus to announce.

Mr Gladstone is under the impression that Lord Wolseley's force might have been sufficiently advanced to save Khartoum had not a large portion of it been delayed by a circuitous route along the river, upon the express application of General Gordon. . . .
Now, let's leave aside these details about the route of the relief party and so forth.  What's striking to me is the fine balance that Gladstone strikes between decorum and deniable sarcasm.  It is impossible for me to imagine a comparable letter being written to the queen today.  Other, of course, than the one I just fired off . . .

Sunday, August 24, 2014

I Wrote Another Poem

"Map Room 2014"


What is it like
To be on the wrong side of history?

It is almost too perfect.

These pasty white boys from Nevada
Trying to play baseball
Against a south side team
Essentially 100% black.

With the whole city of Chicago behind them,
Rahm Emmanuel shutting down streets,
Clogging the intersections, bringing downtown to a standstill.
But fuck the drivers.
This is our team, these incandescent chocolate-colored boys
From the south side.

Essentially 100% white, pity these Nevada boys who
Didn't quite realize they were up against something bigger
Than themselves, than a baseball diamond.

If they could be here in this
Essentially 100% white beer bar on the north side of Chicago
(with maybe a few Asians)
Who cheer uproariously when these black boys
From the south side make a double play
And kill the dreams of Bill Buckner-looking mother fuckers.

Maybe they would realize that
It turns out you can be on the wrong side of history
Even if you are lily white.
And maybe John McCain could have told you
For sure Mitt Romney could have told you
These south side boys, with black skin and the whole city behind them
Are not to be fucked with.

It is almost too perfect.

These effete north side white liberals
On whose narrow shoulders nothing too important can be placed
Flinging magnetic curses
Have somehow understood
Have grasped something bigger and far more implacable than themselves.
And so Jackie Robinson West
(it is, as I tried to warn you, almost too perfect)
Advances to the finals
Where they will face the Koreans
Who know a little something about being on the wrong side of history.

Tuesday, August 19, 2014

Measuring Social Welfare

A few thoughts on GDP.  (As always, I make no claim to originality or accuracy.  Just a little wild surmise.)

GDP is not really a measure of well-being, or even of economic activity.  It is a measure of economic activity mediated by the formal marketplace.  (Or the not-so-formal marketplace:  Italy recently made waves when it announced that it would include black-market activity in its GDP calculations.)  In the classic example from introductory economics, if I hire a babysitter, then the monetary compensation I pay counts toward GDP.  But if I arrange for a family member to babysit my child, for no monetary compensation, then it doesn't count toward GDP.  This may be seen as a limitation of the metric, but for now let's just note that GDP is not all-inclusive.

Various efforts have been made to find a more direct measure of the thing we are actually trying to maximize, but as far as I know none of them has really taken off.  I think this is probably because there is a fair degree of squishiness and value judgment involved.  For instance, the per-capita GDP of the United States is considerably higher than that of Japan (according to the CIA, Japan is at $37,100 while the U.S. is at $52,800).  But Japan is undoubtedly better off in a lot of ways.  Its life expectancy at birth is 84.46 years, while in the U.S. it is 79.56 years.  Infant mortality is 2.13 deaths/1,000 live births in Japan, vs. 6.17 in the U.S.  Adult obesity is 5% in Japan, 33% in the U.S.  The unemployment rate was 4.1% in Japan in 2013, while it was 7.3% in the U.S. (now it is 6.2%).  (As far as I can tell, the CIA World Factbook does not report countries' incarceration rates.  A puzzling omission.  Anyway I would bet a substantial amount of money that it is lower in Japan than in the U.S.)

And you can draw similar comparisons between the U.S. and the social democracies of northern Europe, which have substantially lower GDPs than the U.S. but which enjoy better outcomes on a number of dimensions.  But you can't really say who is doing better unless you have a way of adjudicating the relative importance of those dimensions.  And it's worth noting that in a big-picture sense GDP is highly correlated with good outcomes on many of the most important dimensions (though perhaps obesity is not among them).

So just as an intuitive matter, I think the right way to think about it is to postulate some kind of hard-to-measure "gross domestic capacity," which is meant to reflect a society's ability to meet whatever goals it might embrace.  GDP would be a major component of (and therefore a rough proxy for) GDC, which would explain why higher GDP is generally correlated with good outcomes.  But it would be a mistake to take GDP too seriously as a measure of social welfare.  If researchers developed a new sex position that improves pleasure by 50%, it would have almost no direct effect on GDP, but it would mark a huge step forward in human flourishing.  [150% of zero is still zero, you fucking loser. - ed.  What the hell, man?]

I bring all of this up because to some extent a society can choose how to "spend" its GDC.  If you choose to "spend" it on market goods and services (cars, houses, restaurant meals), then it will appear in GDP numbers and your country will be demonstrably wealthy.  But you can also choose to "spend" it on non-market things like long vacations, short work hours, preparing meals for yourself, exercising, having good sex.  [Is there such a thing as bad sex? - ed.  I wouldn't have thought so, but my girlfriend takes another view of the cathedral.  Also, weren't you just mocking me for being bad at sex?  I was implying you don't have any sex, but obviously the one thing causes the other. -ed.]  This is essentially what northern Europe has done.

And I want to emphasize, this is to some degree a collective decision.  A market-oriented society will punish people who engage heavily in non-market pursuits (I will have some vituperative things to say about this in a separate post), while a society that taxes itself more heavily can provide public goods and non-market protections that enable non-market activity.  And it's not just political:  a society that venerates wealth will confer status on people who orient themselves towards wealth-acquisition, thus punishing those who don't (status being a positional good).  So there are limits on the degree to which an individual can simply "opt out" of his society's choices about how to allocate GDC.  We are engaged in both a political struggle and a culture war, and sadly I think the capitalists/libertarians are winning (though there have been some positive developments on the political front).

In future posts I will take this thought in two directions:  first, I will (as I mentioned) have some negative things to say about the U.S.'s brand of capitalism.  Second, though, I want to return to my earlier posts about macroeconomics and monetary policy, in examining the concept of potential output.

Sunday, August 17, 2014

Encouragingly

I continue to be greatly amused by Gladstone by Roy Jenkins.  Today's entry finds Gladstone contemplating a move to a new constituency (at the time, it was common to represent a district you did not actually live in).  At this point, Gladstone represents Oxford University, and its conservatism on many of the great issues of the day is acting as a moderating influence on his public positions.  As Jenkins puts it, "Palmerston hoped Oxford would keep him at least half muzzled."  (Gladstone is serving as Chancellor of the Exchequer in Palmerston's government.)

Anyway Gladstone decides to stick with Oxford at this point (he ultimately switches to South Lancashire in 1865, after losing his seat at Oxford).  Here's Jenkins:

"Gladstone had to settle for the small step of resigning from the Carlton Club [a heavily Conservative institution], which he did in March 1860 and which his faithful amanuensis Robert Phillimore thought a considerable mistake, particularly as Phillimore added encouragingly, 'They hate Gladstone more at Brooks's than they do at the Carlton.'"

By the way, Jenkins also notes that Gladstone went to the Carlton Club to write a few letters immediately after destroying Disraeli's budget of 1852, and with it the only Conservative government between 1846 and 1858.  (And when I say immediately, I mean immediately - Gladstone wrapped up his devastating speech at 4:00 a.m. and was sitting in the Carlton Club writing letters at 4:30.)  Recalling that the Carlton Club was highly Conservative in sentiment, it was an odd thing to do - Jenkins calls it "surprising and perhaps insensitive."  So anyway you can see why they hated Gladstone at the Carlton, though he stuck around for several years after his 4:30 a.m. visit.

Friday, August 15, 2014

Dizziness from Success

To quote from the diary of then-seventeen-year-old Lucy Lyttleton, a niece (by marriage) of William Gladstone, as quoted in Gladstone by Roy Jenkins:
Uncle William has taken office under Ld. Palmerston as Ch. of the Exchequer, thereby raising an uproar in the midst of which we are simmering, [in] view [of] his well-known antipathy to the Premier.  What seems clear is that he feels it right to swallow personal feelings for the sake of the country; besides he agrees at present with Lord P.'s foreign policy, also he joins several Peelites. . . .  There is this question, however:  why, if he can swallow Palmn. couldn't he swallow Dizzy, and in spite of him go in under Lord Derby?  I don't pretend to be able to answer this, but one can enough understand things to be much excited and interested. . . .
Now there's a lot going on in this passage, but what amuses me is the reference to "Dizzy."  Can you guess who that is?  I am going to take the unusual step of inserting a "break" so that you can guess before you click to see the answer.


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You Think Hard, You Lose Clarity

Again I'm going to write a bit about macroeconomics.  I want to focus on an area I poorly understand.  At some point I will have to read some of the literature that is out there, but I will put that day off as long as I can.

The thing I am thinking about is my earlier distinction between deferring consumption and assuming risk.  The logic is that when I buy a financial asset for $x, I am generally doing both:  I am (A) spending $x less than I otherwise could have, in the hopes that I will be able to spend more in the future, and (B) taking on the risk that the asset will decline in value.  (Let's focus on traditional securities and similar products, not, like, triple-short ETFs or whatever.)  (And as a side note, the risk-bearing concept shows up in people's description of their investment activity when they say they want "exposure" to a particular region or sector.  What they mean is that they want to bear the downside risk of losses in exchange for the upside "risk" of gains.)

Now I think these two concepts (deferring consumption and assuming risk) are fairly easy to distinguish as a conceptual matter.  Of course most financial products blend the two, though you can imagine exceptions.  (For instance, if my broker allows me 100% margin, then I can "gain exposure" to a security without foregoing any current consumption.  In the U.S., this is generally not permitted for equity securities.  Or I can sell options and use the premiums to increase my current consumption - again assuming the margin requirements are low enough that I can extract the cash.)

But while I think the concepts are reasonably distinct, I wonder if we can really separate them in practice.  Here's what I mean.  Imagine that I can buy either of two Treasury securities.  One of them is a 6-month bill, and the other is a 5-year note.  (For our purposes, the only difference between a bill and a note is time to maturity.  In real life I think bills are sold on a discount basis while notes bear a coupon.  Ignore this complication.)  Imagine that these are TIPS (Treasury inflation-protected securities), meaning that the payment on the security is adjusted to reflect inflation.  Assume for simplicity that the securities bear zero credit risk and that they reflect a completely accurate measure of inflation (so that there is truly no inflation risk with these securities).  And finally, assume that the securities can't be sold or pledged.  Once I've bought them, I'm stuck with them until maturity, no matter what.

Now, there are still risks with these securities.  Most notably, there is interest rate risk - if interest rates go up after I buy the securities, then I will incur an opportunity cost - if I had held my money in a checking account, I could invest in the same securities at a higher interest rate.  And maybe I will be compensated for that risk (more so with the 5-year note than with the 6-month bill, because the risk is greater the longer I have to wait to get my money back).  But it seems as though these securities are as close to pure consumption-deferral as you can get (you are trading away $x in 2014 dollars in exchange for $y in 2014 dollars in the future), and again the compensation should be higher for deferring my consumption for 5 years than for 6 months.  (Strictly speaking, the point here is that I could either defer consumption for 5 years, or defer it for 6 months with an option to extend for another 6 months and so forth.  Since the rolling 6-month option gives me more opportunities to consume in the relatively near future, it should bear lower compensation, that is, a lower yield.)  So in ordinary conditions we would expect the interest rate to be higher on the 5-year note than on the 6-month bill.  (In rare situations the "yield curve" may be "inverted" - this just means that long-term securities actually bear a lower interest rate than short-term securities.  This might happen if short-term interest rates are currently high but are predicted to drop in the future.)

Okay, very well.  But now imagine the same securities, except they can be sold or pledged as collateral.  And imagine there is a reasonably liquid market for the securities, meaning that in practice I can sell them quickly for a reasonable price.  Now it's easy to see that I'm still bearing interest rate risk (in a sense, it's easier to see because if interest rates go up I might actually sell the securities for a loss, whereas in the previous example I was compelled to hold them to maturity).

But the crucial insight (I think!) is that I'm no longer deferring my consumption differently with the two securities.  I can sell either one of them on short notice.  I'm still taking on more risk with the longer-dated security, but I'm no longer really committing to wait 5 years before I can spend the money I'm investing.  I could sell the 5-year note next week and buy some kidney beans or whatever.  So my consumption-deferral is now roughly equal as between the two securities (although, to repeat, I am exposed to more risk, both upside and downside, on the longer-dated security).

The point here is that consumption-deferral seems to be fungible with risk-taking as an economic matter.  (Extending the amount of time I am willing to defer my consumption is fungible with bearing additional interest-rate risk.)  So distinguishing between the two might not be so easy to do in the real world.  I ought to be able to enter into some kind of derivative contract with no money down (if my counterparty is willing to take my credit risk) that exposes me to roughly the same risk as holding these securities, but doesn't require me to defer consumption at all.

Now I'm not sure what the implications of this are.  Maybe nothing?  But it seems odd that consumption-deferring and risk-bearing might be fungible in terms of how they contribute to the economy and how they are compensated.  (Again, I acknowledge that most securities involve both activities, so I wouldn't be surprised if it were difficult to sort them out if we tried to measure them.  But I am surprised that they may turn out to be truly interchangeable as an economic matter.)

In my earlier post I wrote that in our current economic climate, risk-bearing should still be rewarded but consumption-deferral should not.  (This is because we currently have a shortage of consumption, so deferring it does the economy more harm than good.)  But if I'm right now, then I was wrong then.  A more accurate way to put it is that certain kinds of risk-bearing should be rewarded and certain other kinds (the ones that replicate the economic features of consumption-deferral) should not.  Maybe this is just another way of saying that the yield curve should be flat.  Which is another way of saying  that short-term interest rates should be low for a long time.  Which makes sense.  But it lacks the clarity of my earlier framework.