Topic: Finance, Banking & Monetary Policy

Friedman and Hanke on Bitcoin

In 2008, Bitcoin was mysteriously introduced to the world in an obscure, technical paper written under the pseudonym Satoshi Nakamoto. By late 2013, the financial press was filled with reportage on Bitcoin and its dramatic price increase.

Well ahead of Satoshi Nakamoto, Nobelist Milton Friedman, champion of free market economics and noted expert on money and banking, anticipated the coming of digital currencies, and foresaw the potential impacts that they would have on finance and economics.

In a 1999 interview, Prof. Friedman concluded:

I think that the Internet is going to be one of the major forces for reducing the role of government. The one thing that’s missing, but that will soon be developed, is a reliable e-cash, a method whereby on the Internet you can transfer funds from A to B without A knowing B or B knowing A. The way I can take a $20 bill hand it over to you and then there’s no record of where it came from.

You may get that without knowing who I am. That kind of thing will develop on the Internet and that will make it even easier for people using the Internet. Of course, it has its negative side. It means the gangsters, the people who are engaged in illegal transactions, will also have an easier way to carry on their business.

Prof. Friedman’s anticipation of Bitcoin is truly remarkable. He even understood the concept well enough to anticipate something like the Silk Road scandal involving illegal Bitcoin transactions.

In April 2013, Nathaniel Popper of The New York Times reported on Bitcoin in an article titled “Digital Money is Gaining Champions in the Real World”. In his reportage, Popper asked me if I thought Bitcoin had the makings of a speculative mania like the 17th century Dutch tulip bulb frenzy. My response was clear and unambiguous: “To say highly speculative would be the understatement of the century.”

Subsequently, the price action in Bitcoin confirms my diagnosis (see the following chart). In January 2013, one could buy a Bitcoin for about $13. By late November, one Bitcoin would have set a buyer back over $1100. And what about Bitcoin’s price volatility? As shown in the chart, Bitcoin’s volatility is truly fantastic.

While the price currently fluctuates around $600, Bitcoin remains far from secure. Serious discrepancies in price exist even between exchanges. For example, the price of a Bitcoin on the Mt. Gox exchange has fallen by over 50% in the past week, while the price of the exact same Bitcoin on the BitStamp exchange has fallen by only 3% in the same time period.

Jared Bernstein’s “Tax Reform” Assault on Pensions, IRAs and 401(k)s

The bad habit of defining “tax reform” in terms of fairness or “closing loopholes” sidesteps the most essential task of effective tax policy – namely, to collect taxes in ways that do the least possible damage to incentives for productive effort, investment and entrepreneurship.

The Joint Committee on Taxation list of “tax expenditures” is arbitrary accounting, not economics, and tax expenditures are not necessarily “loopholes.” These estimates do not take taxpayer behavior into account and therefore do not estimate revenues that could be raised by closing the so-called loopholes (e.g., a higher tax on capital gains would shrink asset sales and revenues). Policies that make sense in terms of economic incentives can therefore be portrayed as useless tax subsidies in the purely static accounting of “tax expenditures.”

For example, a recent New York Times article by former vice presidential adviser Jared Bernstein complains that tax deferral for retirement savings is unfair because, “most savings subsidies go to households that would surely save anyway, while almost nothing goes to the households that need help to save.” 

These “subsidies” for high-bracket taxpayers mainly consist of deferring rather than avoiding taxes, which only partly offsets the way savings are double-taxed. Even if higher-income households would actually save the same without 401(k) accounts (which contradicts research), they would still end up with much smaller retirement savings. Dividends and capital gains would then be repeatedly taxed, year after year, rather than being continually reinvested within a tax-deferred pension, IRA or 401(k) account. 

Estimated “subsidies” from tax deferral are deceptive: Instead of having recent dividends and capital gains taxed at a 15-20 percent rate in recent years, distributions from tax-deferred accounts will later be taxed at rates up to 39.6 percent. It’s a subsidy only if you don’t live much past 70.

Bernstein presents a graph showing the top 20 percent getting a 66 percent share of these “subsidies” for pensions and defined-contribution plans while the middle fifth gets only nine percent and the poorest 20 percent just two percent. What these figures actually demonstrate is that (1) people who work full-time for many years have more income to save than those who don’t, and that (2) people who pay no income tax cannot benefit from any policy that reduces taxable income, even temporarily.

There are five times as many workers in the top 20 percent than there are in the bottom 20 percent. To exclude young singles and old retirees, Gerald Mayer examined the work experience of households headed by someone between the working ages of 22 and 62. Average work hours among the poorest 20 percent still amounted to just 1,415 hours a year in 2010, while those in the middle fifth worked 2,771 hours, and the top 20 percent worked 4060 hours.

If Bernstein’s “subsidies” were properly expressed as shares of income, rather than as shares of foregone tax revenue, the differences nearly vanish. The Congressional Budget Office (the undisclosed source of his estimates) shows tax benefits for retirement savings worth only about twice as much to the top 20 percent (2 percent of net income) as to the middle 20 percent (0.9 percent of income). Retirement savings incentives appear to be worth only 0.4 percent of income to the poorest 20 percent, since they rarely owe taxes, yet annual benefits are a poor guide to lifetime benefits. Those in low income groups while they are young commonly move up to higher tax brackets by the time they start saving for retirement.

The alleged unfairness of lower-income households not getting the same dollar tax break as couples earning more than $115,100 (the top 20 percent) could be alleviated by reducing marginal tax rates on two-earner families. But Bernstein instead suggests “closing loopholes that make it easy for wealthy individuals to exceed contribution limits to tax-preferred accounts (as was found to be the case with Mitt Romney), reducing contribution limits for high-income filers, or simple limiting the value of tax breaks for the wealthiest of filers (e.g. allowing them to deduct such contributions at 28 percent instead of 39.6 percent.” None of these schemes would add a dime to the savings of low or middle-income households, of course, and they wouldn’t work.

It is not legal – and therefore not “easy”– to exceed strict contribution limits for high-income taxpayers, and Mitt Romney certainly did not do so.  What Romney did was to roll over qualified retirement plans into an IRA and then earn high compounded returns on very successful investments.  Similarly, albeit on a much smaller scale, I rolled-over a lump-sum pension into an IRA in 1990 when I changed jobs, and that IRA is now 12-times larger thanks to compound interest and bold investments.  Since I never contributed another dollar after 1990, tougher or lower contribution limits would have been entirely irrelevant.  

Bernstein’s final proposal is from the Obama budget – “allowing taxpayers to deduct contributions at 28 percent instead of 38.6 percent.” But that too is irrelevant. Any alleged “loopholes” for retirement savings have nothing to do with itemized deductions for top-bracket taxpayers, who are not allowed to deduct contributions to an IRA.  Failure to include employer contributions as taxable income is not an itemized deduction to begin with, nor is the exclusion from adjusted gross income for contributions to a Keogh retirement plan for the self-employed.  

In the process of giving “tax reform” a bad name, Jared Bernstein uses a sham fairness argument to justify arbitrary and unworkable anti-affluence policies that are irrelevant to any ill-defined problems. 

 

 

 

 

 

 

The Federal Reserve’s “Foreign Banking Organization” Rule Is Unnecessary

Last November, Arthur Long and I released a policy study on the likely impact of the Federal Reserve’s 2012 “Foreign Banking Organization” proposal.

We argued – along with many others – that the proposal amounted to little more than a costly corporate reshuffling exercise. Of even greater concern, we suggested that the proposal threatened the ability of global banks to allocate capital and liquidity in an efficient manner, would increase financial instability, and dampen economic growth.

Yesterday, the Federal Reserve released a final rule that is essentially the same as the original proposal. The final rule is more lenient only in the sense that it increases the timeframe for compliance, simplifies the leverage requirements a little, and impacts fewer organizations. To that end, the fundamental criticisms still apply, as does the confusion around why such a proposal is necessary.

Governor Tarullo – a leading proponent of the rule – has argued that the Federal Reserve extended financial “support” to foreign banks at unprecedented levels during the crisis and therefore should be given greater oversight of these banks’ activities. That sounds reasonable. But upon closer review, the support he refers to was limited to liquidity provided through the Fed’s discount window. Foreign banks were not eligible to receive TARP or other forms of bailout assistance.

Fed officials have gone to great lengths to argue that providing liquidity through the discount window (which may be provided only to otherwise solvent institutions on a fully collateralized basis) is a legitimate central bank function and is NOT financial assistance constituting a bailout.

I agree (although on this point, I note that I depart quite radically from some of my contemporaries). However, this argument does undermine the central pillar supporting the Fed’s new rule. In addition, if protecting U.S. taxpayers is the fundamental aim, why implement a rule that will close-off the channels of liquidity and support that the U.S. subsidiary could receive from the foreign parent? 

The Fed’s rule may well spark retaliatory actions from foreign regulators, who are even more annoyed about it than the banks they oversee. The losers will be both local and foreign banks and, most importantly, consumers of credit. Governor Tarullo himself noted during yesterday’s open meeting that the rule “may not strike the right balance indefinitely.” The Fed had an opportunity to lead from the front. That it failed to do so is unfortunate. 

William Galston’s Not-So-Great Decoupling of Pay, Productivity, and Common Sense

Wall Street Journal columnist William A. Galston says “the Great Decoupling of wages and benefits from productivity [is] the biggest economic story of the past 40 years.”  Wow!  The Biggest Economic Story of the past 40 years!  Imagine that!  I have been researching such data longer than 40 years yet this particular story is so old (and so wrong) I had almost forgotten about it.   

The alleged decoupling of growth of pay from productivity, as Robert Gordon explained in 2009, “compares apples with oranges, and then oranges with bananas.” Median wages for the whole economy were deflated by the consumer price index, which exaggerated inflation and understated real income growth. Rapidly growing health and retirement benefits were often excluded. These muddled measures of real pay, which also failed to adjust for changing household size or hours, were compared to productivity of the nonfarm business sector, not the whole economy. And real output was calculated using GDP deflators that showed much less inflation than the CPI. With those errors, one estimate for the income-productivity gap from 1979-2007 was 1.46 percentage points, but Gordon’s adjustments shrunk that to a negligible 0.16. He also noted that mean and median incomes grew at remarkably similar rates, suggesting inequality did not explain much.

A 2013 study from the London School of Economics likewise found no significant gap between growth of compensation and productivity in the United States or UK (unlike the EU and Japan) if both measures are properly calculated with the same price index. The LSE study concluded that, “the debate around net decoupling in the UK and US is rather a distraction (it is actually more important in Continental Europe and Japan). Obtaining faster productivity growth is a highly desirable policy goal in the current climate of near recession as it will ultimately lead to faster wage growth and consumption.”

Galston tells other stories, such as “mobility has stalled” – which is indefensible nonsense. His allusion to the “past 40 years,” appears based on a Pew Research paper’s pointless claim that the “middle class” constituted a smaller share of adults in 2011 than in the idyllic year of 1971. As Pew Research hesitantly revealed, that is mainly because millions of people moved up – “the upper-income tier [earning more than double median income] rose to 20% of adults in 2011, up from 14% in 1971.”

All this statistical fog is thin camouflage for Galston’s invitation to grant authoritarian politicians and bureaucrats the discretion to somehow “link the tax rates individual firms have to the compensation practices they adopt.” That may well be the worst economic policy idea of the past 40 years, trailing barely behind Nixon’s dictatorial price controls.

Venezuela Verifies Hayek on Exchange Controls

Foreign airlines have begun to restrict ticket sales in Venezuela. As the bolivars’ value evaporates, and with exchange controls in force, the airlines fear that the funds they have in Caracas will evaporate, too. By restricting ticket sales, the airlines will limit the amount of new money that is trapped behind the government’s wall of exchange controls.

Of course, President Nicolas Maduro isn’t the first autocrat to impose exchange controls, and he won’t be the last to impose these confiscatory policies. Indeed, the pedigree of exchange controls can be traced back to Plato, the father of statism. Inspired by Lycurgus of Sparta, Plato embraced the idea of an inconvertible currency as a means to preserve the autonomy of the state from outside interference.

So, the temptation to turn to exchange controls in the face of disruptions caused by hot money flows is hardly new.  Tsar Nicholas II first pioneered limitations on convertibility in modern times, ordering the State Bank of Russia to introduce, in 1905–06, a limited form of exchange control to discourage speculative purchases of foreign exchange.  The bank did so by refusing to sell foreign exchange, except where it could be shown that it was required to buy imported goods.  Otherwise, foreign exchange was limited to 50,000 German marks per person.  The Tsar’s rationale for exchange controls was that of limiting hot money flows, so that foreign reserves and the exchange rate could be maintained.  The more things change, the more they remain the same.

This brings me to Nobel laureate Friedrich Hayek’s 1944 classic, The Road to Serfdom. Many thought Prof. Hayek hurt his case because he was extreme. What nonsense. Just consider the Wall Street Journal’s reportage from Caracas about the real concerns of foreign airlines that have funds locked up in Venezuela. And then reflect on the following insightful analysis from the Road to Serfdom:

The extent of the control over all life that economic control confers is nowhere better illustrated than in the field of foreign exchanges. Nothing would at first seem to affect private life less than a state control of the dealings in foreign exchange, and most people will regard its introduction with complete indifference.  Yet the experience of most Continental countries has taught thoughtful people to regard this step as the decisive advance on the path to totalitarianism and the suppression of individual liberty.  It is, in fact, the complete delivery of the individual to the tyranny of the state, the final suppression of all means of escape—not merely for the rich but for everybody.

Hayek’s message about convertibility has regrettably either been overlooked, or thought to be too extreme. Exchange controls are nothing more than a ring fence within which governments can expropriate their subjects’ property. Open exchange and capital markets, in fact, protect the individual from exactions, because governments must reckon with the possibility of capital flight.

Free the Inside Traders

Manhattan U.S. attorney Preet Bharara claimed another victory in his crusade against “insider trading,” a practice he once called “pervasive.”  Last week he won a conviction against Mathew Martoma, formerly at SAC Capital. 

Another big scalp was hedge fund billionaire Raj Rajaratnam, convicted in 2011 and sentenced to 11 years in prison.  A decade ago Martha Stewart was convicted of obstruction of justice in an insider trading case.

Objectively, the insider trading ban makes no sense.  It creates an arcane distinction between “non-public” and “public” information.  It presumes that investors should possess equal information and never know more than anyone else. 

It punishes traders for seeking to gain information known to some people but not to everyone.  It inhibits people from acting on and markets from reacting to the latest information. 

Martoma was alleged to have gotten advance notice of the test results for an experimental drug.  Martoma then was accused of recommending that SAC dump its stock in the firms that were developing the pharmaceutical.

If true, SAC gained an advantage over other shareholders.  But why should that be illegal?  The doctor who talked deserved to be punished for his disclosure.  However, Martoma’s actions hurt no one.

No Big Deal. Just Taxpayers Getting Clobbered

According to Ben Jacobs at the Daily Beast, Sen. Elizabeth Warren (D-MA) will soon be introducing legislation to allow holders of federal student loans to refinance at lower interest rates. There’s no indication that the new rates would be in exchange for longer terms, or anything like that. Just lower rates because someone might have borrowed at 7 percent, rates for new loans are now at 3 percent, and, well, paying 7 percent is tougher.

According to Jacobs, the proposal “seems to encapsulate…free-market principles” because recent changes to the student-loan program connect rates on new loans to broader interest rates. Apparently, pegging interest rates to 10-year Treasuries is very free market-y.

Perhaps more concerning than the questionable use of the term “free-market principles,” however, is the article’s handling of my reponse to the author’s request for comment. Apparently, I was fine with Warren’s rough idea, except for one little thing. Writes Jacobs:

In fact, Neal McCluskey, a higher education expert at the libertarian Cato Institute, had difficulty finding objections to the concept of Warren’s bill though he cautioned that was without any legislation for him to read. Instead, he was agog at the issues involved with reducing government revenue through lowering interest rates because the lender has to pay for it and, in this case, the lender is the American taxpayer.

How much bigger an objection could there be to “the concept of Warren’s bill” than that such a move would leave taxpayers holding the bag? As I often try to emphasize, taxpayers are people, too. There are lots of other concerns – most centrally, easy aid fuels tuition inflation – but to gently paraphrase Vice President Biden, reducing revenue that’s already been budgeted is a big deal!

Let me rephrase that: It should be a big deal. But as proposals like this indicate, it’s not nearly as big as it ought to be.