The Hydraulic Theory of the Euro

Jean-Baptiste Queru recently posted what I call the "Hydraulic Theory" of currency union.  Other than an overall theme of "Blame Germany", it's somewhat discombobulated, but I think the basic point is:

The core mechanism that allows multiple states to share the same currency is pretty simple: since the weaker states can't devalue their currency to compensate for their trade deficit with the stronger ones, money has to flow from the stronger economies to the weaker ones in order to maintain the balance.

Which is pointing out that balance of payments in an identity: your surplus + my deficit = 0

This identity doesn't cause the balance of payments, rather it merely identifies that if someone owes money, someone else must be OWED that money.  Consider if I told you that last year I racked up $20k in debt (credit card).  You could correctly infer that I spent $20K more than I made last year.  It would be ABSURD to say that the debt caused the spending! Rather, the debt simply MEASURES the spending.  The spending resulted from choices I made!

JBQ seems to think that the deficit numbers are simply handed out or something, and that Greece was simply handed a number (-100 Billion) and then forced to spend and borrow that much.  Hopefully you will recognize that this is an absurd way to think of this.  Rather, the deficit number is simply the sum of all the spending decisions Greece made over the course of the year.

Jean-Baptiste is further confused on the facts in the EU.  There are plenty of "weaker states" both inside the EU and outside which run trade surpluses.  Ireland, which is emerging from a mini-depression, and has much lower per capita GDP than Germany, runs a trade surplus.  This is because the Irish government and Irish individuals have made decisions to consume less and save more.  [Update 7/9/15:  It's been pointed out that Ireland in fact has higher GDP per capita than Germany!  I was not aware, and in fact I'd generally thought of Ireland as one of the poorer Western EU nations.  In any case, the hydraulic theory is so wrong there are plenty of counterexamples.  For instance Slovakia has a per capita GDP ~ 40% lower than Germany, but seems to run a trade surplus.] In fact, the general pattern is that poorer (but well-run) nations tend to run trade surpluses which fund further internal investment.  China has run a massive trade surplus for ~20 years.

JBQ is also confused about the US system.  It is true that the Federal government tends to redistribute money from richer states to poorer states, but this has nothing to do with "currency union".  Rather it reflects that fact that the US tax code is highly progressive (more so than EU average) and Federal spending is also progressive (though less so than EU).   JBQ wants to argue that this redistribution is REQUIRED for a currency union.  To argue the contrary, I'd simply point out that c.1900, when differences between the states were even larger, total Fed spending was like 3% of GDP, and most of that was spent on non-redistributive costs like defense.  JBQ's theory predicts that the US system c. 1900 would blow up, but nothing of the sort happened.

Another sort of contrary example is Puerto Rico.  PR gets enormous net transfers from the Feds- about $4k for every man, woman & child in PR per YEAR- 13% of GDP, yet PR has a huge debt, which it just announced it is defaulting on.  Perhaps the problems of debtor states are due to the choices they make, rather than a balance of payment number which "forces" them to assume debt?

Kevin Drumm's Crazy Uncle Ivan theory of Finance and Trade

In covering the Greek tragedy that is the Greek tragedy, Kevin Drumm espouses what I like to call the "Crazy Uncle Ivan" theory of finance and trade.  It's a popular mix of Mercantilism and Keynesianism which explains how rather than being the villain of this tragedy, Greece is actually the tragic hero.

Kevin quotes the German view of the situation:

"In Germany especially, the fear is that providing new loans to Greece without extracting more spending cuts represents a fateful step toward a so-called transfer union, with wealthier nations providing handouts to Greece and other weaker countries."

The facts on the ground are quite clear.  Greece does in fact want German money, and there is really no way for Kevin and the liberal intelligentsia to deny this.  But perhaps if we step back, we can still blame Germany:

But so far Europe has done next to nothing for Greece. They've made lots of loans, but mainly so that Greece could pay back its debt to shaky European banks*. It's been every bit as disingenuous and self-interested as all the cheap loans those banks made to Greece in the first place so that Germans and others could enjoy access to cheap Greek products during the aughts. They enjoyed the boom from those loans and supported it with monetary policy that favored Germany but overheated Greeece[sic], and then when the economy went sour they set monetary policy continent-wide to favor Germany yet again, not the folks they'd been shoveling money too all those years.

Here is the the Crazy Uncle Ivan theory:
1) Your crazy Uncle Ivan loses his job.
2) You let him crash with you for a few weeks.
3) Ivan still can't find a job, so you decide to "rent" your spare bedroom to him.
4) Ivan has no cash, so he gives you "IOUs", promising to pay you in 10 years.
5) You and the wive put these IOUs in your safe deposit box.
6) Thinking that you now have some savings, you decide to save less for retirement. WOOT! The economy gains from your spending
7) After a few years, Ivan moves out
8) Ten years later, Ivan says he can't pay you
9) Ivan is struggling, so you decide you are going to cut his debt is half, but as a measure of good will, Ivan has to sell his new car, buy a  used car, and use proceeds to help pay debt.   Additionally, he's going to pay you $50 each month.
10) Ivan agrees, sells the car, hands you some of the proceeds
11) 2 years later, Ivan decides that he doesn't like paying you, and he doesn't like driving a used car, so he buys a new car and demands new loan terms.
12) Given that you have no legal recourse, you do the only thing you can.  You tell Ivan to fuck himself- he can forget about loaning money from you or anyone in your family ever again.

A normal person would look at this and conclude that Ivan is the villain here, or if not a "villain" at least an irresponsible relation.  He took advantage of your easy credit, staying in your home essentially rent-free, then decided he'd rather consume than pay off his debts to you.  This example shows that the IOUs Ivan writes are worthless.  You've given Ivan shelter and sacrificed your well-being in return for empty promises.

Under the Crazy Uncle Ivan theory of trade, the villain here is not Ivan, but rather you!  You should never have loaned him the money so cheaply, and you profited from him living in your apartment.
This is one part Mercantilism, one part Keynesianism.

The goal of a Mercantilist is to hand over goods in return for money, and preventing the return of money to the other side.  This is long since discredited.  As the Mercantilists found, money is worthless unless it can be converted into goods**.  With Ivan, we can see this directly- you've let him stay on your couch for years, but have no way of collecting any compensation.  Kevin's claims about Greece are similar- Germany handed over years worth of goods & services, but never collected anything in return, except worthless IOUs.

Keynesianism adds another element to the Ivan theory.  Drumm claims that Germany profited by simply holding the worthless IOUs.  This is point 6.  In our example it's clear that all the "boost" was in fact just the opposite, as you now find yourself deep in a savings hole, and 10 years closer to retirement.  But even if we believe in Keynesianism,  I think Kevin is wrong here.  Even Keynes only held that spending is positive only during recessions.  Maybe he's arguing the opposite, complaining that Greece was spending too much during the boom?  No one forced Greece to spend- in fact, Germany adopted specific policies against deficit spending in the EU to prevent just this sort of crisis.  It's true Germany didn't enforce this, but it seems like deficit spending is still Greece's responsibility and has nothing to do with ECB interest rates.

So in short the CUI theory:
1) Loan money to CUI
2) CUI consumes your goods/services
3) CUI can't pay loans
4) You are villain, not CUI.
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*It's true that the original debt was not primarily held by German taxpayers, who stepped-in to fill the breach and prevent bank failures.  I suppose an argument could be made that Greece was under duress when it agreed to the new loan terms.  There are 2 problems with this.  First, the new loan terms were EXTREMELY generous.  Lots of forgiven debt, low interest rates, long terms.  I've seen estimates that the terms amounted to a 30-40% haircut for the debt holders (not even accounting for the fact that Greece may turn out not to pay the debt at all!).  Second, if Germany hadn't stepped in and had instead just nationalized it's own banks, would Kevin not be complaining?  Would Greece be any better off?

**The classic example of this failing is Spain c. 1600.  The control of Gold and Silver mines in the New World, led to a huge influx of bullion into Spain.  However, Mercantilist policies prevented Spain from actually spending this bullion outside of Spain.  The net result was inflation as more and more Gold chased the same number of goods. 

Medicaid vs Transit in LA.

In his budget, Obama proposed increased spending on transportation funded largely by tax increases. This naturally raised the ire of Conservatives, who though generally in favor of infrastructure, oppose tax increases.  This also raised the Conservative talking point that welfare spending is consuming the entire budget, leaving very little left over for traditional government spending (also known as "discretionary spending").

The amounts proposed for transportation are relatively small.  As a small-government advocate, I find it mystifying that Obama's administration could not identify even small cuts to welfare spending to pay for this increased spending.  If they had proposed such an exchange, it would have been an easy sell in Congress- a welcomed bipartisan compromise.  So why didn't they propose such a deal?

It's possible that the Administration recognized that a compromise would be welfare-enhancing, but felt that political considerations made it undesirable.  This is unlikely for a variety of reasons and would reflect poorly on the Administration, so let us consider the more straightforward possibility- that Obama does not consider transferring even small amounts from entitlement spending to transportation welfare-enhancing for the nation.

So is the Administration right on this point?  One way of analyzing this is to consider some extreme tradeoffs.  Progressives generally bemoan the state of mass transit so it should be a high-value alternative for welfare spending.  Lets do a thought experiment- what would mass transit in LA look like if we took all the money we spend on Medicaid in LA and instead spent it on mass transit?

In 2013-14 the proposed CA Medicaid budget is $57.4B* (see slide 41).  LA has 40% of CA population, so we can ballpark the LA-specific Medicaid spend as $27B per year**.

How much is $27B?  A lot.  In fact, an enormous amount.  The entire "LA Metro" budget for 2013 was only $4.5B (page 17).  That includes bus, light-rail, subway operating and capital expenses!  Fares on the system came to only $0.35B.  Operating expenses to $3B. So what would the LA transit system look like if it were funded instead of Medicaid?

First, for <2% of Medicaid spending you could make the entire system free.  For another 6% (1.5B) you could increase operating frequency by 1.5x*** making it easier for the poor to get around LA. With the remaining $25B you could buy 25 new miles of subway every year at a bloated $1B/mile cost****.  Not light rail but SUBWAY.  That's more subway miles each year than LA now has in total.  In about 8 years, LA would have more subway miles than NYC.

One other interesting note- transferring this spending from Medicaid to mass transit would also transfer $27B of income/year from wealthy, white-collar medical workers to blue-collar construction and transit workers.

So here's the question- are the poor of LA better off with nearly-free world-class medical care, or with a free, world-class transportation system?

And before you answer, consider the actual revealed preferences of the poor.  In the Oregon Medicaid lottery "experiment", only 60% of those who won the lottery actually bothered to fill out the enrollment forms!  And only 30% ended up enrolling.  It's true that some of those eligible for the lottery might no longer be eligible once notified, either because they found a job, or perhaps moved out of state.  Reasonable estimates for this percentage are quite low though.  The vast majority of those who didn't enroll are presumed to have not done so because they could not be bothered.  The value of Medicaid to them wasn't high enough to deal with the paperwork!

I don't intend this as a polemic against Progressives.  Rather, I think think they are making an honest mistake.  First, they are conflating "cost" with "value".  That is, because Medicaid costs $27B to run in LA, it must be worth $27B to the recipients.  Second, most voters and politicians have no sense of scale.  How often have you ever seen the budgets for an awesome public transit system and a health care system for the poor compared?

For me, the general lesson of this exercise is- we really are starving infrastructure spending due to entitlements.  In fact, we are doing this in ways that make absolutely no sense.  The tradeoffs involved cannot possibly be good for the recipients.  Perhaps the gains to compromise here are so large that a political deal can be worked out.

* I'm a bit uncertain about this figure.  I first derived this stat another way by looking at CA cost per enrollee then multiplying by the size of enrollment.  By this estimate, the spending is only $30B/year.  I chose the $57B number since it's a direct number from government budget slides and it also jibs much better with national Medicaid spending numbers.  My best guess is the CA cost per enrollee omits the Federal component of the spending which is why the number comes out wonky.

 

** It's probably more than $27B as LA is both poorer and more expensive than other parts of the state, but we're just ball-parking things here.

*** The assumption is that by increasing operating costs by 50% you can increase frequency by 50%.  I believe this to be a very pessimistic estimate since there's a lot of overhead that doesn't need to be increased (it doesn't cost 50% more to run a subway station with 50% more trains).  And there are economies of scale with more spending (for instance, you can buy off the Unions by promising to hire more workers instead of higher wages). 

Also, I realize you can't just turn money into subway miles- there are time and planning issues, etc.  There is some deferred gratification, but it doesn't affect the underlying tradeoff math.

**** PedestrianObservations notes that the LA "subway-to-the-sea" is projected to cost $500M/mile.  In the interests of showing real tradeoff opportunities, I've doubled that cost to approximate what it will probably actually cost.

More evidence against the Obesity Epidemic

Interesting WSJ article on a new JAMA Obesity study.

Long story short, BMIs of 25-30 and 30-35 show no increase in mortality vs BMI 20-25 (which is considered "normal" weight).  In fact they showed a slight decrease in mortality, but perhaps not statistically significant.  Note that these BMI classes are "overweight" and "obese" respectively.  This is actually great news for the vast majority of Americans that occupy these BMIs.  No doubt organizations like CDC will still say "40% of US population is overweight or obese", but for the most part the data say there's *no health risk* associated with that statement!

The article also talks about the "Obesity Paradox":

The new report is the latest, and largest, to document what scientists call the "obesity paradox." Other studies have shown that people with heart disease, diabetes and other chronic health conditions tend to live longer if they carry excess pounds even though excess weight is associated with heightened risk of heart disease, type 2 diabetes and several cancers which in turn raise the risk of premature death

Imagine how silly it would be for a WSJ article to talk about a "long pants" paradox- that long pants are strongly associated with tall people, but putting long pants on short people or short pants on long people didn't make people shorter or taller!  The obvious conclusion is correlation, not causation.  Yet the article (and presumably medical literature) present this as some profound mystery, not one easily explained by a common statistical effect.

Note how careful the reporter and quoted researchers are not to offend conventional wisdom.  Even with this powerful evidence that having moderately high BMI is no health danger, saying so is openly considered anathema.  In the end, this is not science- this is ideology.  It seems like no matter what the data say, being overweight is "bad" and losing weight is "good".

Death by a thousand cuts

Matt Yglesias discusses Republican intransigency is his latest post.  I'm not particularly interested in the partisan implications here, but Matt makes a good point about one specific policy issue:

Republicans have hammered away at the idea that Obama's environmental commitments are stifling the short-term job creating impact of investment in fossil fuel extraction and transportation. And precisely because this isn't a crazy idea, over time Obama administration policy has evolved to become increasingly enthusiastic about the short-term economic impact of fossil fuel extraction and less and less focused on the long-term environmental problems involved. 

Obama's willingness to make concessions on this point hasn't changed partisan politics, but has had impact in the real world. As expected, we have both more pollution and more mining sector employment than we would had this pivot not taken place. 

But America's way too big a country for us to all get jobs fracking for natural gas.

Matt goes on to opine about the need for Keynesian stimulus spending, but he should pause and think about his own example.  Relaxing regulations on natural gas drilling resulted in more investment, more jobs, and greater wealth.  No Keynesian stimulus required!

Matt is right to point out that fracking alone cannot restore full economic growth.  But perhaps we can apply to same principles to other fields- if the returns are high enough, businesses will invest and create jobs and wealth. Matt actually goes on to suggest something along these lines with respect to housing and he doesn't mention it here, but he'd probably also favor deregulating occupational licensing.  These are just the tip of the regulator iceberg however.  There are thousands regulations at the federal, state, and local level which drive up the costs of investment and drive down the return on capital, meaning less investment and fewer jobs.

We see the impact of fracking regulations because it's new, it's large, and it's disparate- America now has low natural gas prices and a thriving natural gas sector, France does not.  There's no symbolic industry where we see the impact of  the Endangered Species Act, but business know it slows down development, and increase costs.  They understand these costs- they lead to less investment.  We don't see how standards of "disparate impact" and discrimination lawsuits impact employment, but we know it does raise costs and reduce employment.  Businesses are not blind to these costs and it reduces employment since we've made it more expensive to employ people.

Matt might argue that this doesn't explain why 2012 is different than 1994.  Regulation isn't that different now than 1994- why is this recovery so much slower?

First, there actually is a lot more regulation now than 20 years ago. In the past 3 years, the Code of Federal Regulations has increased 7.4%.   Of course, the size of the federal register is only and a rough proxy.  Also this is not a Democrat vs. Republican issue.  For instance it was Bush Sr. who signed the ADA, which has been interpreted to mean you can't fire drunks and makes building new commercial or multi-family housing more expensive.

The second reason we're seeing the impact of these regulations now, is that most regulations grandfather in existing facilities and arrangements.  The ADA didn't make it illegal to work at a non-compliant building- it simply required new buildings to comply to code.  Existing building owners didn't need to teardown their buildings, the law simply make it more expensive to build new ones or remodel old ones.

Further more, regulations which do apply to existing business often benefit from sunk costs.  Citibank may hate the new Dodd-Frank credit card regulations which cost them money and lower their return.  However, Citibank has already invested in the business- they have millions of customers, offices, back-office technology, and employees.  Perhaps they make 4% instead of 6%- the regulations aren't so onerous that they abandon the business.  A new competitor will forgo entry when faced with these higher costs- it's not worth tying up capital at the new low rates of return.

The housing and investment bubble combined with changing technology and globalization resulted in a real shock to the economy.  Old jobs disappeared.  Old jobs have been disappearing for 200 years in America- we typically see new ones appear almost immediately.  But the weight of regulation represents a huge drag.  It was worth hiring the old employee because they were hired *before* ADA and other laws increased the cost of employment.  It was worth investing in the existing infrastructure because this was done under a more liberal regime- no need to worry about multiyear EPA delays.

There's an asymmetry between the old and the new.  We only see the full price of regulations when we face change.  New businesses see the full weight of these costs in a way old businesses never did.  It's death by a thousand cuts.  Each regulation has a small impact, but the weight of all these thousands of cumulative regulations slows down investment and reduces entrepreneurial risk taking.

Matt Yglesias makes a good point about the Chicago teacher's strike:

The most salient difference, completely absent from his armchair psychologizing, is surely that public school teachers work for the government. If AT&T workers get a better deal for themselves, that may well mean a worse deal for people who bought AT&T stock in past years but I'm not going to cry on their behalf. By contrast, if Chicago public school teachers get a better deal for themselves that may well mean a worse deal for Chicago taxpayers.

I completely agree with Matt here.  Matt's not afraid to criticize his own side- it's one of the reasons I read Matt despite his being a raving lefty.

In fact, I think Matt will eventually come around to the Libertarian side of the force.  He's smart enough to recognize that unions don't create wealth- they just redistribute it.  In the case of city unions, they redistribute wealth from taxpayers to union employees.  Matt can understand why city taxpayers might not love this concept.

Matt's example should lead him down another track as well.  Most people don't really think about where the additional wealth union workers enjoy comes from.  Matt's a smart guy- he understands that this is wealth is "stolen" wealth- that is, it's taken from someone else rather than "created" wealth which is gains from free market work, trade, and technology.  So who is it stolen from?

The obvious answer is their employers.  In the case of government unions, this means the government, a.k.a. taxpayers.  In the case of private-sector unions, the obvious answer is companies, and of course companies are just proxies for the owners- a.k.a the stockholders.  Here we just have a difference of opinion- Matt thinks it's fine for one set of people to steal (he would prefer "redistribute" I'm sure) from another as long as the people being stolen from are wealthy (or at least wealthy enough to be stockholders).  I disagree, but my point isn't about whether their should be redistribution.

It's a question of how that redistribution works.  The idea that unions primarily redistribute from wealth from company owners is in fact incorrect.   Let's take Matt's example company- AT&T.  But not AT&T the wireless company of 2012.  Instead, consider AT&T the telephone monopolist of 1960.  Under the old regulatory regime, AT&T made a fixed profit as regulated by the FCC.  Something like Price = costs * profit margin.  Now there are some benefits to AT&T from lowering costs- transient benefits as well as benefits from a larger market.  But in the long-term, a regulated monopolist like AT&T doesn't passes 100% of its costs onto its customers.

A union for a regulated monopolist transfers wealth from the *customers* to the union employees.  In the long-term the wages gained by the union workers come from price increases paid by AT&T customers.

Regulated monopolies are fortunately few and far between in the US these days.  However, the same logic applies to any industry who's workers are completely unionized!  To understand why, first consider a hypothetical $1000 tax on new cars.  If the government imposes this solely on car company X, then X is screwed.  They cannot simply increase their prices- presumably their prices are already optimal given their costs and the competition.  Almost all of this "tax" is paid by company X's shareholders- very little is paid for by consumers, since consumers have other, non-taxed options.

Now consider what happens if instead of imposing the tax on one company, the government imposes this tax on *all* car companies (which is usually how these things work).  The day the government imposes this tax, car prices rise by ~$1000.  Regardless of whether the tax is an explicit consumer (sales) tax, or an excise fee paid directly by the car companies, almost 100% of the tax will be paid by the consumer.  It's true that since demand will fall and car companies have high fixed costs part of the price will be paid by companies, but in the long-term once car companies have adjusted to the new equilibrium, their profits margins will be essentially unaffected.

For a completely unionized industry (take the UAW for instance), union demands can be thought of as "excise taxes" on the products they produce.  In fact, the UAW explicitly operated as a monopoly labor supplier, imposing almost identical wages and working conditions on the Big 3.  You can think of the UAW's as a mini-government which taxed all car production and redistributed those taxes to those who happend to work at auto plants.  The people who paid this tax were other middle class consumers who bought the cars.  Thus the UAW served only to redistribute wealth from one set of middle class consumers to another very particular set, primarily in Michigan.

Once non-union (or more specifically, non-UAW) cars became widely available to consumers in the 80's, this broke down.  Consumers were no longer forced to pay the UAW tax- the burden of the tax started to fall on the Big 3 shareholders.  Eventually, the UAW burned through 100% of shareholder value and with the aid of management, they started taking bondholder and taxpayer money (in the form of direct bailouts and retirement fund bailouts).

The irony is that the great heydays of the American union in the 50's and 60's were the times when union stole primarily from each other and the non-unionized middle class.  It's only been since globalization started in the 80's that unions are finally taking for shareholders.

Everybody Wins

Here's Felix Salmon talking about US fuel efficiency standards:

Fuel-efficiency standards are a way of preventing car companies from being forced to hedge their bets by working on gas guzzlers as well as efficient runabouts. As a result, those companies can take the money they’d otherwise spend on developing six-ton monsters, and invest it instead in the efficient cars of the future. Everybody wins, and the cost — contra Porter — is negligible. He’s absolutely right that higher gas taxes are a very good idea. But that’s no reason at all not to implement higher fuel-economy standards as well.

Felix has written a 2 page editorial complete with color charts without considering the curious question of why Ford sells so many inefficient SUVs.  He says "everybody wins", except that is, the people who currently choose to buy Ford Explorers over Ford Fiestas.  These people will be prevented by law from using their own money to buy the car they want.

Felix could make all sorts of arguments about the benefits of the Fiesta, but he can't argue the facts, that many Americans weigh this same decision and believe the Explorer is better for them.  Why is Felix in a better position to judge what car they should drive?  How is limiting his fellow citizen's choices a "win"?  Felix commits the classic Progressive mistake of confusing his own preferences for that of all his countrymen.   Perhaps his next editorial can suggest that every car should be blue- then companies wouldn't have to bother with all those different paint colors! Everybody Wins!