An Economist’s Economist

Wednesday, September 29, 2010

In a discipline that celebrates specialization, Robert E. Hall is a Renaissance man, and economics is far the richer for it. The Stanford economist’s extensive publications over four decades—books, blogs, articles, and lectures—provide ready evidence of wide-ranging expertise. As a labor economist, Hall has produced some of the field’s most influential models of labor market dynamics and essential articles on labor supply, demand, and wages. A scholar of fiscal policy, he built the intellectual foundation for the 1986 tax reform bill as well as recent consumption tax proposals. His work in financial theory, consumer and corporate incentives, and government policy illuminates regulatory issues currently under debate in Washington. Innovative analysis of stock market valuation by Hall demonstrated the importance of intangible capital. His studies of entrepreneurial incentives (with his wife, economist Susan Woodward) and antitrust theory are pathbreaking. Hall’s research on trading through electronic markets—“digital dealing” is his term—provided one of the first lucid explanations of the economics of then-new Internet phenomena such as eBay.

Hall’s analytical gifts also have generated important insights on monetary theory and optimal monetary systems. He has done invaluable work as well in growth theory, determinants of productivity, spending on health, and economic geography. His erudition has range, depth, and quality that few economists can match. And the profession has recognized this with honors including the Richard T. Ely lecture in 2001, presidency of the American Economic Association in 2010, and fellowship in the American Academy of Arts and Sciences, the Econometric Society, and the National Academy of Sciences.

“The Fed itself is just not a danger. It is run by people who know exactly what to do.”

Hall’s public profile, however, is largely confined to the sphere of business cycles, in which he also has unquestioned expertise. That narrow “fame” is due to his chairmanship, for over thirty years, of the committee that determines when U.S. recessions officially begin and end. It is a painstaking and largely thankless task. Pundits and policy makers clamor for the committee’s announcements, but inevitably second-guess the decisions made. Committed to the integrity of process and result, Hall has never bent to pressure, manifesting time consistency that monetary policy makers can only envy.

THOUGHTS ON U.S. MONETARY POLICY

Douglas Clement, the Region: Perhaps we could start with monetary policy. What is your broad view of the Fed’s efforts over the past few years to stem the crisis using unconventional monetary policy and strategies?

Robert E. Hall: First of all, I believe you should think of the Fed as simply part of the federal government when it comes to the financial side of its interventions. If you look at how the federal government responded initially, it was the Treasury that was providing the funds. Of course, TARP [Troubled Asset Relief Program] was there using the taxpayers’ money without involvement of the Fed. Also, early in the crisis, Treasury deposited hundreds of billions of dollars at the Fed, which the Fed then used to buy assets. So there the Fed was just an agent of the Treasury. It was as if the Treasury took its funds to a broker.

Eventually, the Treasury was impeded from doing that by the federal debt limit. But the debt limit doesn’t apply to funds borrowed by the Fed, so it then started borrowing large amounts from banks by issuing reserves. That is what caused all the confusion about thinking this was somehow part of conventional monetary policy.

I would distinguish between conventional monetary policy, which sets the interest rate, and this kind of financial intervention of buying what appear to be undervalued private securities. Issuing what appear to be overvalued public securities and trading them for undervalued private securities, at least under some conditions and some models, is the right thing to do. In my mind, it doesn’t make a big difference whether it’s done by the Federal Reserve, the Treasury, or some other federal agency.

“Dividends are exactly equity depletion: with a government guarantee, it’s exactly what there’s incentive to do.”

Clement: And what are your thoughts on the best course for a Fed exit strategy?

Hall: That again gets at this confusion. Traditionally, reserves at the Fed pay zero interest in the United States, so in normal times with positive market interest rates, banks try to unload reserves; when they do so, they expand the economy. That does not happen when interest rates in the market are zero because there’s no incentive for banks to unload reserves. They can’t gain by getting something off their balance sheet if what they buy doesn’t yield any more. And during the crisis, there was no differential, nothing to be gained by unloading reserves.

As the differential re-establishes, which the markets think is going to happen in the next year or so, then that issue comes up. It would be highly expansionary and ultimately inflationary if market interest rates began to rise above zero and the Fed didn’t do something to either reduce the volume of reserves or increase the demand for reserves.

So the Fed has two tools, and Chairman Bernanke has been very clear on this point. The Fed can either leave the reserves out there but make them attractive to banks by paying interest on them, or it can withdraw them by selling the corresponding assets they’re invested in. Selling assets will be timely because those investments will have recovered to their proper values; the Fed can sell them and use the funds to retire the reserves.

Both branches to the exit strategy are completely safe, so it’s a nonissue. The Fed itself is just not a danger. It is run by people who know exactly what to do. And we have 100 percent confidence they will do it. It’s not something I worry about.

EQUITY DEPLETION

Clement: Let me ask you about a paper you wrote in December 2008, on equity depletion, defined as the “withdrawal of equity from firms with guaranteed debt.” We’re all well aware of government bailouts, and implicit or explicit guarantees of financial institutions. You had a wonderfully provocative statement in your paper. You declare that equity depletion “appears to be an unlimited opportunity to steal from the government.” Could you tell us what you mean by that? Why does equity depletion occur, and how does it constitute an opportunity to steal?

Hall: George Akerlof and Paul Romer published a paper in 1993 that described what they called “looting.” The particular form that looting took was through the ownership of a savings and loan; this was a feature of the savings-and-loan crisis of the late 1980s. As a “looter,” you would use the savings and loan to attract deposits, pay the deposits as cash to yourself and then declare bankruptcy.

“In retrospect, what we did was to save the economy from a tremendous train wreck. But we didn’t do it in a way that was as cheap for the taxpayer as it could have been.”

One of the big problems encountered recently is that institutions that have become very undercapitalized were still depleting their equity by paying dividends. The government has had to push very, very hard to get these financial institutions to stop paying dividends. Dividends are exactly equity depletion: with a government guarantee, it’s exactly what there’s incentive to do.

It’s a danger whenever you have guaranteed financial institutions that have gotten into a very-low-capital situation. They’ve suffered asset value declines, they’ve become extremely leveraged, and they have this very asymmetric payoff to the owner: if they go under, it’s the government’s problem; if they recover, it’s the owner’s benefit. That asymmetry, which is the so-called moral hazard problem, is just a huge issue.

It looks like we’ve been somewhat successful in preventing the worst kind of stealing, but the asymmetry is still potentially a big issue. There are way too many bank failures that should not have occurred and especially should not have cost the taxpayers as much as they did.

“This has been a critique of fiscal policy as long as I’ve been an economist, this notion that it takes so long to get spending up that typically the spending rises only after the recovery has occurred. And it comes at completely the wrong time.”

Clement: Your thoughts about what measures can be taken to curb this moral hazard?

Hall: The most important thing is to be sure that financial institutions that are guaranteed by the government have large amounts of capital so that the danger of them spending the taxpayers’ money rather than their own money is very small. That’s a principle that’s been deeply embedded in our regulations for a long time.

But the principle of so-called prompt corrective action says that if capital goes below this mandated level, which is typically around 8 percent, then something has to be done right away before all the remaining capital gets depleted.

We just have not been successful at doing that. We have principles of regulation that allow the regulators to say that a bank is well capitalized even though the markets know that it’s not. Banks have been declared to be well capitalized even when the market value of their debt and the market value of their equity have declined to very low levels.

Regulators seem to ignore something that everyone in the market seems to know, which is that they’re shaky. There seems to be a lack of willingness to pay attention to all the signals that a regulator should pay attention to. All they do is look at certain accounting records, which don’t reflect what people know.

In retrospect, what we did was to save the economy from a tremendous train wreck. But we didn’t do it in a way that was as cheap for the taxpayer as it could have been.

GOVERNMENT SPENDING AND GDP

Clement: The federal government’s stimulus package has been a topic of heated debate among economists, in terms of how much stimulus it’s truly provided and whether more is needed. In a recent paper, you analyze basically what happens to GDP when government purchases goods and services. Would you give us your rough estimate of the size of the government multiplier in the current era of very low interest rates, and share your sense of the impact of the current stimulus package?

Hall: When the idea of a stimulus through federal purchases program first came up in the current crisis, the thinking was, “That’s feasible. We can increase purchases.” And then the question was how much would it raise GDP. There was a vigorous debate on this multiplier question.

The discussion has shifted now because the premise was that we would be able to raise government purchases. But in fact, government purchases have not increased.

“While there are a lot of good ideas in flat-tax reform, it wouldn’t be remotely practical to do it with a single positive tax rate now. So I play around with systems that have, say, two brackets. The ‘not-so-flat’ tax.”

In part that’s because it’s very difficult and time-consuming to actually get the government to buy more stuff. This has been a critique of fiscal policy as long as I’ve been an economist, this notion that it takes so long to get spending up that typically the spending rises only after the recovery has occurred, and it comes at completely the wrong time.

Clement: We searched in vain for “shovel-ready projects.”

Hall: Yes, “shovel-ready” turned out not to be.

But the other fact is that there’s been a small increase in federal government purchases, but it’s been more than offset by declines in state and local government purchases. The stimulus bill recognized that danger. We have had these tremendously pinched state and local governments, which had no choice but to reduce spending when their tax revenue declined.

In spite of recognizing that potential when the stimulus program was designed, still the net effect of the crisis and the policy response was for government purchases to decline, not to rise—but by very small amounts. Basically, nothing happened to government purchases. And that was in an environment in which everybody (including Congress) was willing to go for a program with higher purchases. But no matter how hard they tried to turn the knob, it just wouldn’t go very far.

Clement: So ARRA [American Recovery and Reinvestment Act of 2009] was for naught?

Hall: First of all, you have to take it apart and ask how much of it went directly into government purchases, which is fairly small, or would stimulate state and local purchases, which was also fairly small.

A lot of it was providing income supplements, and there you get into the question of whether the people receiving the supplements increased their spending or not. That’s a whole other issue; I’m not commenting on that issue. That’s a very difficult question to answer.

To go on to the other part of your question, had there been an increase in government purchases that was successfully achieved, how much would that have increased GDP? The answer I got was a factor of around 1.7, which is at the high end of the range of what most economists were talking about.

I only reached that by thinking very carefully and reading a lot of recent commentary on this question of the implications of having a zero fed funds rate. That turns out to be very important. Others have found that to be true. So I think that the people who looked at the evidence of what the multiplier is in normal times and said it’s maybe 0.8 or 1.0 (which I would agree with) kind of missed the point. There was a lot of, I think, inappropriate criticism.

TAX POLICY

Clement: Of course, this raises the issue of taxes, of needing to pay for deficit spending. And I notice the Time magazine cover above your desk about the flat tax.

Hall: From long ago!

Clement: Yes, exactly. Your work with [Hoover senior fellow] Alvin Rabushka on the flat tax was a huge sensation in the early 1980s, as represented by making the cover of Time.

Hall: That’s right. It’s one thing to get your face on the cover of Time; it’s quite another to get your idea on it!

Clement: And I think it can be argued that that helped pave the way toward the 1986 Tax Reform Act.

Hall: We like to think so. I’ll accept that.

“Did macroeconomists fail to understand that financial collapse would result in deep recession? Not at all.”

Clement: Twenty-five years later, you reissued the book, updated of course, and continue to advocate it as the “most fair, efficient, simple, and workable plan on the table.” Given its clear merits and strong advocates, why do you think it’s gained relatively little traction in the United States?

Hall: Contrary to some people’s impressions, it’s not gone very far in the rest of the world either.

Clement: Not in Central and Eastern Europe? Mexico, perhaps?

Hall: Yes, but if you look at their overall tax structure, it’s not what we have in mind. Their rates are high because they’ve adopted income-tax systems that work like a flat tax, but they’re on top of a very high value-added tax. So the combination doesn’t achieve the low rates that we were hoping for.

In the United States, there’s been a lot of backsliding. It looks like there’s going to be more and more. The state of California, for example, has a couple of times added surcharges for very high incomes. There seems to be a belief that it’s a great idea, that we can get all the revenue we need by taxing high incomes, without regard to the problems that those tax rates create, especially in the longer run. There’s more to the logic of low marginal tax rates than just the question of who pays the tax.

But another factor is that since 1981 when we first promoted that plan, there’s been a dramatic widening of the income distribution in the United States. That means that the idea of the poor paying the same tax rate just seems less viable than it was when the income distribution was tighter. The division between a small number of winners in the modern economy, mostly businessmen and lawyers, as opposed to most other people, has grown significantly.

While there are a lot of good ideas in flat-tax reform, it wouldn’t be remotely practical to do it with a single positive tax rate now. So I play around with systems that have, say, two brackets. The “not-so-flat” tax. But of course that doesn’t have quite the simple appeal that the “flat tax” did. [laughter]

But there’s still a great idea in that book which applies to any tax system: it basically figures out how to implement a value-added tax or other consumption tax in a way that’s progressive.

The origin of our initial flat tax effort was Rabushka coming to me in 1980 and saying: “I know what the people want. The people want a flat tax, but I don’t know quite what that is.” And I said, “I know what it is because I’ve been thinking about it since I was a graduate student.” But, of course, for me, it was a consumption tax—an efficient, simple, fair consumption tax. The flatness wasn’t so important, but of course the flat-tax name, which Rabushka contributed, was very important politically.

Clement: Marketing is important.

Hall: Yes, but now the idea of tax flatness is understandably not as popular.

THE STATE OF ECONOMICS

Clement: The past few years seem to have brought about a crisis of confidence in the economics profession, with critics suggesting that macroeconomics has failed in some fundamental way. Do you agree that the macro profession failed the nation during the financial crisis?

Hall: I don’t. There are two parts to the issue. First, did macroeconomists fail to understand that a highly levered financial system based in large part on real-estate debt was vulnerable to a decline in real-estate prices? No way. Many of us pointed out the danger of thinly capitalized banks. We had enthusiastically backed the idea of prompt corrective action in bank regulation, so that banks would be recapitalized well before they became dangerously close to collapse. We watched in frustration as the regulators failed to take that action, even though they had promised they would.

Second, did macroeconomists fail to understand that financial collapse would result in deep recession? Not at all. A complete analysis of that exact issue appears in an extremely well-known and respected chapter in the Handbook of Macroeconomics in 1999, written by Ben Bernanke, Mark Gertler, and Simon Gilchrist. Depletion of the capital of financial institutions raises financial frictions to levels that distinctly impede economic activity. In particular, credit-dependent spending on plant, equipment, inventories, housing, and consumer durables collapses. That chapter is an excellent guide to the depth of the current recession.