Thursday, February 21, 2013

Think Email Retention is not a Big Deal?

Think again. If your email retention is not compliant, you need to address it.

FINRA Fines ING Affiliates $1.2 Million for Email Retention and Review Violations

Heinz Trader was Goldman Client?

From the WSJ Law Blog - Heinz Trader Tied To SEC Probe Was Goldman ‘Private Wealth Client’

Banks, Brokers With New Facebook and Twitter Problem

No, not problems with employees and social media - this problem is of the firms' own making. Many web sites allow users to log in to the site using their Twitter, Facebook or LinkedIn account. It makes the log in process easier for the user, they don't have to remember additional passwords, and simply click a link to use their social media account to log in.

Apparently the banks and brokerage firms are considering using social media logins for their customers - giving their customers faster and easier access to their account information. The problem? The hacking of Twitter, Facebook, LinkedIn or other social media sites. A hacker gets into a social media account, and if the user's brokerage firm allows a social media login, the hacker has access to the customer's account.

Definitely not a good idea.

The One Thing Banks Should Never Do on Facebook and Twitter | On Wall Street

SEC Charges Virgin Islands-Based Investment Adviser with Defrauding Clients

The SEC charged an investment adviser located in the U.S. Virgin Islands with defrauding clients from whom he withheld the fact that he was receiving kickbacks for investing their money in thinly-traded companies. When he faced pressure to pay clients their returns on those investments, he allegedly used money from other clients in a Ponzi-like fashion to make payments.

The SEC’s Enforcement Division alleges that the investment adviser  through his St. Thomas-based firm TAG Virgin Islands, routinely used his discretionary authority over the accounts of his clients to purchase promissory notes issued by particular private companies. In exchange for financing those companies, TAG received millions of dollars in cash and other compensation — a conflict of interest that was never disclosed to investors. The Enforcement Division further alleges that when the promissory notes neared or passed maturity and his clients demanded payment, the investment adviser misused assets of other clients to meet those demands.

“[The investment adviser  was anything but forthcoming with his clients and he repeatedly failed to act in their best interests,” said Andrew M. Calamari, Director of the SEC’s New York Regional Office. “He didn’t tell them about the compensation he received from the companies they were financing, and then compounded his fraud by using client assets to pay other clients when the conflicted investments came due.”

In a parallel action, the U.S. Attorney’s Office for the Southern District of New York today announced criminal charges against the investment adviser.

FINRA's Latest Attempt to Expand Its Authority - New Membership Rules

FINRA is again trying to expand its power and authority over its members. Its earlier attempt to expand its memberhsip rules, to reguire additional and more frequent reporting of routine business activities was severely criticized, and abandoned. But they are back again.

This is NOT going to be good for the industry, and is certainly going to be a significant problem for the 4,000 small firms that are FINRA members. Firms need to pay attention to these proposals, and to spend a few minutes providing comments and feedback on the proposals. 

Finra to try again on controversial membership rules - InvestmentNews

Tuesday, February 19, 2013

Two cents on the minimum wage

Once upon a time, the minimum wage, like free trade, was a basic test of whether you were awake in the first week of econ 1. We put a horizontal line in a supply and demand graph. Minimum wages increase unemployment of poor people.

It's  back of course. I won't review here the debate over Card and Kruger's provocative results, diff in diff estimators, empirical work without theory (is there really no substitution to capital or high skilled labor? Is the price elasticity really zero?) and so on. This is all low-hanging fruit. (See Greg Mankiw, who asks if $9 why not $20,  David Henderson's nice post with great quotes from Paul Krugman on just how bad minimum wages were before evil Republicans didn't like them, the Becker-Posner Blog, and Ed Glaeser, noting how minimum wages are hidden taxing and spending and better ways to achieve the same goals, and this clever Steve Chapman oped asking, why not fix prices lower instead?.)

Let's presume for the sake of discussion that a rise in the minimum wage would indeed not much change the demand for labor, the costs would just be passed on in the form of somewhat higher prices, with little decline in output -- as usual in non-economics, assume that all elasticities vanish.

It still strikes me, that like much of the current policy discussion, we're asking the wrong question. The question is not "is this great" or "is this terrible" but "does this have anything to do with current problems?"  The fiddling while Rome burns is worse here than the belief in minor economic magic.

President Obama's state of the Union Address  was to me, an interesting peek into the Administration's thinking, and a revealing piece of political rhetoric (I mean that in the good sense of "rhetoric," i.e. "what arguments we use to persuade people"), a full-time worker making the minimum wage earns $14,500 a year. Even with the tax relief we’ve put in place, a family with two kids that earns the minimum wage still lives below the poverty line. That’s wrong....

Tonight, let’s declare that in the wealthiest nation on Earth, no one who works full-time should have to live in poverty, and raise the federal minimum wage to $9.00 an hour. This single step would raise the incomes of millions of working families. It could mean the difference between groceries or the food bank; rent or eviction; scraping by or finally getting ahead. For businesses across the country, it would mean customers with more money in their pockets....
What caught my eye is the "family with two kids,"  "...millions of working families." It paints a grim picture: mom, dad, two kids, trying to survive one wage earner's full-time minimum-wage job.

My thought: What planet do the president's advisers live on? Come take a look, say, at the south side of Chicago, where I grew up and live, and where President Obama spent many formative years as a community organizer and so knows it even better. Is the first-order problem of these neighborhoods that its residents live in intact families with two kids, one full-time wage earner, trying to live on the wages from a full-time minimum wage job, but  having a tough time making ends meet? Is there anyone like this?

The tragedy of the neighborhoods around where I live, and President Obama used to live, is the vast number of people with no job at all.  How does raising the minimum wage for the few who have a minimum-wage job help the vast majority who have no job at all?

Minimum wages are about teenagers and young adults, most still living at home. It's about the "dating" phase of work-force attachment, where people learn the skills and habits, and make connections by which they can move up to better jobs when they are ready to have families.

"Families" is an interesting word as well. Marriage among lower-income Americans is rare, as President Obama made clear when he came back to talk to students at Hyde Park High school and made some controversial remarks about the absence of fathers.

For example in zip code 60619, just south of the University, there are "4,967 married couples with children, and 12,745 single-parent households (2,655 men, 10,090 women)." Here's the marital status chart.

What "family" means in this speech is, by and large, a single woman with children. I'm not starting a Murphy Brown argument, but it is an interesting use of the word. I wonder how many of the Republican ears in the audience listened to "working families" and heard "single women with children and no father in sight?" More worthy of our sympathy, indeed, but a very different picture of what kind of policies might actually work.

And even then, the modern Scrooge ("are there no workhouses?") might ask, "Is there no earned-income tax credit? Is there no home heating subsidy? Are there no food stamps? Is there no schip or medicaid? Have they not applied for social security disability? Are there no section 8 housing vouchers?"

The point is not to be heartless -- government programs or not, life on the lower end of America's economic and social spectrum is pretty awful.  The point is, if we seriously want to address the problems of the "working poor," if we want policies that actually work rather than spew a lot of TV time and make us feel good, let us paint a vaguely realistic picture of what their life is like. Absolutely nobody (except perhaps illegal aliens) is trying to support a family on $14,500 from a full time minimum wage job, period.  The actual economic life of the "working poor" is a welter of government programs, transitory employment, and a lot of illegal activity

And, one huge problem facing  people who do work full time and earn minimum wage is the astounding marginal tax rates that our various social programs imply.  In fact, much of the raise from $7.25 to $9.00 will be taken away. Even more of a raise to $20 an hour will be taken away. The structure of our programs that are supposed to help people are instead trapping them. (Previous posts here and here.)

Yes indeed, let us help families to "finally get ahead!" Let us talk about lousy schools, incentive-destroying social programs, horrendous violence, life-destroying incarceration, and the war on drugs run amok. The minimum wage may slightly help the few who can get such jobs, and put such entry-level jobs slightly more out of reach for many others. But it's just irrelevant to the real, first-order problems such families face.

The final line also caught my eye: "For businesses across the country, it would mean customers with more money in their pockets."  I wonder who signed off on that one.

Even if the Administration's theory works, it is exactly the same as a tax on sales of local businesses (i.e. cost passed on as higher prices) to subsidize employment. This is an interesting harbinger of things to come in the politics of budgets: Passing a national sales tax on businesses that employ minimum wage workers, to fund an on-budget subsidy of those workers' wages, would obviously go nowhere politically, and would count on the budget. But forcing businesses to do it, though economically equivalent, makes it looks as if the government is not taxing and spending as much as it is. 

And of course, that tax comes out of the very pockets it's going back in.  Back to Greg Mankiw's question about how much the wage should be: on this theory there is no limit!  If you pay them $20, then customers have $20 more to spend. If you pay them $50, then they have $50 more to spend.

Now we really have crossed the line, from serious economics, to fiddling while Rome burns, to believing in magic.

Bloomberg TV on debt and magic

I did a short interview on Bloomberg TV this morning. Nothing new for readers of this blog, but fun anyway. Coffee just starting to kick in at 6:15 AM. As always, walking home I figured out 10 better ways to answer.

Sunday, February 17, 2013

Surprising candor at NYT on health care

The New York Times published a surprisingly sensible piece on health care on Sunday, "The health care benefits that cut your pay" by David Goldhill. A sample

We manage health care as if our needs were always urgent and unpredictable, ignoring how deeply this industry is integrated into our lives, with a vast amount of care now devoted to treating ongoing, chronic conditions.

Our system takes resources from all of us, pools the cost of certainties disguised as risks, extracts enormous costs of administration and complexity and then returns — to almost all of us — a fraction of the money we’ve put in.

Try to imagine what homeowners’ insurance would look like if we expected everyone’s house to burn down and then added coverage for each homeowner’s utility bills and furniture wear-and-tear. This would be insanely expensive without meaningfully reducing anyone’s risk. That, in short, is how health insurance works.

...Traditional health experts may repackage their ideas, but they are never discouraged by past failure. So the new Accountable Care Organizations are a reinvention of H.M.O.’s. The Independent Payment Advisory Board is the new Medicare Payment Advisory Commission, or MedPAC. Bundled payments are the new Prospective Payment System.

We often see some early benefit from the introduction of new ideas, but over time such initiatives are always subjugated by our system’s nefarious economic incentives. Implement cost control reforms and watch providers circumvent new rules and guidelines. Reduce reimbursement rates for procedures, and witness providers expand the definition of required services. Convert fee-for-service reimbursements into bundled payments, and soon more severe diagnoses are given. Attempt to use government buying power, and see providers turn to lobbyists to keep prices up. We are approaching a half-century of fighting this losing battle


Here’s a completely different idea, one that might actually work. Let’s give every American health insurance, but only for truly rare, major and unpredictable illnesses. In other words, let’s cover everyone but not everything. It would take a generation to transition fully to such a system, but eventually the most routine and expected medical treatments, from checkups and minor illnesses all the way to common chronic conditions and expected end-of-life care, would be funded from our individual health savings; only the most major needs — for example, cancer, stroke and trauma — would be paid out of insurance.

Defining insurable events more narrowly and enabling Americans to use the premium savings to build health savings would reduce the distortions inherent in our insurance approach. Most importantly, it will also compel providers to compete on the basis of price, quality and service, as they meet the one force that creates real incentives for good performance, innovation and safety: the consumer.
Sheer poetry, in few words accomplishing what took me many pages of "After the ACA."  Newspapers often publish contrary views to show they are balanced (or so a WSJ editor once told me when I complained!) But that this can even get aired at the Times is pretty remarkable.

Tuesday, February 12, 2013

SEC Charges Husband and Wife in Florida with Defrauding Seniors Investing in Purported Charity

The SEC charged a husband and wife who raised millions of dollars selling investments for a purported charitable organization in Tallahassee, Fla., while defrauding senior citizens and significantly exaggerating the amount of contributions actually made to charity.

The SEC alleges that after the couple were hired at We The People Inc., the organization obtained $75 million from more than 400 investors in Florida, Colorado, and Texas among more than 30 states across the country by selling an investment product they described as a charitable gift annuity (CGA). However, the CGAs issued by We The People differed in several ways from CGAs issued legitimately, namely that they were issued primarily to benefit the couple and other third-party promoters and consultants. Only a small amount of the money raised was actually directed to charitable services. Meanwhile the couple received more than $1.1 million in salary and commissions, and they also siphoned away investor funds for their personal use.

The SEC further alleges that the couple lured elderly investors with limited investing experience into the scheme by making a number of false representations about the purported value and financial benefits of We The People’s CGAs. The Olives also lied about the safety and security of the investments.

“The [couple] raised millions from senior citizens by claiming that We The People’s so-called CGAs provided attractive financial benefits and were re-insured and backed by assets held in trust,” said Julie Lutz, Associate Director of the SEC’s Denver Regional Office. “Investors were not given the full story about the true value and security of their investments.”

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Monday, February 11, 2013

SEC to Hold National Compliance Event for Broker-Dealers

The SEC announced the opening of registration for its National Compliance Outreach Program for Broker-Dealers that will take place in Washington D.C. on April 9.

The event is sponsored by the SEC's Office of Compliance Inspections and Examinations in coordination with the SEC's Division of Trading and Markets and the Financial Industry Regulatory Authority (FINRA). It provides a forum for open discussions about effective compliance practices for broker-dealers and will focus on topics of interest to compliance, risk, and audit officers of large broker-dealers with multiple and complex business lines.

"To be effective, compliance and ethics programs cannot exist in silos. They need to be ingrained in the DNA of the organization and the decision-making framework of the organization. They need to be part of the way business is done," said Carlo di Florio, Director of the SEC's National Examination Program. "Compliance and risk management programs add tremendous business value. They protect the business. They enhance the brand. They ensure that reputation is protected. Our National Compliance Outreach Program is one of the ways that we try to support and enhance the compliance and risk management functions of firms."

FINRA Member Regulation EVP Susan Axelrod added, "FINRA is pleased to continue the partnership with the SEC to provide this opportunity for broker-dealer compliance professionals and regulators to foster two-way communication and work together to protect investors. Given the pace of change in the industry, face-to-face meetings of this kind are more valuable than ever."

For more information on the even, visit SEC to Hold National Compliance Event for Broker-Dealers

Defending 10b5-1 Plans

Seal of the U.S. Securities and Exchange Commi...
We haven't seen much interest in Rule 10b5-1 plans recently. I suppose that a declining market during recent years tempered the desire to sell stock. If so, we should see a rise in the interest in such plans once again.

For those unfamiliar with these plans, a 10b5-1 plan is used by insiders in public company to sell securities of their company, without running afoul of insider trading laws. The plans are detailed, specific plans that are designed to let executives sell off shares at regular intervals, regardless of events inside the company at the time of the sales. Properly structured and executed, the plans provide a clear defense to an insider trading allegation.

Years ago the SEC began investigating the use of the plans, or rather the alleged abuse of the plans. According to the Commission, some executives were attempting to modify their plans as events at the company unfolded, causing potential violations of Rule 10b5-1, the SEC rule that permits the use of such plans. I wrote about the issue back then - 10b5-1 Plans Under Attack.

Along with a potential increase in the use of the plans, the Commission is once again looking into the use of the plans. According to the Harvard Law School Forum on Corporate Governance and Financial Regulation,  several recent Wall Street Journal articles suggest that some executives may have achieved above-market returns using the plans. These articles are reported to have drawn the interest of federal prosecutors and the SEC enforcement staff.

The problems that we have seen in the plans are in the execution of the plan itself, not in the creation of the plan. Defending executives in an SEC investigation over the use of a 10b5-1 plan  should not be a difficult endeavor. As noted in the article, although regulators and the media may scrutinize trades made under 10b5-1 plans even when above board and done according to best practices, a well-thought-out and implemented 10b5-1 plan may help a company and its executives avoid or ultimately refute accusations of impropriety.

More details are available at Rule 10b5-1 Plans: What You Need to Know

The attorneys associated with my firm include former SEC Senior Enforcement Attorneys and criminal prosecutors. In addition, I have been representing executive, financial professionals and firms in regulatory investigations and proceedings for over 25 years. If you have a question regarding an investigation, give me a call or send me an email - 212-509-6544 or

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Friday, February 8, 2013

Mary Jo White - Prosecutor, Defense Attorney, SEC Chair?

From The New York Times Mary Jo White at the S.E.C. She has smarts and guts, but she needs to make clear that she can be a strong regulator of Wall Street.

Wednesday, February 6, 2013

What's holding back the US economy?

This is a video I did with Steve Davis and Amir Sufi, moderated by Hal Weitzman, part of the new Chicago Booth "The Big Question" series. Youtube link here. I'm actually a lot calmer through most of it than I appear in the cover shot.

Sunday, February 3, 2013

Three views of consumption and the slow economy

I'm still digesting New-Keynesian models. As part of that effort, today I offer some thoughts on how economists come to such different views of the current situation and desirable policies. It's a nice story, in the end. Real economists, unlike much of the commentary and blogging world, come to different conclusions by using much the same model, but making different assumptions and simplifications, each of which we can look at and evaluate, and hopefully come to some consensus.

The economy is not doing well. The black line in the graph shows log consumption. (The units are percent increase in consumption since 2002.) After trending up steadily at close to 3% per year through the previous decade, consumption -- along with output and everything else -- took a dive, totaling 10% loss relative to the red trendline. And consumption has been stuck there ever since.

So, the big questions: why, and what might be done about it?

All current macroeconomic theories start with the same basic story: when interest rates are higher, people consume less today, save, and then consume more in the future. Higher real interest rates mean higher consumption growth. In equations,

(c represents log consumption, i is the interest rate, pi is inflation, rho and gamma are parameters. Rho is a "discount rate" capturing how much people prefer the present to the future, and gamma captures how strongly people react to interest rate changes. I simplified, leaving out uncertainty.)

We build on this insight in different ways. 

I. New Keynesians 

Integrating forward, today's consumption reflects all expected future interest rates, and where we think consumption will be in the far-off future

This is the central equation of the new-Keynesian model and world-view. (For example, this is Johannes Wieland's equation 2, see my last post. I have taken out growth or trend, so these represent deviations from a steady growth path.)

The green line in the graph presents the New-Keynesian diagnosis of the current situation. New-Keynesians assume consumption will return to trend, so the last term in the equation is zero. In the graph, they anchor future consumption at the green dot. Then, a too-high interest rate means too-high consumption growth, which drives the level of today's consumption down.  (For example,  Ivan Werning's figure 3, discussed in an earlier post here.)

Why is the interest rate too high? The "zero lower bound" is to blame. The Fed cannot lower nominal interest rates (i) below zero. So if the inflation and discount rate terms (pi and rho) require a strongly negative nominal rate, the real rate will be stuck at a big positive number.

From this one equation and graph, you can make sense of lots and lots of new-Keynesian analysis and policy advice.

The level of today's consumption depends on the whole string of future interest rates, not just today's interest rate. So, if people expect the interest rate in 2014 to be lower, that is every bit as effective in raising today's consumption as would be lowering today's rate. Hence, "open mouth operations," "forward guidance," and "managing expectations."  If the Fed by just talking can persuade people it will hold interest rates low for a longer periods, when they are expecting rates to rise above zero, that expectation will "stimulate" today's consumption. If promises don't help, perhaps announcing a new "rule" which if followed would lead to lower rates for longer will help to change expectations.

In this equation, more inflation lowers the real interest rate too. So, anything that boosts inflation is a good thing. Boosting inflation isn't primarily about a Phillips curve, direct "monetary stimulus," encouraging investment, and so on. It's a way to lower real interest rates inside the integral and shift consumption from the future to the present.

Once again, increasing expected future inflation would be just as effective as increasing current inflation. Hence, calls for the Fed to announce a higher inflation target, or at least announce that it will tolerate more inflation before beginning to raise rates, as it has.

Fiscal stimulus, and many of the other seemingly magical properties of new-Keynesian models (see  last post) follow from the idea that inflation is good. Fiscal stimulus raises inflation. Broken windows, hurricanes, pointless public works projects, temporarily lowering the economy's productive capacity, all raise inflation (how is in other equations of the model), which lowers interest rates.

I'm not sold on this story, as you probably guessed, for a variety of reasons.  

New Keynesian models are a bit fuzzy on just why interest rates have to be so low -- why the "natural rate" is sharply negative and why zero interest rates aren't enough. Many of the formal models assume that consumer's discount rate (rho) has declined sharply, beyond the capacity of the interest rate to follow it. If rho goes to, say -5%, with our 2% inflation, then even a zero nominal interest rate is like a 3% real interest rate. (These are deviations from trend, so one might not need actually negative discount rates to hit the zero bound. But even adding growth, it's hard to avoid the need for a negative natural rate to cause a problem of this size.)

Now, a spontaneous outbreak of thrift, to the point of valuing the future a lot more than the present, seems a bit of a strained diagnosis for the fundamental trouble of the US economy. That a bit more thrift is a great danger to the economy, rather than the long awaited return to normal after decades of debt-financed consumption, seems strained as well.

To be fair, all the papers I've read say clearly that they regard the decline in the discount rate rho as a stand-in for some more complex process involving the financial crisis. For example, a more precise version of my first equation adds a "precautionary saving" term. When people are very uncertain about the future, they save more, just as if they had become much more patient. In equations,

This story seems possible for 2008 and 2009, in the depths of the financial crisis and recession. But I'm less convinced that it describes our current moment. Just look at the graph. Our state is one of steady but sclerotic growth, not one of great consumption volatility.

New-Keynesian introductions have something more complex in mind, involving the "frictions" of the financial crisis, and lots of models in this spirit add explicit financial frictions. That too seems to me a useful line to pursue to understand the onset of the recession and the financial crisis. But that too is really not our question. The  "frictions" of the financial crisis -- capital constraints at banks and financial intermediaries,  or the run in the shadow banking system -- passed quite a while ago, and the models with frictions are by and large not being used to address the current moment. 

The question before us is not really why consumption fell so drastically in 2008 and 2009. The question is, why did consumption get stuck at so low a level starting in 2010? For this question, it's much harder for me to understand what a strongly negative discount rate means.

This question and controversy is much like those surrounding the Great Depression. The controversy there has not been about why the stock market crash and recession happened in the first place. (Though perhaps it should, as we really don't know much about that process.) The controversy is, why did the US get stuck so low for so long? Was it bad monetary policy (Friedman and Schwartz), bad microeconomic policy, war on capital, and high marginal tax rates (Cole, Ohanian, Prescott, etc.), or inadequate fiscal stimulus (Keynesians)? 

Many new-Keynesian models (such as Ivan Werning's) generate the high real interest rate by predicting strong deflation. Yes, if inflation (pi) were negative 10% in (2), then a zero interest rate would be a 10% positive real rate. But our inflation has been positive throughout. Our zero interest rate has meant a negative 1.5% to 2.5% real rate all along. Deflation simply did not happen. Moreover, the other ingredient in new-Keynesian modeling -- the Phillips curve -- says that a big output gap should be accompanied by some action on inflation, not a steady 2%.  The Phillips curve part of the model suggests that "potential" dropped, not that current output is far below that potential.

I graphed the green line to 2010, a good date for supposing the crisis is over and we entered the period of sclerotic growth rather than swift return to trend. We've had some time since 2010. Again, the new-Keynesian model generates a low consumption level by saying that we have too-strong consumption growth. But we don't have strong consumption growth. Equation (2) does not produce a steadily depressed level of consumption, with (if anything) weaker than normal growth. I guess you could argue for a constant sequence of unexpected negative shocks, so that each quarter, people are expecting the big consumption growth which just ends up not happening. But you can see how strained that argument is. It would be much more appealing to refer to a model and analysis that describes slumponomics directly.  (Update: I just found Kathryn Dominguez and Matt Shaprio on a sequence of negative shocks.)

And, you might be exploding a bit at the economic logic of it all. How can it be that all we need to do is to decide how much to consume, and the output just magically appears? Doesn't consumption have to be limited a bit by income?

Well, the new-Keynesian models are coherent on this subject. The simple models have no capital; output is produced by more or less labor each period. The logical structure of the models, is, roughly, that you first decide how much you want to consume, then you'll work hard enough to make the required income. (This isn't a behavioral assumption, it's the equilibrium outcome of sticky prices and monopolistic competition.)

That's why fiscal stimulus works at all. You might think that if you have to pay taxes to the goverment, which buys output to throw it away, you'll have to consume less.  (Again, stimulus in these models is Ricardian so the same whether from taxed or borrowed money, and stimulus does not depend on the government doing anything useful with the output.) But if consumption is determined first by the above equation, then you just work harder to pay taxes and make the stuff the government wants to throw away. That gives us a multiplier of one, not zero, and then inflation kicks in to raise desired consumption and give us a larger multiplier. (Roughly! Again, I'm trying to explain the core simplest idea, not to fairly describe all the complexities of the models.)

The very simple new-Keynesian model also does not have investment or capital stock. Output is produced as you need it. That's why consumption "demand" immediately means changes in output. I've always wondered why buying a car is good (consumption) but buying a forklift is bad (investment) in new-Keynesian models. You just can't ask that question in the very simplified model here -- there is no investment. Now, real quantitative new-Keynesian models do have investment and capital (with adjustment costs and other wedges). But as far as I can tell, the same basic conclusions emerge from models with capital, so the intuition must be as here, in which consumption is everything.

II Permanent income

An alternative view asks, what about the second term on the right hand side of the basic equation (2)?  What if nothing's terribly wrong with the intertemporal allocation of consumption, but the long-run productive capacity of the economy has declined?

There is certainly an abundant litany of such complaints. What if all the over regulation (Obamacare, Dodd-Frank, EPA "crucifixions," etc.), sand in the gears, disincentives of social programs, crony capitalism, policy uncertainty, high and prospectively much higher marginal tax rates, and other litany of complaints, have permanently reduced the productive capacity of the US economy, or, worse, its long run growth rate? Then we are not returning to trend. The trend has shifted down.

If so, the trouble is in the second term on the right hand side of the basic equation (2). And this basic equation has a dramatic and important lesson for us: Long-run ("supply") will depress today's consumption every bit as much as expected future interest rates ("demand") effects do. And improving the long-run "supply" effects can have a direct "stimulative" effect on consumption today.

I italicized, because I think this is an underappreciated consequence of the common world-view of all modern macroeconomics, both new-Keynesian and not, embodied in (2). The old-Keynesian view was,  take care of the short run now, because helping the long run only helps in the long run. You hear this over and over in policy circles. More stimulus now, and then talk about "structural reform" once the economy has recovered. Equation (2) denies that separation:  Improving the long run improves the present. 

I drew the blue line to reflect this view of matters. For an equation, we can turn to our old friend the permanent income model

Here W represents wealth (capital stock), r is the real rate r = i - pi, and y represents the stream of expected future income. This is an extremely oversimplified version of the standard stochastic growth model at the heart of... well, I don't know what to call us anymore. "Neoclassical?" "Anybody left who is a bit suspicous of the new-Keynesian juggernaut?"

The difference is really one of emphasis, not deep economics. (3) also derives from (1), but with a different set of auxiliary assumptions. The real interest rate is constant at r. There is capital W, and investment freely adds or subtracts from capital. Labor's product y is fixed rather than produced.

Again, this model is, like (2), extremely simplified. Yes, interest rates do vary, and it's easy enough to add that to the model.  Similarly, new-Keynesians know there is capital and investment.  We're outlining basic stories today, not constructing completely realistic, but often obscure and complex, models.

In this equation, the level of consumption shifts up and down along with expectations of permanent income. So, if you get news that the productive efficiency of the economy is permanently 10% lower, consumption drops 10%, and then goes on at the previous growth rate. As, by picking 2010 as the decision date, my graph suggests.

Like the new-Keynesians,  I won't be that specific here about just why consumption fell so drastically in the financial crisis.  The permanent income model does suggest that we look for changes in permanent income to explain the fall, rather than (only) a rise in discount rates or real interest rates, i.e. the desired intertemporal allocation of consumption.  From this perspective, consumers realized in fall 2008, that this recession was going to last forever rather than bounce back quickly, and they adjusted consumption downward accordingly. They were right. Just how they knew, when all the Government's forecasters thought we would quickly bounce back, is an interesting question.  Surely, my litany of free-marketer's complaints did not obvioulsy get suddenly worse in October 2008, just coincident with a run in the shadow banking system.  Well, maybe not so surely. Maybe consumers thought, we're in a horrible banking crisis, and our government is likely to prolong this one with ham-handed policies just like they did in the 1930s. But that's pretty speculative. And I do think (just as speculatively) there was a run in the shadow banking system, effective risk aversion spiked, and the financial crisis was more than just a signal of bad policy to come.

But all that is a topic for another day. The question is why consumption (and output) remain so low for so long after the crisis, when whatever outside-the-model chaos is over. The permanent income view suggests the problem is a poor long-term level, poor long-term prospects for the productive capacity of the economy, not too high growth, to an unchanged long-term level.

In this view, the Fed largely wasting its time with all its QEs and promises about future interest rates. The right policy answer is to forget about stimulating and fine tuning. Fix the long-run growth problem and the short run will take care of itself, much faster than you might have thought. This isn't the Fed's job. For Europe, do the "structural reforms" now and you'll start growing now in anticipation of their effect.

Moreover, in the underlying stochastic growth model, a rise in real interest rates is a good thing. Yes, we can get on the new-Keynesian green trajectory. What does that is a rise in the marginal product of capital, which raises interest rates, attracts investment, and leads to greater output. In that model, consumption is (very roughly) anchored at its position today, and increased interest rates raise future consumption, not the other way around. Of course, in the stochastic growth model, the Fed can't raise interest rates all on its own --  a higher marginal product of capital comes from greater efficiency or better technology. Still, it encapsulates the comments you read here and there that maybe the conventional sign is wrong -- maybe higher interest rates are desirable, as a sign of a good thing, not as a cause of a bad thing. There is always supply and demand in economics, and two sides to every question.

Which view is right? To my eyes, consumption seems stuck on a lower trend line, not growing sharply. Real interest rates are already negative -- we do not have deflation -- and I find it hard to believe that the discount rate and marginal product of capital are negative 5% or worse. The very large discount rate shock needed for the new-Keynesian story is pretty nebulous. The shocks to long-run productivity are staring us in the face.

I wish, of course, for more serious structural investigation to separate the two stories. I haven't seen a serious attempt to look at the structure of the US economy and measure a sharp negative "natural rate." (I welcome pointers from commenters.) I would welcome a quantitative assessment of how much the level of GDP is depressed from my litany of free-market complaints. With trillions of dollars of GDP, and potentially trillions of wasted stimulus at stake, you'd think we could do better.  

I want to emphasize, this is not a fight between models. This is the same model, with different emphasis, and different simplifications. There is nothing in the new-Keynesian modeling paradigm that forbids one to ask the question, what if the long-run productivity of the economy has sunk and high real rates are not the problem? The models were developed to talk about other things, to talk about historical "cycles" defined as deviations from "trend." Nothing but old habits prohibits one from asking the opposite questions.

III. Old Keynesians

A traditional view of consumption has been conspicuously absent so far, the textbook old-Keynesian consumption function

Consumption depends on today's income through the "marginal propensity to consume" mpc.

Modern new-Keynesian models are utterly different from this traditional view. Lots of people, especially in policy, commentary, and blogging circles, like to wave their hands over the equations of new Keynesian models and claim they provide formal cover for traditional old-Keynesian intuition, with all the optimization, budget constraints, and market clearing conditions that the old-Keynesian analysis never really got right taken care of. A quick look at our equations and the underlying logic shows that this is absolutely not the case.

Consider how lowering interest rates is supposed to help. In the old Keynesian model, investment I = I(r) responds to lower interest rates, output and income Y = C + I + G, so rising investment raises income, which raises consumption in (4), which raises income some more, and so on. By contrast, the simple new-Keynesian model needs no investment, and interest rates simply rearrange consumption demand over time.

Similarly, consider how raising government spending is supposed to help. In the old Keynesian model,  raising G in Y = C + I + G raises Y, which raises consumption C by (4), which raises Y some more, and so on. In the new-Keynesian model, the big multiplier comes because raising government spending raises inflation, which lowers interest rates, and once again brings consumption forward in time.

Old-Keynesians spent two generations fighting against the intertemporal view of consumption embodied in my first two equations, and now at the heart of the new-Keynesian model, in favor of the last equation. They said consumers were "liquidity constrained," or "rule of thumb," their expectations (if they had any) "adaptive," either too stupid to look forward in time or unable to do so.

I must confess a little sympathy to some of these views. A long long time ago I wrote a paper on "near-rationality" criticizing excessive zeal in the application of equation (1). Really, if the Fed today raises interest rates to 12% (annual rate) for a month, would everybody's consumption fall one percent today, so that it could rise one percentage point over the next month? Or is the relation between consumption and interest rates one of those looser relations that yes, applies roughly, for large sustained changes, and over long time periods, but not necessarily instantly?

In any case, a look at (1) and its application in (2) tells us that Friedman won more than he could possibly have imagined. Intertemporal optimization is now not the heretical pariah suggesting a low marginal propensity to consume and low multiplier, but it is the heart of the model. The Lucas-Sargent-Prescott revolution pervades new-Keynesian models as much as their more classical counterparts. Consumers are forward-looking. Expectations matter. No self-respecting mid 1970s Keynesian would have said that Fed pronouncements about what interest rates were going to be in 2016 -- or how the future unemployment rate would condtion that choice -- would have the slightest effect at all on today's consumption. Consumers are myopic, he would say. Expectations are adaptive.
But as a result, the new-Keynesian model really has nothing to do with the old-Keynesian intuition.

IV. Bottom line

Enough history of thought, though. The relevant choice today is between the first two alternatives. Are we in a situation where the long run is just fine, but the zero bound is forcing us to have too high interest rates, so consumption growth is too high and the level is depressed? Or are we in a situation that consumers doubt the long-run productive capacity of the economy, and are consuming little today because they expect to consume little tomorrow and little 10 years from now?

The answer matters: whether the economy can be stimulated merely by more solemn promises from the Fed about future interest rates and inflation, by broken-window interventions that reduce supply today to engender some inflation, or whether the economy must be stimulated today by ignoring short-run stimulus, fixing the long run, and counting on the permanent income model to increase consumption, and the present value model (q theory) to increase investment today.


P.S. It's 2013. Why is displaying math in html so hard?! The people who developed the internet are all nerd engineers who took calculus! I'm back to  pasting in png files to show equations. I tried mathjax, but it only seems to work on traditional screens, not in mobile, rss, etc. Suggestions welcome.

P.P.S. Martin Boulanger and Absalon below asked if maybe consumption wasn't growing unsustainably before the crash. Here's a longer view of the first graph, with my 2000-2007 trend line.
Or, even go back to 1945.
A big boom in the 2000's does not stick out from the consumption data. If anything, it was a little weaker than usual.

Also, yes, this is total consumption. Nondurable and services does not look much different. I started to break out the components but the post was getting too long.