Clive Crook

If you ask me, Jonathan Chait, a writer I respect, has made an ass of himself in a fight he picked with Veronique de Rugy over taxes and progressivity. She offended him by saying that America's income taxes are more progressive than those of other rich countries. Chait assailed her "completely idiotic" reasoning, called her an "inequality denier", "a ubiquitous right-wing misinformation recirculator" and asked if it was really any wonder he cast insults now and then at such "lesser lights of the intellectual world". (Paul Krugman said he sympathises. With Chait, obviously. The only danger here is in being too forgiving, Krugman advises. Chait may think the de Rugys of this world are only lazy and incompetent, but we know them to be liars as well.)

Just one problem. On the topic in question, De Rugy is right and Chait is wrong.

Income taxes in America are more progressive than in other rich countries--according to an authoritiative official study which, to my knowledge, has not been contradicted. The OECD's report "Growing Unequal", on poverty and inequality in industrial countries, includes a table that provides two measures of income tax progressivity in 2005. This is evidently the source of de Rugy's numbers. Here they are in an excel file. According to one measure, America's income taxes were the most progressive of the 24 countries in the sample, except for Ireland. According to the other, they were the most progressive full stop. (A more recent OECD report, "Divided We Stand", uses different data, a smaller sample of countries and a different measure of progressivity: the results are similar.)

Before you ask, this ranking takes account of employee-side payroll tax as well as the federal income tax.

Chait first objected to de Rugy's claim about progressivity because he thought she was inferring it from the fact that the US collects the biggest share of income taxes--45 percent of the total, col B1 in the table--from the top income decile. That would be a false inference, as Chait says, because it could be true of a country with a very unequal income distribution even if its taxes were not especially progressive. But look at the table. There was no need for de Rugy to draw any such inference, let alone try to mislead readers. All she needed to do--and all, I'm sure, she did--was glance over to the last column, which actually gives the measure of progressivity, showing the US to have the highest score.

The measure of progressivity is hard to explain, so I can see why de Rugy quoted the tax share instead. But she could have chosen a much more dramatic number if she was seeking merely to bamboozle her readers. Exclude payroll tax, and the top 1 percent of taxpayers, not the top 10 percent, have lately accounted for nearly 40 percent of income tax receipts, the top 5 percent for nearly 60 percent, and the top decile for roughly 70 percent. (Here are the IRS data, excel file.)

For the reason I just gave, this does not prove that the US tax system is more progressive than anybody else's--but it surely has some relevance to the question, "Are the rich paying their fair share of income tax?" If this isn't fair, what would be?

When Chait, with all the authority of a leading light of the intellectual world, says "Rich Americans pay a bigger share of the tax burden because they earn a bigger share of the income, not because the U.S. tax code is more progressive," he is making the same kind of sloppy bias-driven error he falsely accuses de Rugy of making. (I'll refrain from wondering whether he made the mistake deliberately.) According to the OECD, rich Americans bear a bigger share of the tax burden because they earn a bigger share of the income and because the US income tax system is more progressive.

There's a lot more to say on this subject.

Is measuring progressivity straightforward? No. It's difficult, because the underlying data are very complicated and hard to compare across countries. Another problem: expressing progressivity across the whole income range as a single number, so that one can say A is more or less progressive than B, can be misleading. Unfortunately, we all want to be able to say, A is more or less progressive than B.

Why, according to the OECD, is the US system so progressive? Not because the rich face unusually high average tax rates, but because middle-income US households face unusually low tax rates--an important point which de Rugy mentions and Chait ignores.

How does the picture change if you take indirect taxation into account? That would make the US system look even more progressive, because the US doesn't rely on a flat consumption tax like most other governments.

What does the tax-rate schedule tell you about progressivity? Very little, until you factor in deductions, thresholds and opportunities for avoidance. High top rates are meaningless if nobody is paying them.

What happens to tax progressivity at the very top of the US income distribution--inside the top one percent, or 0.1 or 0.01 percent? Good question. When it comes to international comparisons, I don't know of any good answers. But note that the US isn't the only country to tax capital at preferential rates.

Should the US system be even more progressive than it already is, bearing in mind the skewness of the pre-tax distribution, especially at the very top? Maybe it should--but a steeper tax-band schedule is a dumb way to improve fairness and raise more revenue.

I'll take some of these questions up in a bit more detail later. To be getting on with, here's a column I did that touches on the subject.

For Chait at his excellent best, try this. Meanwhile, I'd say he owes de Rugy an apology.

Institutional or constitutional fixes for broken US fiscal policy are ever on the agenda: Gramm-Rudman-like fiscal rules, PAYGO schemes, balanced-budget amendments, and so on. In Europe "fiscal councils"--appointed, purportedly apolitical bodies to oversee budget policy--have been catching on, and they've had some success. The US has flirted with this idea too. The Bowles-Simpson commission was a kind of fiscal council, though its fast-track legislative powers were never activated. Italy, you could say, now has an unelected fiscal council in place of its entire government.

Dealing with fiscal emergencies is one thing, but should technocrats or balanced-budget rules have a more permanent role? Advocates draw a parallel with central-bank independence. Politicized monetary policy has a pro-inflation bias. Politicized fiscal policy has a pro-deficit bias. In each case, it's argued, we're better off if governments somehow bind themselves to do the right thing.

I start out skeptical. Forget simple balanced-budget rules. They're just bad economics. Sometimes, like now, countercyclical fiscal policy is a vital tool. Complex rules (eg, balance the budget over the course of the cycle) are better because they can allow more flexibility, but they're also easier to subvert.

What about "independent" fiscal councils? I've doubts about the central-banking parallel. As I've previously mentioned, the standard case for central-bank independence needs to be revisited. (Central banks have lately gone way beyond monetary policy as previously understood.) Also, there's a subtle but important difference between the two cases. Although inflation is always tempting, low inflation here and now is often good politics. Central-bank independence makes low inflation easier to deliver, so there's a quick pay-off for the government of the day in surrendering some power. In contrast, balancing the budget here and now is unavoidably painful. If the job can be passed along to the next administration, that's better for the team currently in charge. So you'd expect politicians to be much less likely to surrender fiscal powers than monetary powers.

Nonetheless they keep talking about it and now and then even do it.

In a new column I mention an approach that I think might make a lot of sense: a fiscal council equipped with (1) a narrow remit and, more adventurously, (2) a tax instrument.

Imagine an independent agency whose mandate is fiscal stability. It would be the fiscal equivalent of the central bank. Suppose that agency had one, and only one, sufficiently powerful and flexible instrument: a national sales tax, say. It could cut this tax in recessions to provide short-term stimulus, and at other times would set it at whatever rate it judged necessary to stabilize long-term debt. That would be its dual mandate: short-term stability and long-term fiscal solvency.

This Fiscal Stability Board would not be deciding which districts get bridges or defense installations, when people should retire, what medical treatments should attract public subsidy, or how mildly to tax manufacturers and private-equity partners. Above all, it would not be deciding what share of national income the government should spend. All that would fall to elected politicians.

In the U.S., Congress could carry on doing what it loves best: showering favors on its preferred constituencies. But once the legislature had made its choices, the Fiscal Stability Board would decide whether the fiscal balance looked right, short-term and long-term. Much as a central bank sets an interest rate and gives an expected path of future rates, the FSB would then set the sales tax.

Perhaps the chances of this happening are close to zero. But just suppose. Would it be a good idea?

The point to notice is that this would not be taking the politics out of fiscal policy. In emergencies, doing that (or trying to) might be the lesser evil, but as a permanent regime it stinks. If democracy isn't about taxes and government spending, what is it about? Elected politicians should set national priorities, write the budget and decide who pays. But I'm claiming that control of deficits and management of public debt--the macro rather than micro aspects of fiscal policy, where politics encounters the constraints of arithmetic and solvency--fall into a different category. Sure, polarized politics can annex almost any issue and recast it in left v. right terms, but disagreements over the pace of fiscal adjustment ought to be technical more than ideological.

I look at it this way. With its remit confined to deficits and debt, a fiscal council with a blunt tax power would ask us to yield only a little democratic control in exchange for a really big improvement in fiscal stability.

Worth thinking about.

Advocates like myself of renewed fiscal stimulus for the US, Germany and some other EU countries have to answer a lot of weak arguments. One that especially riles Paul Krugman's cult-followers is the idea that balancing a nation's budget is exactly like balancing a household's budget. Well, they're right about that: it isn't, for the reasons Krugman tirelessly points out.

One qualification: when a nation's budget deficit does have to be curbed, the prudent household story is not a bad political tool to use. Margaret Thatcher deployed it to good effect when it mattered. Meryl Streep has a little speech on the subject in The Iron Lady. My inner pragmatist says politicians shouldn't be too squeamish about using bad economics in a good economic cause.

Still and all, it's annoying. Simon Wren-Lewis points to two more species of annoying anti-stimulus arguments. (1) Arguments that ignore the zero lower bound for interest rates, and (2) arguments that say fiscal stimulus is Econ 101, and the profession has moved on. I've nothing to add to Wren-Lewis's critque of that pair. When you're right, you're right.

But I noticed that one of Wren-Lewis's commenters said we should also acknowledge, for the sake of balance, a few annoying pro-stimulus arguments. (1) Arguments that invoke the ZLB but ignore inflation. (2) Arguments that ignore the possibility that temporary fiscal stimulus might lead to a permanent increase in government spending. "There's nothing so permanent as a temporary government program"--Milton Friedman. (3) Pro-stimulus arguments that ignore the possibility of tax cuts.

I don't quite follow (1). If the risk of inflation argues against further stimulus (monetary or fiscal) then you shouldn't be at the ZLB in the first place. But I think (2) and (3), folded together as they probably should be, are indeed annoying: Arguments that regard the size of government as a non-issue. Maybe, as another of Wren-Lewis's commenters says, this is a political judgement more than an economic one, but let's not disdain political economy. Advocates of strong stimulus in the US undermined their case in 2009 by arguing so strongly in favor of spending increases over tax cuts.

I'd like to nominate three more annoying pro-stimulus arguments. (4) Arguments failing to acknowledge that some level of debt is too much. What's the limit to further fiscal expansion? (5) Arguments that assume the bond market won't abruptly change its mind about the US cost of borrowing. I find it very annoying when liberals, of all people, tell me that the bond market is a wise forecaster. (6) Arguments that dismiss the tax consequences of ever-mounting debt. Yes, we will owe it mainly to ourselves, but eventually somebody's taxes will still have to rise to service the payments.

On a rough count, I'm thinking, the pro-stimulus camp's annoying arguments may outnumber the other side's. Could that be where we've gone wrong? We're still right, but we haven't made the best possible case.

The most important question in fiscal policy is also the most difficult: how, as a practical matter, to combine short-term accommodation with a credible commitment to medium-term restraint. In the US, this is something nobody much likes to discuss. Liberals don't want to talk about medium-term restraint (except for raising taxes on the 1%) and conservatives don't want to talk about short-term accommodation (they want tax cuts, but they always want tax cuts). I'm not a member of the austerity-now school but they have a point when they say--as Britain's Tories did when announcing their severe budget cuts--that the only way to make a promise of future restraint credible is to start at once. If that's wrong, as I hope it is, what's the alternative?

One possibility I've mentioned before is greater reliance on automatic stabilizers. Martin Wolf, discussing British fiscal policy, has another suggestion, though he rather buries it toward the end of the piece:

The starting point must be to stick to the announced cuts in current spending. If that is brought down to sustainable levels, even relative to a pessimistic view of potential output, credibility should be ensured. But temporary tax cuts could promote spending: national insurance charges and value added taxes are obvious candidates... When the government can borrow at real interest rates of below zero, good, time-limited investment projects must make sense. [My emphasis.]

Britain's position is different from America's of course. Their spending cuts have already been announced, which alters the political calculation: the US isn't starting from the same place. Nonetheless, how about it? Cut ongoing programs immediately by enough to fix the long-term problem, then provide the necessary fiscal accommodation through temporary tax cuts (payroll tax) and new infrastructure projects (time-limited by nature).

Wolf says it probably won't happen in the UK. It probably won't happen in the US either. The question is, should it? Wolf has a wide following among US liberals because he has argued so effectively against over-zealous fiscal tightening. Paul Krugman loves to quote him. I'd be interested to know what they make of "the starting point must be to stick to the announced cuts in spending".

Spain, unemployment rate 22.9 percent, shows why structural reform really is needed in Europe. What does "structural reform" mean? Mostly, labor-market reform--which is another euphemism. Let's be plain: Spain and some other EU countries need to confront their unions. I've a new column for Bloomberg View on the subject.

To say the problem is merely the power of organized labor is too simple-minded. Germany has strong unions yet has been successful -- too successful from Europe's point of view -- in controlling wage costs and maintaining high employment. The problem is not powerful unions in their own right, but powerful unions combined with maladapted wage-setting arrangements that, once established, unions are determined to defend.

That's why it's not only simple-minded but also plain wrong to deny that Europe's unions are part of the problem. Unions arguably act in the longer-term interests of their members. What Spain shows is that, depending on the rules, these gains may come not mainly from the owners of capital but from fellow workers, or ex-workers to be more precise.

In other words, there's a social justice component to structural reform -- but not the soak-the-rich, save-the-worker one emphasized by the European left. It would be good to understand that before taking sides.

The column mentions an article by Samuel Bentolila et al. There's a short version on Vox, The Spanish labour market: A very costly insider-outsider divide, and a fuller study, CEPR Discussion Paper 8691, posted on the CEPR website (gated). If you don't read the column--how dare you even think that?--do read the Vox article.

I believe I've mentioned--I hope I've mentioned--how much I liked Jonathan Haidt's The Happiness Hypothesis: Finding Modern Truth in Ancient Wisdom. I don't always agree with him but I think his work is fascinating. Haidt's a social psychologist, liberal by inclination but sufficiently respectful of conservatives to offend his colleagues and the left more generally. (One of his findings is that his colleagues are a subset of the left.) Odd that such an outlook should appeal to me, but there you are.

Anyway, I'm very much looking forward to his new book, The Righteous Mind: Why Good People Are Divided by Politics and Religion, and in in the meantime there's a profile to read in the Chronicle of Higher Ed, which I recommend: Jonathan Haidt Decodes the Tribal Psychology of Politics. (HT A&L.) This piece allayed any doubts I might have had about his working method.

His previous book, The Happiness Hypothesis, trekked through centuries of philosophy and science in a quest for the secret to well-being. (Bottom line: relationships. Also helpful for Haidt: naps. He snoozes each afternoon on a futon in his office.)

I'm a great believer in naps, myself.

How much of moral thinking is innate? Haidt sees morality as a "social construction" that varies by time and place. We all live in a "web of shared meanings and values" that become our moral matrix, he writes, and these matrices form what Haidt, quoting the science-fiction writer William Gibson, likens to "a consensual hallucination." But all humans graft their moralities on psychological systems that evolved to serve various needs, like caring for families and punishing cheaters. Building on ideas from the anthropologist Richard Shweder, Haidt and his colleagues synthesize anthropology, evolutionary theory, and psychology to propose six innate moral foundations: care/harm, fairness/cheating, liberty/oppression, loyalty/betrayal, authority/subversion, and sanctity/degradation.

...[T]he six moral foundations are central to how Haidt explains politics. The moral mind, to him, resembles an audio equalizer with a series of slider switches that represent different parts of the moral spectrum. All political movements base appeals on different settings of the foundations--and the culture wars arise from what they choose to emphasize. Liberals jack up care, followed by fairness and liberty. They rarely value loyalty and authority. Conservatives dial up all six.

If you read the profile be sure to read the sidebar--A Political Defector--as well. One of Haidt's critics, fellow psychologist John Jost, mentions the damage Haidt is doing to their field--and draws an interesting parallel.

Another [criticism] is that [Haidt's] argument might arm those who are "eager to dismiss our findings," as John T. Jost, a psychologist at New York University, expresses it. "We've seen this with climate-change issues," he tells The Chronicle. "If you can just accuse the scientist of ideological bias, then you can ignore the research findings."

Jost adds that the personal beliefs of social scientists are "scientifically irrelevant" because of safeguards against bias that are built into the research system. "Any research program that is driven more by ideological ax-grinding than valid insight is doomed to obscurity," he wrote in response to Haidt's talk, "because it will not stand up to empirical replication and its flaws will be obvious to scientific peers--all of whom have been exposed to conservative perspectives even if they do not hold them."

One young psychology professor feels that Haidt painted an accurate portrait. It's a measure of the sensitivity of this topic that the professor, a conservative who contacted Haidt to express her gratitude for the talk, declined to let The Chronicle publish her name.

Ponder that. And Jost took the words out of my mouth. "We've seen this with climate change". Haven't we though. Deny the charge of groupthink until we're blue in the face, because to see a particle of merit in the accusation will call our important findings into question. Clear? The charge of groupthink is outrageous...and let's not hear a whisper of dissent about it.

As for "Any research program that is driven more by ideological ax-grinding than valid insight is doomed to obscurity", I'd say yes, maybe, eventually--but in the social sciences it might take a while. Social psychology can look out for itself. I'd say Haidt's a good thing.

A new CBO study of federal workers' pay finds that:

Overall, the federal government paid 16 percent more in total compensation than it would have if average compensation had been comparable with that in the private sector, after accounting for certain observable characteristics of workers.

Civil servants with professional degrees do worse than their private-sector counterparts, the others do better. Overall, the federal workers come out ahead.

Megan McArdle asks, Federal worker pay: how much is too much? She says:

The right question is not "Would these people make less in the private sector?" It is "Are we getting a high enough quality workforce?" And also "Could we get the workforce we need for less?" At any rate, that's the right question if you view government programs as a means to provide services.

True, but "Would these people make less in the private sector?" seems a good place to start in answering "Could we get the workforce we need for less?" There are exceptions (financial regulators) but you don't much hear it argued that the qualifications and experience of federal workers need to be significantly upgraded. And we know we could retain the federal workforce we already have at lower rates of pay and benefits, because that's what the study shows. If federal workers are overqualified for the work they have to do, the savings would be greater.

The federal government has an obligation in this. It isn't supposed to pay its workers what it thinks they deserve. It's supposed to pay them wages and benefits like those of similarly qualified private-sector workers. The CBO study says it is failing to do that. So it looks as though something is wrong with the system for setting pay and benefits in the federal government.

If we're suggesting better questions, here's mine: How does that system actually work?

I wouldn't go so far as to say Romney looked relaxed and confident in last night's GOP debate--he never looks relaxed and confident--but it was a much more effective performance than his others of late. This time it was Gingrich's turn to be feeble. Romney slapped him down very effectively on investments in Fannie and Freddie. (a) What is it about "blind trust" you don't understand? (b) Aside from being on their payroll, don't you have mutual-fund investments in Fannie and Freddie too? Despite having raised the subject, Gingrich didn't appear to know. He just stood there.

Grandiosity may be going out of style too. Moon Unit Gingrich didn't appear to get off the ground. And Romney's complaint that Gingrich offers each state he visits some huge new publicly financed project hit home.

Romney was good rebutting the "anti-immigrant" charge. He called it repulsive and almost looked as though he meant it. Of course, he still needs a good immigration policy, but who doesn't? Also, for the first time he began to look nearly unapologetic as he insisted he would make no apology for being successful. This posture needs more work. He could use a better tax reform plan as well. If he gets the nomination this will obviously be Obama's principal line of attack. "How dare you be so rich?" might bounce off. "How come you pay so little in tax?" is more problematic. Still, he's moving in the right direction.

Ron Brownstein at National Journal makes some characteristically shrewd observations, including this one:

All of the Republican contenders may be fortunate that former Florida Gov. Jeb Bush decided not to seek the nomination this year. After Fred Malek, the big Republican fund-raiser and one of the group's founders, introduced Bush at the HLN event by asking the audience whether his resume made him sound "like somebody who would maybe make a good president," Bush delivered a personable, engaging and even intimate speech about opportunity and inclusion that held the audience rapt. And that was after holding a press availability in which he toggled between English and fluent Spanish for the press corps. The public may need some time before it accepts another Bush, but his short appearance left no doubt that he remains a major political talent. If Florida Sen. Marco Rubio is serious about his insistence that he doesn't want to run as vice president, Bush could be an attractive alternative with potentially substantial appeal not only in Florida, but in the Hispanic community elsewhere.

The Peterson Institute recently staged a debate about the European debt crisis between Simon Johnson and Peter Boone in the pessimistic corner and Fred Bergsten and Jacob Funk Kirkegaard for the optimists. You can watch video here.

In a column for Bloomberg I offer my two cents. I think Boone and Johnson are too gloomy about the short to medium term: I doubt that the euro system is going to collapse this time, despite the amazing dithering of the EU's leadership. It's more likely they'll muddle through, because all parties have so much to lose if they fail. But I don't agree with Bergsten and Kirkegaard that the EU will emerge from all this not just intact but stronger than before. I argue that this crisis will weaken not strengthen the EU's institutions. They are sowing the seeds of the next, and bigger, disaster.

Bill Galston measures the State of the Union against the criteria he suggested yesterday. Interesting observations, but I would have liked to know whether he thought the speech was any good.

Myself, I wasn't much impressed. The speech was far too long (as SoU addresses nearly always are) and well before the end I wondered if anybody who wasn't being paid to listen was still attending. It's a small point but I also find that Obama's thing of letting his voice break for emphasis on key words has become very annoying. It's now a tic. He does it too much and it no longer signals sincerity--rather the opposite.

The theme was "an economy built to last". Bad metaphor. Successful economies aren't castles or cathedrals. They aren't "built to last". They are perpetual works in progress, in a constant state of being unbuilt and rebuilt. And they don't have one master builder.

The lofty rhetoric seemed disconnected from the endless small and mostly humdrum proposals (many of which, I grant you, have a lot to be said for them). There were some bigger ideas too, but they were always left vague. The Buffett rule for instance. All those earning $1 million or more should pay at least 30 percent of their income in taxes, the president said--a good idea, and a deft jab at Mitt Romney, for good measure. But what does "income" mean? You could make the Buffetts and Romneys of this world pay 30 percent of their income from employment and they wouldn't even notice. The same goes for raising the top marginal rate of income tax to, say, 99 percent. On the other hand, tax capital gains and dividends at ordinary income tax rates--as I would favor--and Buffett might wish he had never opened his mouth. Is that what Obama is proposing? Or does he have a second alternative minimum tax in mind--an alternative to the alternative to the main code? For the sake of simplicity.

At the same time, he reaffirmed his commitment to no tax increases on households making less than $250,000 a year. You can't balance the budget that way.

The main thing that made me wince was the emphasis on outsourcing as the greatest threat to American prosperity. In my book, it's a bad idea to criticize firms that strive to drive down costs. Well, you might say, greater efficiency might not be all bad, but we certainly shouldn't subsidize firms to move jobs abroad--and that was Obama's point. Again, what would this denial of subsidy actually mean?

Perhaps it means denying government contracts to firms that outsource, as many Democrats advocate. Perhaps it means taxing outsourcers more heavily. Two points on this. First, using taxpayers' money to buy from higher-cost rather than lower-cost producers would seem to create a subsidy rather than end one. Second, do we really want to victimize Apple that way? No more Macbooks in schools or publicly supported colleges? No more iPhones in the White House? If that would be going too far, maybe just tax the company until it moves to Canada? It seems a high price to pay, even for an economy built to last.

As usual, Bill Galston has some good advice for the president. Including this:

The plight of hard-working, hard-pressed Americans--those struggling to remain in the middle class and those struggling to get there--must be front and center. And the president must address it in the right way. A December 16 Gallup survey found that while 82 percent of Americans believe that it's extremely or very important to expand the economy and 70 percent believe that it's extremely or very important to increase equality of opportunity for people to get ahead, only 46 percent believe that about reducing the gap between the rich and the poor. While 72 percent of Democrats want government to emphasize measures to reduce inequality, only 43 percent of independents agree. And 52 percent of Americans say that "the fact that some people in the United States are rich and others are poor" is acceptable, actually up from 45 percent in 1998. A Pew survey released on December 16 found 58 percent of Americans rejecting the view that America is divided into "haves" and "have-nots." Another Pew survey released January 23rd found 86 percent of Americans giving "top priority" to strengthening the nation's economy and 82 percent to improving the job situation, versus 52 percent for dealing with the problems of the poor and needy. A majority of Americans will support requiring the wealthy to pay their fair share (that is, higher taxes)--but not in the name of reducing inequality. Obama's speech must address middle class anxieties, but without triggering long-standing middle class fears about redistributive measures that could deepen their plight.

Romney's tax returns are a tempting target--not least because Romney himself is evidently so embarrassed by them. (I mean, who would have guessed that all this was going to come up?) Nonetheless, for Obama it's a trap, and for the reasons Galston says.

As I've mentioned before, Douglas Elliott at Brookings is among the most astutue analysts of the financial breakdown and the regulatory response to it. This recent testimony to Congress on the effects of the Volcker rule is the best commentary on the subject I've read.

As I will explain, I believe that the Volcker Rule is fundamentally flawed and will do considerably more harm than good for the economy. I base this on two decades on Wall Street as well as on the years I have spent examining federal policy towards financial institutions at Brookings and earlier at another think tank. Despite being a former banker, my views on the Volcker Rule do not stem from opposition to the Dodd-Frank reforms. Indeed, I am on record as a strong supporter of the overall approach of that legislation, although there are certainly things I would have preferred to see done differently.

My core problem with the Volcker Rule is that it seems to me to be trying to eliminate excessive investment risk at our core financial institutions without measuring either the level of investment risk or the capacity of the institutions to handle the risk, which would tell us whether the risk was excessive. Instead, the rule focuses on the intent of the investment rather than its risk characteristics.

This approach, says Elliott is wrong. What matters is not the bank's intent (insofar as you can measure it), but the level of risk relative to the bank's risk-bearing capacity. What is a "proprietary" investment, anyway? What is "integral" to modern banking and what isn't? Not easy to say.

Moreover...

by focusing on intent, we are almost certain to miss large swathes of investments that are taken on with an acceptable intent, but still represent excessive risk... As a public policy matter, we want banks, even small ones, to hold substantial portfolios of safe and highly liquid securities so that they can meet sudden demands for cash without having to make a fire sale of their loans or other assets... A large portion of the investment losses at commercial banks in the crisis were on their holdings of securities purchased for liquidity purposes. They bought mortgage-backed and asset-backed securities that were rated "AAA" and which were quite liquid until the financial crisis struck and rendered them illiquid. Thus, the intent would have been considered acceptable, but it did not prevent bankers from weakening their institutions by losing large sums of money.

These are good points and the whole (short) note is well worth reading.

Last night's Republican debate will most likely be remembered for Gingrich's assault on CNN's moderator, who kicked off by asking Gingrich to comment on his ex-wife's claim that he'd asked for an open marriage. Gingrich flattened him: that line of questioning was "as close to despicable as anything [he] could imagine". (He's apparently lacking in imagination.) The audience loved it. Down with the lamestream media.

But my own main thought during the debate was to wonder, not for the first time, why Romney even wants to be president. You couldn't call him a natural politician. The others up there all seemed to belong. There's nowhere else they'd rather be. Give them an audience and they'll set the world to rights. But this supposedly new, improved, campaign-polished Romney is still so unconfident, uncomfortable, stammering and inarticulate, you actually feel embarrassed for the guy. He tries to make a virtue of the fact that he isn't a professional politician--despite his pathological longing to succeed in that line of work--and promptly screws that up too. Did I hear him say he's "from the streets"? From the streets?

Remember Bulworth? Coming up next from the Romney campaign, an impromptu rap on tax shelters. The man's got rhythm, no doubt. I hesitate to mention it in case he thinks it's worth a try.

Things we thought we knew about central banking are no longer so clear.

[T]he past three years have shown that central banking can't be above politics -- not, at any rate, for the reasons previously given. Whether aiming for stable prices makes sense is actually a complicated question. And the line that separates supposedly technical issues of monetary policy from the unavoidably political issues of taxes and public spending turns out be fuzzy.

Why is the case for low inflation in doubt? Because the most powerful remedy for recession is lower interest rates. The deeper the recession, the more aggressive the cut in interest rates needs to be. A "stable prices" mandate for the central bank means that interest rates will be low to begin with, and however deeply the central bank might wish to cut them, it cannot cut them to less than zero.

In typical recessions this problem of the "zero lower bound" doesn't arise, because a moderate cut in interest rates is all that's needed. But the recession that started in 2008 was ferocious. The Fed cut interest rates to nothing, and it wasn't nearly enough. On some estimates, it should have cut rates by five or six more percentage points -- but a nominal interest rate of minus 5 percent isn't possible.

Not unless you abolish physical money--which is what prevents negative nominal interest rates. It's a seemingly outlandish idea which needs to be taken more seriously. (See this paper on the zero lower bound by Willem Buiter.) And if not that, then what? I discuss the options in Great Recession Demands New Rules for Central Banks.

Morris Goldstein of the Peterson Institute for International Economics explains five main defects in the EU's efforts to resolve its banking crisis: Stop Coddling Europe's Banks.

• Incentives for deleveraging;
• Absence of firm guidelines on dividends and executive compensation;
• Omissions of a recession scenario and of an unweighted leverage ratio from the stress tests;
• Inequitable burden-sharing during debt restructuring; and
• Insufficient measures to permit an escape from the adverse feedback loop between sovereign debt and bank debt.

He endorses an approach suggested by Markus Brunnermeier et al. Create a European Debt Agency to repackage euro-zone sovereign debt into senior and junior classes. See their Vox column: ESBies: A realistic reform of Europe's financial architecture. (The full paper is here; this Q&A is good too.)

Our proposal...has all the advantages of euro bonds (financial stabilisation of the Eurozone), without its drawbacks (political constraints). ESBies are politically feasible because they involve no joint liability of member states. They imply no change in European treaties. Yet they will generate a very large pool of homogenous, safe assets that can serve as investment vehicles for global investors and reliable collateral for European banks.

I'd call them ESBs rather than ESBies. Whatever you call them, Goldstein's right that the idea deserves closer attention.

Some thoughts on the charge that Obama wants to turn the US into an entitlement society.

Mitt Romney likes to contrast the U.S. economic system with Europe's welfare state. You can have a merit society, he says, or an entitlement society, but not both -- and an entitlement society is where the U.S. is heading if Barack Obama and the Democrats get their way.

It's a favorite Republican theme, and you can see why. For one thing, there's some truth to it. Contrasting the American model of capitalism with the European alternative isn't absurd. The gap is narrower than it used to be, but they're still different.

Also, Obama and the Democrats do want to move the U.S. in a European direction. Best of all, from the Republican point of view, they are generally embarrassed to admit it. American voters still see their country as a model for the rest of the world, not the other way round. Nobody will ever be elected president of the U.S. on a pledge to make the country more like France.

Democrats therefore find themselves having to deny the obvious. Obama wants to make the country more like Europe? Ridiculous. A straw man.

But it isn't ridiculous. What's ridiculous is the idea that Republicans take for granted and squirming Democrats tacitly endorse -- that making the U.S. more like Europe would be a disaster.

Read on: If Europe Can Learn From U.S., Why Not Vice Versa?

Lawrence Lindsey makes the case for Anybody But Romney by pointing out that "safe" candidates--"low-beta" candidates, he calls them--have a poor record in presidential elections. It's a cute idea. If you're behind, take a chance. Lindsey reckons Obama has the edge, other things equal, in November (the net effect of incumbency, which helps him, and the bad economy, which doesn't). So the GOP should gamble on a high-beta candidate who will shake things up.

With subpar growth, but no recession, President Obama might normally be expected to win narrowly, say by 1 percentage point.

If that model is right and the Republicans ran a "zero-beta" candidate, one with absolutely no variability around the "normal" result, he would perform quite respectably but lose. To be precise, he would lose by one point, 50.5 to 49.5. A very low-beta candidate, say one with a variability equivalent to half a point, would have an equal chance of producing a "tie" or losing 51-49. A high-beta candidate, with 10 times the variability of that very low-beta candidate, would have an equal chance of winning 54.5-45.5 or losing big, by 55-45. But if a party really wants to win--and doesn't care about how badly it might lose--it should pick a high-beta candidate.

Lindsey reviews the history and finds that safe candidates do badly against incumbents: zero-for-five in the post-war period, he reckons. High-beta candidates (Goldwater, McGovern) may get thrashed. But sometimes (Reagan, Carter, Clinton) they win. If your party's trailing, you're better off taking the risk.

This is not to say that it can't be different this time--Romney, the obvious low-beta candidate, could win. As they say in markets, "past performance is no guarantee of future results." But it is certainly not the case that, based on history, he is obviously the most "electable." Statistically, he may be the least electable.

Interesting: the capital-asset pricing model applied to politics. Bearing in mind how hard it is to write anything new in election commentary, I ought to just say I enjoyed the article and leave it at that--but here's why it's nonsense. In finance, you are interested in alpha (underlying return, after allowing for risk) as well as beta (risk). You might say the same of politics, with the difference that in politics the underlying quality of your investment is easier to judge. Lindsey doesn't even mention alpha.

In politics, beta isn't the important parameter. Mitt Romney is not just low-beta, he's also low-alpha. His problem isn't that he's safe, it's that he's weak. As for his rivals, yes, they might have higher beta than Romney--maybe--but one can say something else with more confidence: Gingrich, Santorum, Perry, and Paul have less general-election alpha than Romney. (Huntsman could be an exception, a point worth considering if he does well today.)

Lindsey's notion of political risk is not really beta in the CAPM sense anyway. If it were, he would have to believe that Goldwater's chances (or McGovern's) of overperforming relative to a generic candidate were about the same going in as his chances of underperforming. If he thought that, he might believe that Sarah Palin against Obama in November would have as much chance of shaking things up--in a good way, I mean, for the GOP--as of being a disaster. Statistically, I'd say the odds were against it.

I suppose it's true that if you're likely to lose anyway you might as well take a flier: you've nothing to lose. You don't need the CAPM to reach that conclusion. But the GOP is hardly in this position. It isn't about beta. What Republicans need is a good candidate.

Another column for your consideration:

With the world's rich economies struggling and the leaders of the European Union intent on making things worse, the gravity of the economic crisis still confronting the West is hard to exaggerate. Nonetheless, it can be done.

According to what I read, we face not just the worst recession since the 1930s, but a challenge to the West's entire economic order. The Great Recession exposes the poverty of orthodox economics. It constitutes an ideological crisis. It shows that capitalism itself is "fundamentally" flawed. If all this were true, I'd be a lot more worried about the coming year than I am -- which is saying something.

A new year's corrective is in order. Reports of the death of capitalism are greatly exaggerated.

Read on: A Crisis of Leadership, Not a Crisis of Capitalism.  

I was glad to see Jason DeParle's piece in the NYT about America's disappointing record on economic mobility. One thing I learned: some conservatives have actually mentioned the issue.

Former Senator Rick Santorum of Pennsylvania, a Republican candidate for president, warned this fall that movement "up into the middle income is actually greater, the mobility in Europe, than it is in America." National Review, a conservative thought leader, wrote that "most Western European and English-speaking nations have higher rates of mobility." Even Representative Paul D. Ryan, a Wisconsin Republican who argues that overall mobility remains high, recently wrote that "mobility from the very bottom up" is "where the United States lags behind."

Interesting that not all conservatives are content with platitudes about the land of opportunity. However, most do seem to be. To put it mildly, the right doesn't give the question the emphasis it deserves. Then again, nor does the left. As I noted previously, US liberals let their preoccupation with inequality distract them. They find high incomes more upsetting than poverty.

Obama, to his credit, talked about mobility in his Osawatomie speech--but folded these points into a main narrative about "gaping inequality", thus (I argued) burying the more important question. Cast the central challenge of American governance as the 1 percent against the 99 percent, and the more pressing problem--the bottom 20 percent--becomes a footnote.

So I disagree with DeParle about one thing: mass unemployment hasn't moved the issue of mobility toward center stage. Not yet anyway. It should have, but it hasn't. Still, every article helps.

You might be interested in a piece I wrote for the Atlantic on the subject in 2007: Rags to Rags, Riches to Riches. Here's an extract.

The American model has been regarded as proposing a kind of bargain. This is not Europe: Here, idleness and incompetence are sternly punished--but merit gets rewarded. Much more than elsewhere, your class background will neither prop you up nor hold you back. If you deserve to succeed, you will.

It is an inspiring, energizing offer--and still a profoundly influential one. It colors the national debate about taxes, health care, and other aspects of economic policy. But it is false advertising.

Most researchers now give America much lower marks than they used to for intergenerational economic mobility--the ease with which successive generations move up or down relative to their parents. As flaws in early postwar studies have been addressed, estimates of mobility have fallen. Before the 1990s, researchers tended to put the correlation between parents' incomes and their children's at around 20 percent, implying a high degree of mobility between generations. (Zero would imply no connection at all; a correlation of 100 percent would imply that parents' incomes entirely determined the incomes of their children.) In the 1990s, using better data and techniques, experts tended to put that figure at about 40 percent. Recent estimates run as high as 60 percent. The finding is not that mobility has fallen since World War II--the studies point to no clear trend. It is that as methods of measuring mobility have improved, the result, across a span of recent decades, has gotten worse. The earlier view that postwar America was an economically mobile society is less and less borne out. Perhaps it was once (before data became available to track such things accurately); but it isn't now.

More telling, maybe, is the international comparison. America stands lower in the ranking of income mobility than most of the countries whose data allow the comparison, scoring worse than Canada, all of the Scandinavian countries, and possibly even Germany and Britain (the data are imperfect, and different studies give slightly different results).

Strikingly, the research suggests that mobility within America's middle-income bands is similar to that in many other countries. The stickiness is at the top and the bottom. According to one much-cited study, for instance, more than 40 percent of American boys born into the poorest fifth of the population stay there; the figure for Britain is 30 percent, for Denmark just 25 percent. In America, more than in other advanced economies, poor children stay poor. Other data show that in America, more than in, say, Britain, rich children stay rich as well.

Ron Fournier of National Journal says something that hadn't occurred to me about Iowa and what comes next.

If Romney wins New Hampshire, he would be the first non-incumbent Republican to sweep Iowa and the Granite State since the modern caucuses were formed. There is a reason why that's never been done: Republican coalitions in Iowa and New Hampshire are mirror images of one another and, taken together, reflect the broad GOP electorate. In other words, a candidate who can win older, more conservative GOP voters in Iowa as well as white-collar, independent-minded Republicans in New Hampshire should be able to win everywhere.

Stop Romney in South Carolina? Well, he has essentially already won over a GOP coalition that resembles South Carolina's diverse electorate: Iowa plus New Hampshire equals South Carolina.

Of course, if conservatives had put a single candidate up against Romney, he wouldn't have won Iowa. But he did win, and in a state he fought for much less diligently than Santorum.

Sean Trende at RCP neatly sums things up. One, it was a good night for Romney. Two, the win does not make his nomination inevitable. Three, not this time maybe but one day, Rick Santorum's style of politics could capture the GOP.

Twice in a row now, the party has toyed with nominating a candidate who combined social conservatism with economic populism; Santorum's speech last night was essentially a northern version of a speech Mike Huckabee could have delivered in 2008.

We've already seen white working-class voters move toward the Republican Party over the past several decades -- a shift perhaps epitomized by the GOP's special election victory in New York's 9th Congressional District. If a more credible Santorum/Huckabee candidate could emerge, the party would reciprocate by moving toward these voters. This would have major implications for our political dynamic, and could deal the Democrats a serious blow in states like Pennsylvania and Ohio.

On the other hand, the Democrats have been moving toward a top-bottom coalition of "New Economy" professionals and minority voters. A Santorum/Huckabee-esque Republican Party would probably hasten the exit of upscale suburbanites from the Republican coalition, and potentially reinvigorate the New Democrat approach to governing that dominated the party's politics in the '90s.

Interesting. By the way, Trende has a new book out: The Lost Majority. Judging from this extract, it looks good. I'll be reading it.