Economic bubble reading list: The Lost Bank

Today is the beginning of the big GDP statistics update from the BEA:

At the end of September, BEA will update five years of U.S. gross domestic product and related statistics, as well as GDP statistics for industries and for each state.

Maybe we’ll get some insight into how badly we fooled ourselves in imagining that people sitting at home scrolling Facebook and playing Xbox were as productive as if they’d continued to go to the office. The latest from the BEA:

Speaking of fooling ourselves, let me recommend The Lost Bank: The Story of Washington Mutual – The Biggest Bank Failure in American History by Kirsten Grind, a Wall Street Journal reporter. The Collapse of 2008 has been covered at a high level in a lot of books, but this one manages to touch on all of the big issues in the context of a single enterprise and group of people. As with “A single death is a tragedy; a million deaths is a statistic,” a narrative about one company is more compelling and easier to follow than a story about the entire U.S. economy.

The book explains how our modern world of a handful of enormous banks came to be. When there are no limits on how big a bank can get, small variations in bank health lead to enormous concentration. Due to being slightly larger, WaMu might have slightly lower costs per customer than a smaller bank, e.g., with information systems being spread across a larger base, thus making an acquisition sensible on both sides. WaMu would buy banks after the CEO got sued for divorce, leaving the target without effective leadership while the CEO was defending the lawsuit. WaMu would ultimately buy banks to feed its own executives’ egos, particularly Kerry Killinger’s, regarding its size rank among U.S. banks (when you’re #4, the desire to become #2 or #1 becomes tough to resist).

The book explains the roots of the Collapse of 2008. At a high level, the book identifies the following culprits:

  • the federal government, starting with Bill Clinton, pressuring banks into lending big money to Americans with low income and bad credit history to serve a social justice goal of achieving a desire mix of skin colors among borrowers (regulators could simply shut down a bank that didn’t lend enough money to the groups of interest to the government)
  • Fannie Mae, which abandoned its insistence on high quality mortgages and, partly due to pressure from the government, started buying low quality mortgages issued to home buyers/flippers who could not be expected to pay back loans if house prices flattened
  • New York City, whose investment banks sold mortgage-backed bonds to investors worldwide and, also, those investors. The book describes people on the ground at subprime lenders, e.g., Long Beach Mortgage (acquired by WaMu in 1999), recognizing that the borrowers would never pay but assuming that if Wall Street kept buying the mortgages the investors must know something that they didn’t.
  • California, where most of the fraudulent practices originated.
  • the issuance of complex variable rate mortgages, such as Option ARM, to consumers who lacked the sophisticated or, in many cases the English language skills, to understand them (it didn’t help that these folks had the financial capacity only to pay the initial teaser monthly payments and were guaranteed to default if a house price didn’t go up enough to enable a refinance; Federal regulators at the Office of Thrift Supervision approved the practice of issuing a $4000/month mortgage to a consumer who could afford only the $1000/month teaser rate)

As in Bubble in the Sun book: even those with the best information can’t predict a crash, those on the inside did not always see crash coming. In early 2007, for example, as investors were fleeing from high-risk mortgages and as some of his junior executives warned of impending doom, Kerry Killinger tried to buy a huge California-based subprime lender, Ameriquest, which went bankrupt shortly afterwards. Questioned regarding why he would want to pay for Ameriquest while the crash appeared to be underway, Killinger responded “They don’t ring a bell at the bottom.”

Kirsten Grind references Are You Missing the Real Estate Boom?: The Boom Will Not Bust and Why Property Values Will Continue to Climb Through the End of the Decade, by David Lereah, Ph.D., the chief economist for the National Association of Realtors. The 2005 book was rereleased in February 2006 just as the market for subprime mortgage-backed securities began to collapse (but Fannie Mae kept buying!).

The book is a great lesson in what we might call “success disease.” Executives who take risks when everything is going up imagine that they have some special talents. Like individual investors in high-beta stocks, they don’t risk-adjust their high historical returns for the fact that they took a lot of risk and that it could easily have gone in the other direction.

The book answers the question Why did banks work so hard to lend money to people who obviously weren’t going to pay? Due to the higher interest rates on subprime, and the assumption that almost all of the low-income folks who took out subprime loans would actually pay, it was 5-10X more profitable to lend money to someone with no job than it was to lend money to a person with a job and a history of paying his/her/zir/their bills. The book doesn’t say so explicitly, but this also explains why banks couldn’t easily abandon their subprime practices in 2005 when the problems were already obvious. If they had done so, they would have needed to fire half of their employees (since the revenue from being a mortgage lender to those who could actually afford houses was such a small fraction of the subprime revenue stream).

Those passionate about social justice will be pleased to learn that the one voice of praise from a shareholder at the April 2008 meeting was from a Ph.D. economist who was also and employee. She expressed confidence in the Board and executive team, thanking them for their focus on diversity in hiring and lending to minorities (“community”). WaMu had recently rejected an $8/share buyout offer from J.P. Morgan Chase and also recently obtained $7 billion in smart money from the private equity geniuses (WSJ, Sept 2008 describes all $7 billion being lost). The private equity investors got half the company and let the Board and executives keep their jobs.

The book is also a cautionary reminder that it can take a while for bad decisions to work their way through the system. The California-style lending practices first reached the rest of the U.S. perhaps in 2003. It wasn’t until four years later that the subprime lenders began to go bankrupt, in mid-2007. And it was more than a year later before the broader U.S. markets and economy collapsed. If you think that U.S. economic policy has been misguided since March 2020 (as I do, because the rewards have been tilted in favor of those who don’t work or who engage in counterproductive activities), it could be a few years before the consequences of this policy become apparent.

Don’t forget that a disaster for ordinary folks, investors, etc. may be only a minor problem for the executives who caused the disaster. Kerry Killinger took so much money out of WaMu on the way up that he could pay off Wife #1 while also building and enjoying a dream lifestyle with Wife #2 that apparently persists to this day. The Latinx subprime borrowers lost everything, but Killinger still had his collection of $6 million houses (worth $20 million each today?). Killinger’s epic risk-taking would have been rational, even with full advance knowledge that it would render the bank’s shares worthless. If he had managed the bank conservatively, nothing dramatic would have happened either to the shares or to his own net worth.

I’ve actually been listening to The Lost Bank: The Story of Washington Mutual – The Biggest Bank Failure in American History via Audible, but don’t love the narrator so perhaps the Kindle or print versions would be better.


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Europeans printing their way to happiness

“As Crises Mount, Europe Turns Once Again to Big Spending” (NYT, today):

Nationalizations. Subsidies. Cash handouts. Price caps. Profit taxes. It’s back to 20th-century economics in Europe.

Governments are resorting to old-school solutions, long dismissed as bad policy, throwing vast amounts of money at the energy crisis engulfing the region, in a bid to avert a political, social and economic meltdown.

In response [to rising energy prices], E.U. governments have already earmarked more than $350 billion to subsidize consumers, industry and utility companies; ministers are to meet on Friday to finalize the bloc’s direct intervention in markets to grab excess profits, cap electricity prices and subsidize utilities companies.

The huge public spending is in addition to a nearly trillion-dollar stimulus package adopted over the past year to deal with the economic fallout from the pandemic, mostly through borrowing. The ballooning debt load would have normally caused an uproar in the bloc, where fiscal conservatism has dominated policy and politics for years.

“This is clearly an exceptional and one-off situation,” said Daniel Gros, a German economist and director of the Centre for European Policy Studies, a Brussels-based think tank, who normally takes fiscally conservative positions. “It’s different from increasing unemployment or social benefits structurally forever, and it’s a special situation that won’t last forever.”

The last paragraph is my favorite. Coronapanic was exceptional, so borrowing/printing and spending $1 trillion (amateurs! the U.S. spent $10 trillion) in 2020/2021 was okay. The rise in energy prices is 2022’s exceptional event, so borrowing/printing and spending another $1 trillion will also be okay. The end of the paragraph is also interesting. The U.S. actually did make “structurally forever” changes to the American welfare state, already the world’s 2nd largest (percent of GDP), the free-forever broadband benefit for those who choose not to work and King Biden’s forgiveness of student loans previously owed to the Crown. According to the Germans, therefore, we are headed for disaster.

Eurocrats seem to think that voters won’t notice the subtle inflation tax caused by these programs and/or future standard tax increases. They’re paying subjects with their own money:

The Belgian government has handed out $100 to every household irrespective of income.

This is a fascinating example of human psychology. Europeans will eventually have to pay for all of the energy that they’re consuming in 2022 and they’ll have to pay the 2022 price. But they’re going to be happier paying starting in 2023 if the government gives them a Three-card Monte game to watch in 2022. And they’ll be happier getting a pay cut via inflation than getting a pay cut in nominal euros.

What’s non-EU-member Norway doing, other than getting insanely rich from the war in Ukraine? The nation’s hydroelectric power is being sold at record prices to the rest of Europe. The oil and gas wells are producing unprecedented gushers of money. Consumers have to pay higher prices for natural gas, but the government steps in and pays, using the record revenues coming in for oil and gas, 90 percent of the amount over a set price. Cruise ships that formerly stopped in St. Petersburg now come to Oslo for two days per sailing, paying enormous port fees and buoying the local tour operators.

“The problem with socialism is that you eventually run out of other people’s money,” said Margaret Thatcher. Norway has amended this to “The beauty of socialism is that you never run out of the dinosaurs’ money”.

Here are some of Oslo’s gleaming new waterfront neighborhoods next to the gleaming new Munch Museum:

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Inflation ideas roundup

Having fizzled out, at least on a month-to-month basis (see Inflation of 0 percent reported as inflation of 8.5 percent), inflation got a big boost today when Joe Biden decreed that some members of the laptop class won’t ever have to pay back up to $20,000 of student loans (the debt will be transferred to Walmart cashiers and other working class chumps) and nobody needs to pay student loans until the end of 2022 (and no interest will accrue). From

“no one with a federally held loan has had to pay a single dollar in loan payments since President Biden took office.” I think that this is the more significant driver of near-term inflation. If no one has had to pay a single dollar in loan payments then no one needs to put down the Xbox controller, leave mom’s basement, and look for a job. An employer will have to keep bidding up wages in order to woo some of the limited number of Americans who’ve decided, perhaps out of habit, to stay in the labor force.

With Americans anxious about inflation, how could it make political sense for a politician to do something that will obviously stoke inflation? Nate Silver explains why this is not an irrational move for a federal government run by Democrats:

Note the “redistribute well-being” from the working class to the laptop class, just as low-skill immigration does according to a Harvard prof and just as the newly expanded $7,500 electric vehicle tax credit does. I’m beginning to wonder how much more the working class can be made to pay to the laptop class. In which year of the Biden administration does the Walmart cashier begin to have to subsidize the laptop class member’s purchase of a new fuel-efficient Cirrus airplane?

Economists are back to their multiple hands… “Nobody Knows How Interest Rates Affect Inflation” (WSJ, 8/24, John H. Cochrane):

Conventional wisdom says that as long as interest rates are below the rate of inflation, inflation will rise. Inflation in July was 8.5%, measured as the one-year change in the consumer price index. The Fed has raised the federal funds rate only from 0.08% in March to 2.33% in August. According to the conventional view, that isn’t nearly enough. Higher rates are needed, now.

This conventional view holds that the economy is inherently unstable. The Fed is like a seal, balancing a ball (inflation) on its nose (interest rates). To keep the ball from falling, the seal must quickly move its nose.

In a newer view, the economy is stable, like a pendulum. Even if the Fed does nothing, so long as there are no more shocks, inflation will eventually peter out. The Fed can reduce inflation by raising interest rates, but interest rates need not exceed inflation to prevent an inflationary spiral. This newer view is reflected in most economic models of recent decades. It accounts for the Fed’s projections and explains the Fed’s sluggish response. Stock and bond markets also foresee inflation fading away without large interest-rate rises.

The learned and credentialed author concludes with no conclusion about who is right. Even our most notable economists aren’t going to get rich via financial market trades, it seems, based on their superior predictive abilities for inflation rates.

Also from the WSJ, but written by a journalist rather than an economist, “Jerome Powell’s Dilemma: What if the Drivers of Inflation Are Here to Stay?”:

In an August 2020 book, “The Great Demographic Reversal,” former British central banker Charles Goodhart and economist Manoj Pradhan argued that the low inflation since the 1990s had less to do with central-bank policies and more with the addition of hundreds of millions of low-wage Asian and Eastern European workers, which held down labor costs and prices of manufactured goods exported to richer countries.

Mr. Goodhart wrote that global labor glut was giving way to an era of worker shortages, and hence higher inflation.

Meanwhile, the U.S. labor force has roughly 2.5 million fewer workers since the pandemic began, compared with what it would have if the prepandemic trend in workforce participation had continued and after accounting for the aging of the population, according to an analysis by Didem Tüzemen, an economist at the Kansas City Fed.

The low-inflation environment of the past 30 years caused consumers and businesses to not think much about price increases. Fed officials now worry that even if prices rise temporarily, consumers and businesses could come to expect higher inflation to persist. That could help fuel higher inflation as workers demand higher pay that employers would pass onto consumers through higher prices.

The expert witness world could serve as an example for the last paragraph. An expert witness engagement usually lasts no more than 3 years and, with inflation expectations low, it was conventional for a contract to call for a fixed rate for the entire engagement. Starting in 2022, however, it became conventional for contracts to allow for annual price increases.

[I should do a separate blog post at some point about how economists don’t seem to account for human nature in forecasting labor force participation. The assumption is that humans don’t get habituated to either working or not working. So an American will jump in and out of the labor force as soon as wages or conditions are adjusted. The American’s value of leisure time will be constant and won’t depend on whether the American has just spent the last two years not working, participating in a bunch of online games, in-person clubs and leagues, etc. Because of this flawed model of humans, economists are surprised on a daily basis that higher wages haven’t lured more Americans back into the labor force. There is nothing in the economics models that says if you play a lot of Xbox for a year you will get better at Xbox and enjoy playing Xbox more and, therefore, require a higher wage to tempt you out of the house.]


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Pretending to work from home is not very productive

One of the enduring mysteries of coronapanic is how the economy stayed so apparently healthy for so long. Unless gathering people together in an office was worthless, people working from home in 2020/2021 should not have been as productive as they had been in 2019. Unless education is worthless from an economic point of view, Americans in lockdown states who missed 1-2 years of education shouldn’t have been as productive as their counterparts in 2019.

“U.S. Productivity Falls for Second Straight Quarter” (Wall Street Journal, today):

U.S. labor productivity declined for the second consecutive quarter as overall economic output contracted and employers spent more on labor as they added workers.

U.S. nonfarm labor productivity—a measure of goods and services produced in the U.S. per hour worked—fell at a seasonally adjusted annual rate of 4.6% in the second quarter from the prior quarter, the Labor Department said Tuesday. Economists surveyed by The Wall Street Journal had estimated a drop of 5%.

On a per-hour basis, in other words, Americans generated less value.

Unit labor costs, a measure of worker compensation and productivity, increased at a 10.8% pace in the second quarter from the prior quarter, Labor said. Economists had expected a 9.5% increase.

“The trend in productivity growth has worsened compared to prior to the pandemic, and the surge in unit labor costs makes the Fed’s challenge of getting inflation back down to its 2% target all the more challenging,” Wells Fargo economist Sarah House said in a research note.

In other words, the cost of getting Americans off their sofas and into a productive situation, from an employer’s point of view, is higher.

The bond market does not expect high inflation over the next 10 years. The breakeven inflation rate on 10-year TIPS versus Treasuries is only 2.5 percent per year:

The only thing that I hate more than intolerance and hate is saying that markets are wrong, but I don’t understand how the bond market can be right in this case. If it costs companies more to produce everything, how do prices go up only 2.5 percent per year?


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Americans still prefer not to work, but that preference varies from state to state

While celebrating the fact that the U.S. economy has added back some jobs to pre-coronapanic levels, not bothering to adjust for the millions of additional folks who now occupy the United States, e.g., via immigration, the New York Times is forced to add the following:

In a substantial asterisk for the report’s broad strength, however, high demand has done little to expand the ranks of available workers by bringing people off the sidelines of the labor market.

And an accompanying chart shows that the trend of Americans sitting at home playing Xbox (back in stock!) is actually accelerating:

Does it make sense to look at these statistics on a nationwide basis? The level of coronapanic varied widely from state to state. The attractiveness of relaxing at home on welfare, compared to the spending power afforded by working full time at the median wage, also varies widely from state to state (CATO; see Table 4).

Let’s have a look at New York, where CATO found (2013) that the welfare lifestyle yielded 110 percent of the spending power of a median worker (St. Louis Fed):

Still down a full percentage point compared to pre-coronapanic. With perhaps some exceptions for young attractive women, Science-following Governor Andrew Cuomo made it illegal for New Yorkers to work and they followed his instructions. What about in Florida, where relaxing on welfare was worth only 41 percent of the spending power of a median worker and where the tyrant Ron DeSantis allowed people to continue working? (source)


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Mighty brains of academia and non-profit figure out why Americans are homeless

There is a new book from some of America’s smartest people. First, the credentials…

GREGG COLBURN is an assistant professor of real estate at the University of Washington’s College of Built Environments. … Gregg holds a PhD and an MSW from the University of Minnesota and an MBA from Northwestern University. … Gregg is also a member of the Bill & Melinda Gates Foundation Family Homelessness Evaluation Committee and co-chair of the University of Washington’s Homelessness Research Initiative.

CLAYTON PAGE ALDERN is a neuroscientist turned journalist and data scientist based in Seattle. … A Rhodes scholar and a Reynolds Journalism Institute fellow, he holds a master’s in neuroscience and a master’s in public policy from the University of Oxford. He is also a research affiliate at the Center for Studies in Demography and Ecology at the University of Washington.

What have these mighty brains learned? From Homelessness is a Housing Problem:

the researchers illustrate how absolute rent levels and rental vacancy rates are associated with regional rates of homelessness.

The higher the rent, the higher the rate of people who can’t afford the rent:

In other words, we aren’t wealthy enough to build and maintain the housing to which we believe ourselves entitled.

Meanwhile, more than 200,000 people come over the southern border every month to claim asylum (US CBP stats) and common decency demands that, regardless of whether any can or do work, all be provided with reasonable quality housing. According to a book that I recently finished, The Swamp, there may be a limit to how many of these newcomers can come to South Florida. From a legal point of view, we can’t keep robbing the federally-protected Everglades of water. Our abuse of the animals who live there has some limits.

From a newspaper that passionately advocates for expanded low-skill immigration… “The Housing Shortage Isn’t Just a Coastal Crisis Anymore” (NYT, July 14):

What once seemed a blue-state coastal problem has increasingly become a national one, with consequences for the quality of life of American families, the health of the national economy and the politics of housing construction.

Freddie Mac has estimated that the nation is short 3.8 million housing units to keep up with household formation.

It is not an expanding population due to immigration that drives up prices in an Econ 101 supply and demand curve intersection, but rather inequality:

Other forces like widening income inequality also worsen housing affordability, said Chris Herbert, managing director of the Harvard Joint Center for Housing Studies. That’s because more higher-income households compete for limited housing (prompting builders to build high-end homes).

Our brightest minds are working on this:

The Biden administration also released a long list of ideas this spring for boosting housing supply.

The word “immigration” does not occur in this article.


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Dumbest question of the year: why are gasoline prices higher than in 2019?

Here’s the dumbest question of the year, I think…. if we believe Econ 101, prices are generally determined by supply and demand.

Gasoline prices in 2019 averaged $2.60 ( Right now it is about $4.50 per gallon (also, though in San Diego last month it was $6.999:

The supply of dinosaur blood doesn’t change all that much from year to year. Demand should actually be lower right now compared to 2022 due to (a) some Americans working from home, cowering in place, etc., and (b) airline staff shortages reducing the number of planes flying. Statista says that worldwide oil demand is slightly lower right now than it was in 2019.

If both supply and demand are roughly the same as in 2019, why is the market-clearing price different?

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Abortionomics: Migrant infants make us richer; native-born infants make us poorer

We are informed by our leaders and our media that immigrants, including infants, make the U.S. wealthier, no matter how low their skill level and no matter how low their parents’ and grandparents’ skill level (see The Son Also Rises: economics history with everyday applications).

We are now informed that native-born infants make us poorer and, for maximum economic growth, should be eliminated from the U.S. population via abortion care. “Fall of Roe will have immediate economic ramifications, experts say” (Axios):

The U.S. will see devastating economic consequences from the Supreme Court’s decision to overturn Roe v. Wade, experts warned on Friday.

Why it matters: The landmark Turnaway Study found that women who have to carry an unwanted pregnancy were four times as likely to struggle with poverty years later. Raising a child costs over $230,000 on average, according to the Department of Agriculture.

What they’re saying: “This decision will cause immediate economic pain in 26 states where abortion bans are most likely and where people already face lower wages, less worker power, and limited access to health care. The fall of Roe will be an additional economic barricade,” Heidi Shierholz, president of the Economic Policy Institute, said in a statement.

The big picture: In an amicus brief submitted to the Supreme Court last year, 154 economists wrote that there is “a substantial body of well developed and credible research that shows that abortion legalization and access in the United States has had — and continues to have — a significant effect on birth rates as well as broad downstream social and economic effects, including on women’s educational attainment and job opportunities.

Replacement theory has been proven wrong by science. But science also tells us that the only way we can prosper is if we provide abortion care to all pregnant people who are U.S. citizens and import infants and children via migration.


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Economist answers my question about high interest rates and high deficits

Two weeks ago: Could our epic deficits drive inflation no matter how high the Fed raises rates?

John H. Cochrane, the superstar economist (and sailplane pilot! How does that work when you’re a professor at University of Chicago and the nearest ridge is 1,000 miles away?), answers the question in the Wall Street Journal… “The Federal Reserve Can’t Cure Inflation by Itself”:

By raising interest rates, the Fed pushes the economy toward recession. It hopes to push just enough to offset the stimulus’s fiscal boost. But monetary brakes and a floored fiscal gas pedal mistreat the economic engine.

The Phillips curve, by which the Fed believes slowing economic activity reduces inflation, is ephemeral. Some recessions and rate hikes even feature higher inflation, especially in countries with fiscal problems.

Higher interest rates will directly make deficits worse by adding to the interest costs on the debt. Reducing inflation was hard enough in 1980, when federal debt was under 25% of gross domestic product. Now it is over 100%. Each percentage point interest rates are higher means $250 billion more in inflation-inducing deficit.

Monetary policy alone can’t cure a sustained inflation. The government will also have to fix the underlying fiscal problem. Short-run deficit reduction, temporary measures or accounting gimmicks won’t work. Neither will a bout of growth-killing high-tax “austerity.” The U.S. has to persuade people that over the long haul of several decades it will return to its tradition of running small primary surpluses that gradually repay debts. That outcome requires economic growth, which raises long-run taxable income. Raising tax rates alone is like climbing a sand dune, as each rise hurts income growth. The U.S. also needs spending reform, especially on entitlements. And it needs to break the cycle that each crisis will be met by a river of printed or borrowed money, bailouts for big financial firms and stimulus checks for voters.

In other words, as long as Congress keeps borrowing and spending, at least according to Professor Cochrane, we can experience inflation even with high interest rates from the wizards behind the curtain at the Fed. Maybe there could be a house price crash due to the high interest rates (how many people can afford a $20,000 per month mortgage on a 4BR?), but that won’t bring down the headline inflation number since house prices were taking out of the government’s official stats. The rent prices that are in the CPI stat shouldn’t come down because mortgage rates are high. In fact, maybe the high mortgage rates will lead to higher rents since renting is an alternative to buying and paying a mortgage.

On the third hand, though our realtor says that the crash hasn’t happened yet here in South Florida, houses are sitting longer on the market. This could be because it is mid-summer and that is the traditional dead season for real estate. Here’s a fairly standard 5BR house on a busy street in Abacoa:

Note the 38 days on the market at the bottom. In January 2022, this place would have sold within two weeks. Zillow estimates the payment for living on this vast 1/4-acre estate and listening to cars zip by all day at $17,576 per month. For that to be one third of a buyer’s income, he/she/ze/they would have to earn $633,000 per year (i.e., be a dermatologist or plastic surgeon).


  • Cochrane’s calculation of the complete tax rate for a successful Californian (he also has a job next to Stanford): How much is the property tax? In Calfornia, we pay 1% per year. That doesn’t seem bad, except that property values are very high. You can’t get a tear-down in Palo Alto for under $2 million. If you buy a house that costs 5 times your income — say someone earning $200,000 per year buying a $1 million house — then that is equivalent to 5 percentage points additional income tax. On top of 42% federal, 13.2% state, 9% sales, and other taxes, it’s part of my view that we’re past 70% top marginal rate now.
  • “How did Paul Krugman get it so Wrong?” (2009): Most of all, Krugman likes fiscal stimulus. … In economics, stimulus spending ran aground on Robert Barro’s Ricardian equivalence theorem. This theorem says that debt-financed spending can’t have any more effect than spending financed by raising taxes. … If you believe the Keynesian argument for stimulus, you should think Bernie Madoff is a hero. He took money from people who were saving it, and gave it to people who most assuredly were going to spend it. Each dollar so transferred, in Krugman’s world, generates an additional dollar and a half of national income. The analogy is even closer. Madoff didn’t just take money from his savers, he essentially borrowed it from them, giving them phony accounts with promises of great profits to come. This looks a lot like government debt. If you believe the Keynesian argument for stimulus, you don’t care how the money is spent. All this puffery about “infrastructure,” monitoring, wise investment, jobs “created” and so on is pointless. Keynes thought the government should pay people to dig ditches and fill them up. [Good news for the PPP program is next] If you believe in Keynesian stimulus, you don’t even care if the government spending money is stolen. Actually, that would be better. Thieves have notoriously high propensities to consume.
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Could our epic deficits drive inflation no matter how high the Fed raises rates?

Americans are obsessively following the Federal Reserve’s interest rate adjustments in hopes of figuring out if the future will be inflation, recession, or some combination (stagflation). “Fed likely to boost interest rates by three-quarters of a point this week” (CNBC) is an example.

What if nobody other than the government borrowed money for any reason and, therefore, the Fed’s interest rate became irrelevant to ordinary subjects. Could we still have inflation? Two economists say “yes” in “The Real Cause Of Inflation Is Insane Deficit Spending” (February 2022):

But proponents of MMT do get one thing correct — the Fed can create money to service the debt and avoid a default. But in real terms, meaning adjusting for inflation, this assertion is false. Creating money to service the debt devalues the currency. Investors then receive a lower real return on their holdings of federal debt.

(see also this 1983 paper from the Minneapolis Fed)

In the old days, inflation came down when the Fed raised rates. Therefore, unless our deficits are larger than in the old days, the interest rate hikes should work to tame inflation (maybe by damaging the economy). “U.S. deficit will shrink to $1T this year before soaring, federal forecasters say” (Politico):

While the nation’s shortfall has substantially declined following last year’s $2.8 trillion deficit, the Congressional Budget Office estimates the gap between spending and revenue will grow starting in 2024, reaching more than 6 percent of GDP a decade from now. The U.S. has only run greater deficits than that six times since 1946, CBO noted.

We’re actually in uncharted territory when it comes to deficit spending.

Another reason that inflation came down when the Fed raised rates is that people weren’t able to pay as much for houses, nearly always bought with borrowed money. But the current headline inflation rate has been cooked so that it doesn’t include the actual prices paid for houses or mortgages (those 1980s headlines were too alarming under the old formula!). The inflation rate won’t move until the fictitious “owners’ equivalent rent” changes.

Some prices that are part of the price index will obviously fall if the Fed causes a recession with high interest rates. Used cars, perhaps. But, given the huge deficits indulged in by Congress, will high rates and a recession be enough to push headline inflation down to the 2 percent level that the Fed claims to be targeting? Consider that if there is a recession, the welfare state will automatically kick in to increase spending on housing subsidies, taxpayer-funded health care (more people eligible for Medicaid), SNAP/EBT, Obamaphone, and free home broadband. Congress also likely won’t be able to resist massive new spending initiatives to combat the recession, just as they spent massively to combat the economic impact of the coronapanic shutdowns ordered by government.

Update, June 28: Economist answers my question about high interest rates and high deficits


  • “President Biden orders 100-percent federal reimbursement for city’s Covid hotels” (January 22, 2021), in which taxpayers in Louisiana and Mississippi were forced to pay for San Francisco’s generosity in providing 2+ years of hotel rooms for the unhoused. If there is a housing “emergency” declared due to an interest rate rise, presumably the same executive order mechanism could be used to increase the federal deficit by spending on hotels.
  • The $12 sandwich here in San Diego is temporarily $14 (up 17%):
  • Below, sign at a South Florida car dealer, June 9, 2022
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