Martin Feldstein

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Martin Feldstein: And That Rationing Lie

Humph.

Some people just won’t stop. Now it’s OK for an average peson to get into an argument about health care reform and make claims that a government plan will introduce rationing. But it absolutely not OK for a Harvard professor of economics and former advisor to Presidents to do so.

“Repeat after me: all economic systems ration. The only possible debate we can have about rationing is, therefore, what kind of rationing we would prefer.”

So I get really annoyed when Martin Felstein writes this absurd article for the Wall Street Journal. I give the WSJ itself a pass on the basis that its editorial staff don’t know any better, and they simply shill for the Republicans.

But Feldstein?

He should know better. It makes me wonder what he actually teaches.

I have had my say on this many times, most recently here. For those of you who want to dig deeper go to Professor Mark Thoma’s blog and get a proper education.

For those who may be sending their children to Harvard: make sure you avoid Martin Feldstein’s classes.

No wonder few people have a clue what to think.

Poor people and, in this economy, unemployed people, do not ‘prefer’ not to buy insurance or health care services: they cannot afford them. Choice and affordability are not the same thing. Only a dyed in the wool right wing neo-classical economist would confuse affordability with choice. Even then they wouldn’t shouldn’t mislead readers into thinking that a free market does not ration when rationing is its exact reason for being. And contrary to Felstein’s apparent belief reducing the number of high cost/low effectiveness procedures makes very sound economic sense. Then again sense doesn’t seem to motivate Feldstein much in this case.

This really is embarrassing for the Harvard economics faculty. It’s also ridiculous that the rationing canard keeps finding its way into print in serious, or ostensibly serious, media outlets.

Repeat after me: all economic systems ration. The only possible debate we can have about rationing is, therefore, what kind of rationing we would prefer.

Duh!

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Astrological Economics: Just What is Bernanke’s Sign?

For a subject as dry and mathematically inclined as economics, at least in its orthodox version, the linkage between the real world an the merely imaginary is more tenuous than most laypeople would think.

This occurred to me today when I read an excellent letter in the Financial Times. In it an MIT lecturer talks about how limited the average person’s grasp of rational choice is. We are mostly quite irrational even though we often try to be very sensible in our decision making.

“Star charts are as useful in predicting asset price bubbles as orthodox theory. Why? Because at least an astrologer doesn’t doubt their existence.”

This is, of course, not news to any of us. That’s why many of us find it quite difficult to make decisions about even trivial aspects of life.

The so-called ‘Paradox of Choice’ is a good example. [See Barry Schwartz’s book] Economists theorize that giving consumers a myriad choices will, inevitably, produce the best result: the more choice, the more likely that a consumer will find something that exactly matches what they want.

But this flies in the face of our evolutionary roots. We are not cognitively equipped to get into finely grained decision making, where we are required to evaluate nuanced differences. We are it bit brutish in our thinking. We are equipped for simple and often binary decision making: the kind of on-the-fly type of thinking that primitive animals have to make in order to survive to live another day. So when confronted by a plethora of choices most of us simply freeze up and avoid making any choice at all.

A practical example of this is the supermarket. Researchers have shown that someone going to the supermarket with a specific purchase in mind – say toothpaste – will often turn around and leave if there are too many varieties, flavors and brands on the shelf. It is better, in other words, for the shelf to sport a quite limited choice. Sales will be higher and consumers happier.

Contrast this real world research finding with the assumption within free market economic theory that consumers are ‘perfectly rational’, and we can start to comprehend why economics is such a mess. It is more astrology than science.

The entire edifice of free market theory rests on the notion that you and I are supreme calculators. That we are not defeated by shelf loads of products, but that we are capable of feats of analysis, consciously or not, that allow us to arrive at extraordinarily precise decisions that inevitably lead us to maximize our welfare. We never make mistakes. Never.

Sound familiar?

No, I didn’t think so.

I realize it seems very dull, but I want to reiterate the importance of of this small example: our economic lives have been run for years by people who’s outlook on life is conditioned by, and depends upon, on exactly the theory derived from assumptions like that of ‘perfect rationality’.

Take away perfect rationality, and the superiority of markets, as opposed to, say, governments, as allocators of scarce resources crumbles. That means no one can ‘prove’ that markets left to their own devices will always outperform the government.

So the debate reverts to a political one.

Which is why it is urgent that economics recovers itself from the dead end it was driven into seventy years ago and abandons most of the thinking accumulated since then. It simply isn’t true. Worse: it leads to severely handicapped public policy making. It allows ideologues like Reagan and Bush to slam the government – which is their right from an ideological perspective – from within an aura of scientific discipline.

There are times when markets are terrible – sub-prime mortgages anyone?

Bubbles are common structure within capitalist economies. So are business firms. But both bubbles and firms cannot exist within the purity of orthodox economics. Perfection has no room for the messiness of either.

The Nobel prize winner Ronald Coase pointed out to his economics colleagues in 1937 that since business firms seem to be quite common the profession ought to re-consider its allegiance to perfection. Instead he was ignored for decades and only much later did a subculture sprang up inside the profession studying firms. But the textbooks remain pristine. Indeed the firm as an economic entity remains a curiosity and is ignored by most academics.

So too with bubbles. Visit most academic economist websites and you will find all sorts of opinions as to why bubbles cannot be predicted. Many will deny they exist – even now. This is because they are all so inculcated with the perfectionist view that they fail to see the real world. And rather than admit their subject has a big hole in it, they attempt to explain away the Emperor’s nakedness by resorting to all sorts of arcane and highly jargon laden reasoning.

Economists have even begun to argue that their inability to reject a negative argument against their own theory is sufficient to justify its continued existence. Think about that: they take the fact that they have nothing to say as support for a theory. This is hardly Popperian refutation. It is vacuous.

The fact remains that economists are faced with a choice: either their subject is failing to explain many very common economic structures; or it is akin to astrology.

There are hopeful signs: people like Robert Thaler, mentioned in the letter I referenced at the beginning of this post, are slowly chipping away at the outmoded and mechanistic thinking that supports the orthodox theory. But they have a very long way to go.

Meanwhile ideologues still latch onto the orthodox theory in order to justify their politically motivated views. Which affects all of us. The current debate about health care reform would be so much more sensible were it rooted in real world claims about the efficacy of markets rather than being supported by an orthodoxy that resembles the reading of star charts.

So too would the re-regulation of banking.

The relevance of economic theory has never been greater. That’s why it is fun to get involved in the debate. In large part, the crisis we are living through is a creation of orthodox theory. Which is why it’s protagonists are so vocal in their attempts to misdirect our attention: Robert Lucas, Martin Feldstein, Robert Barro, John Taylor, and many others are constantly popping up in the media to pull the wool over our eyes. Their common theme is that it is the government’s fault. Or, failing that, they throw their hands up and claim that no one, absolutely no one, could possibly have seen the crisis arising.

They protest too much.

Their economics is beautiful. Intricate. Intense. Intellectually fascinating. Difficult to master. Brilliantly conceived. And about as scientific as astrology.

Star charts are as useful in predicting asset price bubbles as orthodox theory. Why? Because at least an astrologer doesn’t doubt their existence.

So with respect to the discussion over whether Bernanke should be re-appointed as Fed chairman: only if he was born under a propitious sign. Turns out he’s either Sagittarius or Capricorn. It is quite obvious that the Fed has far too many of those already. Time for one of us more solid, some would say dull, Taureans?

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Martin Feldstein: Economist or Ideologue?

We are back, apparently, to the thorny discussion of inflation. Depending on who you talk to inflation is an imminent scourge and thus Obama should stop all he is doing and become a Republican immediately, or else it is, at mots, a medium term threat that in no way inhibits whatever is left of Obama’s ‘change’ agenda.

Today in the Financial TimesMartin Feldstein wades in on the side of the ‘let’s turn Obama into a Republican’ camp.

I really hate it when economists who teach and preach economics as a ‘science’ turn into ideologues advocating political positions masquerading as economic analysis. I realize that it hard to separate politics and economics – they are inextricably linked – but then stop advocating economics as a science.

Judging from Feldstein’s argument in the FT this won’t happen any time soon.

Let’s start with the headline which includes an imperative: Obamamust reassure markets. Notice that:must.

What is the basis for this strong assertion? Well, it turns out to be the same thing we’ve discussed here before: the recent rise in medium and long term US government interest rates. This rise is characterized by Feldstein as being dramatic, he tells us that they have ‘almost doubled’. They rose from 2.26% to 3.98% between December 2008 and this month. Let’s set aside the pedantic observation that a ‘doubling’ of 2.26% would be 4.52% which is over 0.5% higher than they are and in the context of an analytical base of 2.26% an additional 0.5% is non-trivial. Clearly Feldstein is dealing in hyperbole. Which must therefore be a scientific trait.

This breathless announcement presumably is meant to shock us. How in the world did rates shoot up so suddenly with such extreme speed?

Feldstein then plunges into his analysis:

The key is to compare the rates on plain US Treasury bonds with those on inflation proofed US Treasury bonds [aka ‘Tips’]. The difference, or spread, between non inflation proofed and inflation proofed bonds of the same maturity is clearly inflation. Or, rather, the estimate of inflation that buyers of plain US bonds are adding to the basic bond yield – the Tips rate – in order to compensate for expected inflation.

That spread was 0.19% back in December, but is now 2.07%.

A little simple math and we find that the rise in expected inflation implied in these changes, i.e. the rise in the spread from 0.19% to 2.07% – or a rise of 1.88% – more than accounts for the increase in bond rates.

Ergo: the ‘rapid’ rise in inflation expectations accounts for the rise in medium and long term rates.

This is obviously bad. At least if we get the tone of Feldstein’s message.

But he doesn’t want to stop there. This is, according to him ‘deceptively easy’. So he sets about adding more reasons for the ‘almost doubling’ of US bond rates.

First he adds the notion that the ‘liquidity premium’ has narrowed. This ‘premium’ is the haircut in rates that an investor is willing to accept in order to own an asset with a very high certainty of being sold easily. That’s a mouthful so let me explain.

Liquidity is a characteristic or ‘property’ of all assets. It is a measure of the ease with which an investor can liquidate the asset and get cash back. One of the huge problems we have had during this crisis is that whole classes of assets suddenly became ‘illiquid’ – no one could sell them at any price. The markets for these assets failed. The auction bid preferred markets a good example. These assets were long term assets that are priced on a weekly basis through a bidding process. As long as the bidding goes well, as it did for years, then the assets can be bought and sold weekly, even though they have long term maturities. This ability to churn was key. Longer term assets usually have higher yields – they are riskier by definition. Some banks and investment advisors wanted to sell these assets to customers looking for good yields during the low rate environment of the past few years. The weekly bidding process gave an illusion of liquidity, so the assets had the allure of both high rates and ease of sale: they were ‘liquid’. But the credit scares of last fall killed the bidding process: no bidders turned up at the auctions, so the assets suddenly became totally illiquid. An investor who thought they had a cashable asset now found that they actually held a long term bond.

This is long example of the reason that investors are usually willing to accept a lower yield in return for the certainty of being able to get cash back. The difference between the illiquid and liquid yields is called the ‘liquidity premium’.

Back to Feldstein:

He notes, without providing any data, that the rise in bond rates also includes a diminution of the liquidity premium. Why? Because, he argues, in the extreme crisis right after the Lehman debacle in September last year liquidity was much sought after and thus the premium rose to unusual heights. Now, as the crisis ebbs, the premium is returning to more normal ranges. So US bonds which are regarded as the world’s most liquid asset have lost a little, but all, of their allure: they are back to their usual relative advantage rather than having an excessive advantage.

This too is not good.

Secondly Feldstein adds in the ‘crowding out’ argument.

Allow me to explain this one too.

Some economists regard high government spending as an anathema because it soaks up cash from the economy that would otherwise have gone towards private investment. They assume that the level of savings – the pool of cash for investment – is relatively fixed at any point in time. And given that, they also assume that the level of investment is equal to the level of savings [this equality is one of those classic ‘economics 101’ things!] Put these two together and you arrive at the conclusion that, as the government sops up savings for its investment, in our case to fund its deficit, it automatically diminishes the amount available for private investment. According to these economists this is damaging: the long term productivity of the economy is reduced because they assume government spending is less productive than private spending. Another result of this ‘crowding out’ is that interest rates are presumed to have to rise in the future: in order for the private investment to be satisfied rates will have to rise to encourage the necessary savings.

The problem with this is that it ignores extreme circumstances. The relationship is not always true. The most obvious time when the relationship breaks down is when the economy finds itself in a ‘liquidity trap’. Such a trap is a time when no amount of movement in interest rates will induce more savings or produce more investment. The key link that economists assume exists between interest rates, savings and investment breaks down and the economy drifts into no mans land.

That’s where we are now.

So the linkage Feldstein is trying to make doesn’t apply right now. There is no crowding out. So the fear of rates rising because of such an effect are not presently an issue. What he is talking about is a prospective crowding out effect sometime in the future.

OK.

So now we have all three of Feldstein’s analytical conclusions: inflation fears, liquidity premium and crowding out effects are all conspiring to send yields through the roof.

What should we do?

Cut social spending.

That’s his prescription. We cannot raise taxes to cover our deficits because that would be a disaster – think the 1930’s. So wemust cut spending. Which spending? Social spending.

Before I get too upset about the obviously political nature of this prescription, let me note a few things:

  1. US bond rates are still relatively low by historical standards. So the panic seems premature.
  2. The implied inflation rate embedded in those rates, about 2.0% according to Feldstein, is exactly in line with the announced and highly publicized target levels the Federal Reserve Board has established. So there seems to be nothing unusual about them at all: the market is accepting the Fed’s target as the expected range for inflation. Duh.
  3. Liquidity premiums have fallen from crisis levels back to normal levels. This is not something to panic about: we should be happy for any evidence of a return to normalcy.
  4. We are in a liquidity trap so the crowding out argument is weak at best. Again no panic.
  5. And, in any case, a long term inflation rate of 2.0% seems entirely ordinary. Nothing there to invoke panic either.

But to ideologues trying to invent an economic argument against expanded social spending this is the best they’ve got. Which is to say that they don’t have much. All they can do is to point at a very ordinary rate increase and try to make it seem extreme. Then they point to the presumed root cause: the target of the right wingers will always be government spending. Or, to be more, precise the kind of government spending they don’t approve of.

So to ideologues like Feldstein itmust be the prospect of government spending that is causing this horrible rise in yields that is already threatening the safety and soundness of our economy.

OK I added a bit there, but he does point out that rising rates will affect the speed of the recovery through more costly mortgages and business loans. That is, of course, if there is any real demand for business loans: just how much spending does a business need to make when it is already running at below 70% of capacity? Which is where the manufacturing side of our economy is right now. Why add more unusable capacity?

Feldstein doesn’t mention that latter point becasue it’s kind of awkward.

Let me get back to my annoyance.

Felstein’s analysis is boiler plate. It takes normal economic thinking and applies it to a phenomenon – rising rates – and then tries to create an aura of emergency. Why?

Because he is implacably opposed to social programs.

He doesn’t use economic analysis to attack social programs head on. He uses the usual GOP trick of setting up a red herring and then bashing it down. He implies that rising rates are unequivocally related to social programs. Rising rates are bad. So social programs are bad.

But the budget includes very large non-social programs – defense spending … shall I be argumentative and call it what it is? ‘offense’ spending?

Why is this not reduced?

So the Feldstein objective appears to be using economic analysis to support an a priori political predilection. There is nothing inherent in the rise in interest rates to connect it, inevitably, with social programs. That’s just the connection Feldtsein wants to make. We could just have correctly called for cuts in offense spending.

So the entire FT article can be reduced to an exercise in ideology.

No wonder those free-market economists are getting a bad rap. They engage in too much politics.

But then again so does Krugman on the left.

So much for the ‘science’ of economics.