Latest Award of Frederic Mishkin Iceland Prize for Intellectual Integrity: Former CBO Director Holtz-Eakin’s Garbage-In, Garbage Out Attack on Dodd Frank

As readers know all too well, there is so much obviously half-baked economic research that this site could turn itself over to shredding examples and only scratch the surface. But we have established the Frederick Mishkin Iceland Prize for Intellectual Integrity to highlight outstanding examples of economic shillery in which the attempt at analysis is obviously cooked so as to produce a pre-determined outcome.

In case you are not familiar with Fredrick Miskin’s distinctive contributions, the Academy Award winning documentary Inside Job depicted how the fish has rotted from the head in the economics academy, using former Harvard dean Larry Summers, former Fed vice chairman Frederic Mishkin and Columbia Business School dean Glenn Hubbard as object lessons.

Despite our publication of Academic Choice theory, which provides more formal support for the Inside Job observations, we’ve seen perilous little in the way of a change in attitudes from within the academy. So to make a wee additional contribution on this front, we created the Frederic Mishkin Iceland Prize for Intellectual Integrity.

Our first recipient, a paper defending the early 2011 mortgage servicer settlement, which not only helped perpetuate a broken servicing model (with the most recent confirmation the slow-motion implosion of Ocwen), but also devised the disastrous, costly fiasco known as the Independent Foreclosure Review. Established readers may recall that we published an in-depth series, based on the input of nine whistleblowers, documenting in gory detail how the entire process was intended to be a cover-up.

Our assessment of our first Mishkin Prize winner, “The Economics of the Proposed Mortgage Servicer Settlement,” by Charles Calomiris, Eric Higgins, and Joe Mason:

First and foremost is that this article goes well beyond the normal boundaries of shilldom, which is generally confined to cherry picking of data and artful framing. There are multiple, gross distortions, which call into question either the writers’ honesty or their knowledge of the basics in the mortgage servicing arena. But that level of inaccuracy is necessary to create the simulacrum their patrons desire, that of a parallel universe in which servicers are virtuous, borrowers are scheming, and the rule of law operates only for the benefit of corporate interests.

Another one of its distinctive contributions is the multiple layering of what mere mortals would call “stupid”. For instance, this paper cites earlier work on strategic default and mortgage mods that is analytically dubious. So it creates a steaming edifice of garbage but via its extensive citations, it hews to the form of normal academic output, making it look legitimate to those who don’t know the terrain.

The second Miskhin Prize went to Promontory Financial’s whitewash of MF Global’s risk controls. Our overview:

A direct analogy to the Mishkin paper praising Iceland’s financial system is reviews produced by private consultants acting as supposedly independent reviewers, or what amounts to an outsourced regulatory function. The glaring problem with this construct is that the reviewers are hired by the companies that need to get a clean bill of health in the end….Now to the immediate example, Promontory Financial. The firm is deeply involved in the OCC foreclosure reviews and also the author of a glowing report on MF Global’s risk controls in May of 2011, a mere five months before the firm failed.

While the initial award recipient, the Calomiris, Higgins and Mason paper, was an impressive confection of dissimulation, our third recipient distinguishes himself through his brazenness, specifically, his willingness to openly rest his entire argument on a bogus assumption. This is garbage in, garbage out writ large.

Specifically, the paper, The Growth Consequences of Dodd-Frank by former CBO director Douglas Holtz-Eakin, attempts to quantify the costs of Dodd Frank. The very language of the paper broadcasts how strained it is. As Dave Dayen noted yesteerday:

Regardless of what you think of Dodd-Frank, this is one of the most hackish things I’ve seen in quite a while. Doug Holtz-Eakin, who used to consider himself a moderate, pulls a number out of his posterior that even he knows is fake. “Clearly, such a computation is subject to large uncertainties,” he says. “It doesn’t change the growth rate dramatically—it’s not even a percentage point,” he adds. “Everyone should take this all with a grain of salt… I have no belief that I’ve nailed it.” And then WSJ runs it anyway with a big headline including the number that Holtz-Eakin spends the entire article disavowing. Shorter version: “This is a meaningless number, but it is big, and therefore important.”

Holtz-Eakin manages to come up with a 10 year cost of $895 billion “or $3.346 per working age person.” Notice the effort at precision when Holtz-Eakin repeatedly has to concede that his analysis is reliable at best to an order of magnitude. So we already have dishonest rhetoric in giving a false impression of exactitude in an at best crude estimate.

Gee, but isn’t insurance supposed to cost money? Isn’t Dodd Frank supposed to protect against financial crises? How does this cost guesstimated compare to the benefits? Let’s turn to a paper by Andrew Haldane of the Bank of England, whose early estimates of the cost of the crisi, in terms of lost output, has proven to be pretty accurate:

….these losses are multiples of the static costs, lying anywhere between one and five times annual GDP. Put in money terms, that is an output loss equivalent to between $60 trillion and $200 trillion for the world economy and between £1.8 trillion and £7.4 trillion for the UK. As Nobel-prize winning physicist Richard Feynman observed, to call these numbers “astronomical” would be to do astronomy a disservice: there are only hundreds of billions of stars in the galaxy. “Economical” might be a better description.

It is clear that banks would not have deep enough pockets to foot this bill. Assuming that a crisis occurs every 20 years, the systemic levy needed to recoup these crisis costs would be in excess of $1.5 trillion per year. The total market capitalisation of the largest global banks is currently only around $1.2 trillion. Fully internalising the output costs of financial crises would risk putting banks on the same trajectory as the dinosaurs, with the levy playing the role of the meteorite.

To put it another way, Haldane’s low end estimate of output losses of one times GDP is now generally accepted. The CBO projects notional GDP for 2020 to be $23 trillion. For simplicity, we’ll use this as a proxy for that time period. $23 trillion (the cost the one-in-twenty year crisis) divided by 20 (the amortized annual cost) is $1.15 trillion. Multiply that by 10 (the time frame of Holtz-Eakin’s forecast period) and you get expected output losses of $11.5 trillion. Holtz-Eakin’s $895 billion looks like a bargain by comparison.

Of course, that assumes that Dodd Frank works, and more important, that his numbers are anything other than sheer fabrication. And where does he start? With a model whose first assumption is invalid:

The starting point is the observation that national saving finances national investment

As readers know well, loans precede deposits. Savings don’t “finance” investment. Banks create money and the central bank provides reserves to the banking system as needed to maintain its policy rate. This mechanism has been discussed at length by the Bank of England and former Treasury official Frank Newman, and acknowledged by Alan Greenspan and Ben Bernanke.

The Wall Street Journal’s economics blog cited other objections to the Holtz-Eakin “analysis”:

Americans for Financial Reform also argued the study was based on several assumptions that exaggerated the costs of financial regulations.

One assumption is that the regulations will subtract from investment in the economy. In fact, they argue, Dodd-Frank requires banks to make significant investments in information technology and data reporting.

Another assumption is that higher compliance costs lead to reduced lending, AFR said, but some of those costs will be absorbed by lower compensation for executives or other cost-cutting measures. They study also assumes the costs of implementing the new rules will extend for at least the next decade, when in fact some of those costs will only last a few years, they said.

So Holtz-Eakin’s entire analysis is the economic equivalent of snake oil. But as we’ve discusses in previous posts, the CBO dispenses quite a lot of that. It should come as no surprise that Holtz-Eakin has found new customers for a well-honed skill.