Our colleague, Richard Wagner, a leading light in the public choice revolution, wrote the following remarkable question for the 2005-2006 graduate political economy preliminary exam at George Mason.

Joseph Schumpeter claimed that capitalism would give way to socialism largely for ideological reasons. This does not seem to have happened, at least directly. But might it be happening indirectly? Consider, for instance, a significant change that has occurred in the economic organization of debtor-creditor contracts. Not too long ago, lenders held their loans in their portfolios. They would lose if the borrower defaulted, which gave the lender a strong incentive to monitor the borrower, particularly for large loans. Now, lenders split their loans into numerous small pieces and disperse them throughout the economy. (For instance, many people who hold mutual funds and retirement accounts will find that they are holding small pieces of large loans made by commercial banks.) The burden of non-performing loans is thus dispersed throughout the economy rather than residing with the original lender. Does this development weaken the incentive of lenders to monitor borrowers and thereby weaken overall economic performance? That is, can market transactions generate institutional arrangements that impair the market economy? However you address this topic, do so clearly and cogently.

I am sorry to say that none of the students got the answer right.  Of course, very few of their teachers, here or elsewhere, got the answer right, either.  Kudos to Dick for his prescience.

I thank David Levy for the pointer.

The stock market sure looks like a bubble now but it’s actually very difficult to distinguish bubbles from rational behavior when dividend growth rates can change and must be forecast. Ironman has an excellent post on this at Political Calculations, titled Acceleration, Amplification and Shifting Time.  See also the simple model discussed in my paper with Gary Santoni which Ironman kindly cites.

I don’t deny that bubbles exist, by the way, my point is that the fact that they are difficult to distinguish from rational behavior is one reason that they exist.   

Mr. Obama also responded to criticism of waste and inefficiency in such
programs by promising new spending rules, like a requirement that
states act quickly to invest in roads and bridges or sacrifice federal
money.

From the NYTimes.

The title is from Oliver Hart and Luigi Zingales writing in the WSJ:

Practically every day the government launches a massively expensive new
initiative to solve the problems that the last day’s initiative did
not. It is hard to discern any principles behind these actions. The
lack of a coherent strategy has increased uncertainty and undermined
the public’s perception of the government’s competence and
trustworthiness.

By principle, Hart and Zingales mean economic principle such as intervening only when market failure in the technical sense is an issue.  Bankruptcy, for example, is not the end of the world (As you may recall I have been pushing the idea of speed bankruptcy for which the FDIC has developed significant expertise.)  For example,

…what would have been so bad about letting Bear Stearns, AIG and
Citigroup (and in the future, General Motors) go into receivership or
Chapter 11 bankruptcy? One argument often made is that these
institutions had huge numbers of complicated claims, and that the
bankruptcy of any one of them would have led to contagion and systemic
failure, causing scores of further bankruptcies…

…This argument has some validity, but it suggests that the best way to
proceed is to help third parties rather than the distressed company
itself. In other words, instead of bailing out AIG and its creditors,
it would have been better for the government to guarantee AIG’s
obligations to J.P. Morgan and those who bought insurance from AIG.
Such an action would have nipped the contagion in the bud, probably at
much smaller cost to taxpayers than the cost of bailing out the whole
of AIG. It would also have saved the government from having to take a
position on AIG’s viability as a business, which could have been left
to a bankruptcy court. Finally, it would have minimized concerns about
moral hazard. AIG may be responsible for its financial problems, but
the culpability of those who do business with AIG is less clear, and so
helping them out does not reward bad behavior.

It’s not just Social Security and Medicare which are underfunded.  State governments have vastly underfunded public pensions.  Here is the abstract to a new NBER paper, The Intergenerational Transfer of Public Pension Promises by Novy-Marx and Rauh. 

The value of pension promises already made by US state governments will
grow to approximately $7.9 trillion in 15 years. We study investment
strategies of state pension plans and estimate the distribution of
future funding outcomes. We conservatively predict a 50% chance of
aggregate underfunding greater than $750 billion and a 25% chance of at
least $1.75 trillion (in 2005 dollars). Adjusting for risk, the true
intergenerational transfer is substantially larger. Insuring both
taxpayers against funding deficits and plan participants against
benefit reductions would cost almost $2 trillion today, even though
governments portray state pensions as almost fully funded.

It began (pdf) in December 2007.

The monetary regime has changed and, as a result, many people are misinterpreting the recent increase in the monetary base.  Paul Krugman, for example, posts the picture at right.  His interpretation is that the tremendous increase in the base shows that the Fed is trying to expand the money supply like crazy but nothing is happening, i.e. a massive liquidity trap.  (Krugman is not alone in this interpretation, see e.g. this post by Bob Higgs).  Thus, Krugman concludes, Friedman was wrong both about monetary history and monetary theory. 

Krugman’s interpretation, however, neglects the fact that the monetary regime changed when the Fed began to pay interest on reserves.  Previously, holding reserves was costly to banks so they held as few as possible.  Since Oct 9, 2008, however, the Fed has paid interest on reserves so there is no longer an opportunity cost to holding reserves.  The jump in reserves occurred primarily at this time and is entirely under the Fed’s control.  The jump in reserves does not represent a massive attempt to increase the broader money supply.

Here’s a bit more background.  When no interest was paid on reserves banks tried to hold as few as possible.  But during the day the banks needed reserves – of which there were only $40 billion or so – to fund trillions of dollars worth of intraday payments.  As
a result, there was typically a daily shortage of reserves which the Fed made up for by extending hundreds of billions of dollars worth of daylight credit.  Thus, in essence, the banks used to inhale credit during the day – puffing up like a bullfrog – only to exhale at night.  (But note that our stats on the monetary base only measured the bullfrog at night.) 

Today, the banks are no longer in bullfrog mode.  The Fed is paying interest on reserves and they are paying at a rate which is high enough so that the banks have plenty of reserves on hand during the day and they keep those reserves at night.  Thus, all that has really happened – as far as the monetary base statistic is concerned – is that we have replaced daylight credit with excess reserves held around the clock.  The change does not represent a massive injection of liquidity and the increase in reserves should not be interpreted as evidence of a liquidity trap.

Addendum: (For the truly wonkish.)  If you want more, see my earlier post on excess reserves, posts by Jim Hamilton, and David Altig, and especially two very useful Fed articles, Keister, Martin, and McAndrews (n.b. the last section) and Ennis and Weinberg.