Separating Hyperplanes

Commentators often argue that replacing cash with "Fedcoin"—a Fed-administered cryptocurrency like bitcoin—would end fractional reserve banking. JP Koning, who wrote the cannonical piece about the idea of Fedcoin, writes

Fedcoin has the potential to tear down the private banking system...As the public shifted out of private bank deposits and into Fedcoin, banks would have to sell off their loan portfolios, the entire banking industry shrinking into irrelevance. One way to prevent this from happening would be for the Fed to make an explicit announcement that any bank could be free to create its own competing copy of Fedcoin, say WellsFargoCoin.

Koning argues that fractional reserve banking is doomed unless commercial banks are able to launch separate side-chains that build off of the official blockchain maintained by the Fed. The idea that Fedcoin would wipe out fractional reserve banking also underlies much of John Cochrane's post where he quotes Raskin and Yermack (2014) who also take this as a given:

Depositors would no longer have to rely on commercial banks to hold their checking accounts, and the government could get out of the risky deposit-insurance business. Commercial banks that wished to keep making loans would raise long-term capital in the debt and equity markets, ending the mismatch between demand deposits and long-term loans that can cause liquidity problems.

This aspect probably appeals to Cochrane because he wants to abolish fractional reserve banking as a matter of policy, to end the possibility of bank run equilibria.

But Koning, Raskin, Yermack, and Cochrane have overthought this. Taking a step back, it's clear that blockchains pose no threat to fractional reserve banking (for better or worse).

Here's the problem I think Koning had in mind when he proposed side-chains: Suppose you own some Fedcoin and you want to deposit them into a bank. One way you could "deposit" Fedcoin is by sharing your private keys for your Fedcoin addresses with the bank. This way, the bank would be able to use your keys to send some of your Fedcoin to borrowers, while you would also be able to use your private keys to use some of your Fedcoin to buy stuff. But there's an obvious problem: you can't spend Fedcoin from the same addresses the bank is lending out to others, because only one of those two transactions will clear in the blockchain, regardless of whether, in principle, the bank has enough Fedcoin deposits to cover these liabilities.

To avoid this, Koning proposes that instead of sharing your private keys with the bank, you'd sign over the Fedcoins to the bank and receive WellsFargoCoin in exchange, which stores would accept as payment because they trust Wells Fargo's guarantee of redeemability. This way, Wells Fargo is free to lend out your Fedcoin deposit. That's one way to do it.

But there's actually a much simpler option that doesn't require side-chains. When you make a deposit you'd sign over your Fedcoin to the bank, as in Koning's version, but you don't get WellsFargoCoin. Instead, just as you do with cash, you'd withdraw whatever amount of Fedcoin you want as spending money. You are then free to spend the Fedcoin you withdrew, while the bank is free to lend out the rest of your deposits.

In practice you wouldn't even be aware of the need to "withdraw" Fedcoins before spending them. Your digital Fedcoin wallet could just do this automatically. You pay for a cup of coffee by pressing a button on your phone, the digital wallet sends an order to your bank to withdraw the funds, then sends the funds to the coffee shop's Fedcoin address. No side-chains necessary.

In this post, I explained why fractional-reserve banking is simple to implement in a blockchain even without sidechains. In a future post, I'll explain why it's likely that most consumers will prefer to keep their Fedcoin in banks.

8/10/2016 09:59:00 AM

The burning question of whether policy should encourage home ownership over renting never quite dies out in the econ blogosphere. Alex Tabarrok caused the most recent conflagration with his February post "Economics on Owning vs Renting a House" which argued, in typical Marginal Revolution fashion, that ownership is overrated.

The conventional wisdom

The conventional wisdom disagrees (hence the "overrated" part). The New York Times typifies this genera:

The arguments in favor of ownership are persuasive, particularly for people who expect to stay in place for at least five to seven years but probably more. A mortgage acts like a forced savings plan, even if you’re paying the bank hundreds of thousands of dollars in interest for the privilege of building equity. Call it the cost of enforcing a positive behavior.

If you rent, all that money goes down the drain, while if you buy, that money goes into savings in the form of home equity, so they say.

Yet the conventional wisdom often leaves people with the wrong impression on how rent costs relate to ownership costs. On twitter, I tried to offer a rule of thumb to help conceptualize the comparison:

Obviously this ignores a lot of other things like taxes, which rent covers (so should say something more like tax+interest=rent).

But even with all the caveats, this is less helpful advice than it seems because you don't pay the same amount of interest each month, and because of compounding you can't just look at the average interest payment.

A numerical example

So here's a concrete comparison. A friend of mine recently bought a $176,500 house, put $15,885 down, and mortgaged the rest for 30 years at 3.6% interest. Taxes work out to $285 per month. In this area, the house will appreciate 3.57% each year. Counting the down payment and monthly payments, here's his equity savings value over the life of the mortgage (my R code here):

Equity savings in a house over the course of a 30 year mortgage, including down payment and annual appreciation.

Of course, buying a house involves a ton of other expenses I'm not considering here—this is just a baseline.

Now suppose that you rent an apartment instead. Instead of home equity, you invest in a diversified stock portfolio at 7% returns per year. Given the same down payment (invested in stock) and monthly payments, here's how much appartment you can afford while building the same amount of savings as in the chart above:

With the same down payment and monthly cost while investing the difference in stocks, renting at these rates each month yields the same total equity savings as ownership.

To start, you need an appartment for less than $813 a month to build the same amount of wealth. Eventually, because of the higher returns from stocks, you can afford up to $1160 per month by skimming some of the returns off the top of your stock portfolio. If you consistently rent for less than these amounts, you would end up with more savings than if you purchased the house.

Rent/Mortgage comparison calculator


Update (7/8/2016): Looks like New York Times has a more detailed but very similar calculator here.


Comparing a house versus a totally equivalent rental property, the ownership will probably cost a bit less most of the time. Although my friend previously paid less than the $813 for his two bedroom appartment, his $1015 per month mortgage probably affords a nicer house than any $812 per month apartment he could find so apples-to-apples ownership probably costs a bit less. On the otherhand, the ownership incurs more risk than a diversified stock portfolio—he will experience more difficulty moving, and must bear sector-specific risks that a stock portfolio can diversify against. Making the rent-equivalence and home equity comparison explicit helps guide your decision on whether the risk premium adequately compensates the extra risk you bear as a homeowner rather than renter.

5/24/2016 06:25:00 AM
Much about this blog has bothered me since the beginning. I've looked at all the various blogging engines and I hate them all. For a while I considered building my own blogging engine, but ultimately decided not to because it turns out as an economist I care more about comparative advantage than clean minimalist web design.

The new look sports a material design lite template—you can check out the MDL project here.

One of the things I often lament is that too many of my posts are walls of text with no visuals, so I decided on a photo-heavy theme. Of course, producing good graphics for every post is more work than I can afford to put into blogging these days, so my compromise was to build random photo picker. Ultimately all of the photos came from an old project from my publishing days that I never was able to publish, so here they are.

Hopefully I've not left any important components out of the redesign. I guess if the RSS isn't working none of you will see this, but in the off chance you do, let me know if anything broke, and I will fix it.
5/23/2016 07:40:00 PM
John Cochrane wrote an op-ed in the Wall Street Journal about the benefits of deregulation that was quickly obliterated by Brad DeLong.

As Dr. Kelso would say, John Cochrane spent 4 years in undergrad and 5 years in grad school, so we can assume he is at least 9. It's extremely hard for me to understand how an 9 year old could make such an absurd claim: that a little bit of deregulation could single-handedly push the US from GDP of $55,000 per capita to $400,000 per capita.

Forget the econometrics for a moment and just look at the graph:
Cochrane is making a claim that is massively out-of-sample. Which is to say, Cochrane's claim is totally unsupported by any of the data he has provided.

Statistics cannot be used to make claims about out-of-sample events. Economists sometimes weasel around this limitation by adding some theoretical assumptions: for example, if we assume that the relationship is continuously differentiable, then it follows that for some small range just outside of the sample, a naive extrapolation of the in-sample trend is a good approximation. But Cochrane is claiming that his relationship holds light years outside of his sample, with zero theoretical or empirical defense of this claim.

Brad DeLong offers some econometric arguments against Cochrane's claims. I say just look at Cochrane's data:
Graph taken from Brad DeLong's post
I've added the green and red boxes to highlight the countries that have higher doing-business scores than the US—those in the green box have higher GDP per capita while those in the red box have lower GDP. The vast majority of countries with better doing business scores have lower not higher per-capita GDP. I count 13 countries in the chart with higher doing business scores than the US, of those just 2 have higher GDP per capita. Even without any statistics, the overwhelming conclusion we can draw from this data is that increasing our doing business score is no guarantee of higher GDP at all.

What's important to remember here is that the Cochrane's critics don't even disagree with his premise that the US would benefit from many kinds of deregulation. In a follow-up post, Noah Smith points us to his own arguments for that point. What we're criticizing is the claim that deregulation alone could push the US to GDP of $400,000 per capita, a claim that makes economists as a whole look stupid, if not dishonest.

I've always regarded Cochrane as a competent, prominent economist, and no doubt the readers of the Wall Street Journal do to. I don't follow finance econ so much, but I've usually found Cochrane's blog enlightening. I guess sometimes even the most highly competent economists say stupid things. One hopes that they wouldn't do so on a medium as widely read as the WSJ, and that they would admit their errors once it is pointed out to them and they have had time to reflect.

Anyway, in hopes of ending this post constructively, here's some competent, honest analyses on how much we can expect to benefit from various kinds of deregulation. There's lots to like about this analysis. Reasonable people can disagree over whether some of those estimates are a bit too high or a bit too low, but they are all defensible. All of the usual caveats about model specification and endogeneity and omitted variables and all the rest apply. But what's really great about it is that it actually identifies real-world regulations we could repeal or modify, not hand-waiving about hypothetically making it easier to do business in the US without naming a single regulation to change. That's much more helpful! That's how you start a constructive discussion about deregulation.
5/08/2016 04:17:00 PM