Ethnic enclaves are communities with high concentrations of one ethnic group usually resulting from immigration patterns. Many scholars believe that ethnic enclaves slow immigrant assimilation into American society, a phenomenon known as the “enclave thesis.” Recent academic literature on the enclave thesis has yielded mixed results, but there are also severe research design problems due to data limitations, a lack of definitional consensus, and seemingly insurmountable endogeneity. This post will analyze key findings within the ethnic enclave literature.

Background and Definitions

Concerns about ethnic enclaves, specifically their impact on assimilation and increased crime rates, run deep. Dan Cadman of the Center for Immigration Studies is concerned that they spread crime. Reihan Salam of the Manhattan Institute wrote that “an ongoing [immigration] influx will tend to reinforce ethnic enclaves and endogamous marriage, both of which impede assimilation.” Salam devoted a few pages of his book Melting Pot or Civil War? to the pernicious effects that ethnic enclaves have on assimilation, ultimately concluding: “But is this any reason to be alarmed? The answer is yes.” Salam’s exhortation to panic was outdone by Andrew McCarthy, who thinks that Muslim enclaves are going to overwhelm European legal institutions and impose Sharia law in the wider society.

Beyond the writings of pundits, there is expansive academic literature on the effects of ethnic enclaves. One of the biggest disputes within the literature is the definition – what exactly is an ethnic enclave? Some studies define enclaves as those communities in which immigrants cluster in residential housing, like Borjas (1995) and Sanders and Nee (1989). Other studies define enclaves as segregated workplaces comprising a specific ethnic group, like Alejandro and Portes (1989). We note where these distinctions matter below.

The ethnic enclave literature also suffers from data limitations. Lower skilled immigrants tend to cluster in enclaves while higher-skilled immigrants find work outside the enclaves. Separating an immigrant’s workplace and personal residence is crucial to statistically account for all members of an ethnic enclave. Many studies control for this factor, but there are other factors such as immigrants’ legal status and the educational quality and regulatory restrictions within the enclave that are rarely controlled for. Although we must be wary of overcontrolling, proper statistical analysis must have enough controls to identify and separate the effects of enclaves from other endogenous variables.

Lastly, many of these studies have exploited recent immigrant arrivals in Western Europe. There have been considerably fewer studies evaluating the effects of recent immigrant inflows into U.S. ethnic enclaves. For various legal, cultural, and economic reasons, Europe’s immigration experience is very different from that of the United States.

Major Findings

Many studies exploit the exogenous placement of refugees by governments as quasi-natural experiments to study how the assimilation rates of those placed in ethnic enclaves compare to those who do not settle in ethnic enclaves. Since government agencies make the settlement decisions for refugees, endogeneity is less of a concern. A recent study by the National Academy of Sciences by Linna Martén, Jens Hainmueller, and Dominik Hangartner (2019) analyzed the marginal effect of increased ethnic clustering on employment outcomes by using Switzerland’s dispersal placement program for recently arrived refugees. The program assigns refugees to specific regions in the country. This program allowed researchers to compare labor market outcomes between the government-placed refugees and non-refugee immigrants who chose to settle in ethnic enclaves. The study found that settling in an ethnic enclave increased the probability of employment in Switzerland. These effects were observed with respect to the number of co-nationals, ethnicity, and language concentration in said enclaves, indicating robust short- and medium-term results.

Sweden used a similar placement strategy for refugees. Economists Per-Anders Edin, Peter Fredriksson, and Olof Åslund (2003) discovered that a one standard deviation increase in an area’s co-ethnic population caused a 13 percent bump in earnings for low-skilled immigrants of the same ethnicity placed in the area by the government. Another study of an exogenous refugee-placement program in Denmark reached three conclusions: first, there is “strong evidence that refugees with unfavorable unobserved characteristics self‐​select into ethnic enclaves. Second, a relative standard deviation increase in the ethnic enclave size increases annual earnings by 18 percent on average, irrespective of skill level. Third, further findings are consistent with the explanation that ethnic networks disseminate job information, which increases the job‐​worker match quality and thereby the hourly wage rate.”

Some studies, however, suggest opposite employment effects, particularly for low-skilled immigrants in ethnic enclaves. For example, George Borjas (2000) measured the impact residential segregation has on “economic assimilation,” or the convergence of immigrant wages with their native-born counterparts. Borjas found that increased residential segregation led to adverse wage effects for both newly arrived and least-educated immigrants. He also observed that increased residential sorting into ethnic enclaves lowers the likelihood an immigrant will become English-proficient but increases the likelihood they will further their education. Borjas attributes these negative results to the lack of diversity within ethnic neighborhoods after 1965, suggesting that the increased homogeneity among immigrants is depressing labor market opportunities and assimilation practices.

The National Institutes of Health found that higher ethnic concentrations in enclaves yield negative employment effects for immigrants in the United States. Hispanic immigrants living in an enclave face an almost 11 percent reduction in earnings relative to Hispanics who live elsewhere, a figure which translates to an approximate $1.37 hourly wage reduction. The authors caution, however, that their small sample size may prevent their results from representing all ethnic groups.

Another study by economists Roberto Pedace and Stephanie Rohn Kumar (2012) evaluated the effects of increased ethnic concentrations on wages and employment propensities for several ethnic groups in the United States, including Mexicans, Central Americans, Cubans, Chinese, and Indians. For Mexican, Puerto Rican, and Cuban males, the overall wage effects of living in an ethnic enclave were negative and statistically significant. For higher educated Korean and Indian immigrants, however, the opposite was true. In addition, economists Barry Chiswick and Paul Miller (2005) found that the costs of increased competition (supply) inside an ethnic enclave offset the potential economic gains from larger ethnic networks in California.

Entrepreneurship inside ethnic enclaves also affects whether their members receive net positive or negative economic impacts. Per-Anders Edin, Peter Fredriksson, Olof Åslund (2003) conclude that higher rates of ethnic self-employment put upward pressure on wages. Alejandro Portes (1987) describes the importance of Cuban-owned banking services that extended funds to recent immigrants with little collateral. These services immensely contributed to the entrepreneurial vibrancy of Miami, especially in the wake of the Mariel Boatlift. Additionally, economist Maude Toussaint-Comeau found that as the size of the ethnic network increases (an indicator of the enclave’s quality), so does the probability that immigrants are self-employed.

A major qualification in the above-cited literature is that increasing an enclave’s educational quality significantly improves employment outcomes and rates of cultural assimilation, such as English language acquisition. For instance, Anna Daam (2014) found that in Denmark, co-ethnics with higher skills and employment rates matter far more than the nominal size of the ethnic enclave. In other words, improving the human capital within and around the ethnic enclave has a far greater effect on immigrant economic success than whether or not immigrants live in ethnic enclaves. The Institute of Labor Economics surveyed the literature and observed that improved quality measures, like education and income, are more important than the scale of an enclave. Economists David M. Cutler, Edward L. Glaeser, Jacob L. Vigdor (2007) also found that an immigrant’s education is more important than his residence in an ethnic enclave. Another study indicates that increased legalization status for immigrants increases immigrant wages and the likelihood they will become naturalized citizens.

Discussion

Enclaves are often formed naturally, and they lower the costs of gathering information for newly arrived immigrants. These immigrants benefit economically and culturally, and these benefits are often perceived as outweighing the potential costs of enclave life. Since ethnic enclaves will not disappear, making them better is the easiest approach to encourage faster and better assimilation.

Granting illegal immigrants legal status would encourage many to contribute in new ways to the formal market economy and improve their skills and income over the long run. Also, research has shown that legalizing illegal immigrants incentivizes many to move from higher immigrant populations to lower immigrant populations – a potentially important development that can lead to more assimilation.

The literature on ethnic enclaves produces many consistent findings. Many of these findings could aid in the creation of immigration policies that better affect immigrant assimilation. Most importantly, immigrants residing in enclaves are more likely to be employed and employed with higher wages when the average education and entrepreneurial levels of said ethnic enclaves are higher. Adopting policies to increase entrepreneurship by relaxing regulatory burdens, like occupational licensing and minimum wage, will give many immigrants the opportunity to more easily establish new businesses. Ethnic enclaves assist in assimilating immigrants into the American economy, and policies focused on maximizing entrepreneurial activity will most improve the enclave’s quality.

Michael N. Peterson helped research and write this blog post.

According to a formal whistleblower complaint, President Donald Trump withheld Congressionally-appropriated aid from Ukraine in an attempt to pressure Ukraine’s new president, Volodymyr Zelensky, to investigate Trump’s 2020 political rival, former Vice President Joe Biden. In addition to seeking dirt on Biden, Trump also asked Zelensky to help locate the computer server allegedly used by the Democratic National Committee that was hacked by Russia, suggesting that Trump is intent on relitigating the Mueller investigation into the 2016 campaign.

Although Trump has tried to pass off this episode as entirely above board, he did all this largely outside official channels. Rather than going through the normal interagency process to carry out official policy, Trump tasked his personal lawyer Rudy Giuliani and several other loyalists to do his dirty work “off the books.” The White House also engaged in an attempted cover up of this chicanery, according to the complaint.

The controversy brings to mind a famous New York Times op-ed published a year ago. In it, an unnamed senior administration official, claiming to be a part of an internal resistance against the president, identified Trump’s “amorality” as “the root of the problem.” “Anyone who works with him,” the official explained, “knows he is not moored to any discernible first principles that guide his decision making.”

We agree. It is clear from the whistleblower complaint, the rough transcript of the Zelensky call, and Trump’s own public confessions that the president put his personal political interests above the national interest. While the revelations are shocking, they should not be surprising.

We study international relations, so that’s our frame for analyzing, in our forthcoming book, what drives Trump’s decision-making. To be sure, President Trump is a hard case. His foreign policy preferences often defy neat categorization, and many of his positions change with the political winds — sometimes even within a single news cycle. The president’s mercurial personality and psychological makeup, and his apparent lack of a fixed ideology, make it difficult to define his worldview with precision.

But it is possible to work out certain consistent features of Trump’s overall worldview that drive his approach to foreign affairs. And his apparent attempt to shake down a foreign leader to provide dirt on a political opponent makes perfect sense in light of these defining features.

First, Trump is driven by zero-sum transactionalism. This mentality pervades his thinking across personal and political domains, and explains his views on trade, alliances, and multilateral agreements. His record in office so far strongly suggests that ethical and strategic imperatives matter far less than whether Americans – or, more often, him personally – can gain at the expense of others.

This calculated transactionalism is reflected not only in Trump’s attempt to use the power of his office to further his own narrow election interests, but also in his expectation that Zelensky’s only concern would be narrow self-interest. Ukraine desperately wanted the U.S. military aid Trump withheld, and the president expected a simple zero-sum transaction — a quid pro quo, if you will.

Second, Trump is a stereotypical Jacksonian. “Jacksonian political philosophy,” explains the political scientist Walter Russell Mead in a 2001 book, “is often an instinct rather than an ideology…a set of beliefs and emotions rather than a set of ideas.” Jacksonians, according to Mead, are disposed “toward conspiracy thinking” and are willing to deploy the powers of the presidency “even at the cost of constitutional niceties.” That political leaders “employ vigorous measures” is more important to Jacksonians “than to worry about the niceties of international law.”

Indeed, Trump’s attempt to pressure Ukraine was driven in part by a stream of debunked conspiracy theories circulating on the fringes of the right-wing online media. One such theory alleges that Ukraine, not Russia, interfered in the 2016 elections on behalf of the Clinton campaign. Another claims that Vice President Joe Biden pressured Ukraine to fire its prosecutor in order to relieve his son, who was then on the board of a Ukrainian company Burisma Holdings, of scrutiny for corruption (in fact, the prosecutor was failing to go after corruption, the investigation into Burisma had gone dormant, and Ukraine’s current top prosecutors says publicly that there is no evidence of wrongdoing on the part of the Bidens).

Third, Trump is obsessed with his own reputation. In a review of five hours of recorded interviews with Trump con­ducted by his biographer in the mid 2000s, the New York Times’s Michael Barbaro identifies Trump’s “deep-seated fear of public embarrassment” as his most powerful driving force. “The recordings reveal a man who is fixated on his own celebrity” and “anxious about losing his status.”

Again, this helps explain Trump’s determination to get information from Ukraine. The finding of the U.S. intelligence community and Special Counsel Robert Mueller that Russia meddled in the 2016 election to help the Trump campaign undermines the legitimacy of his election. Overturning that narrative by getting to the bottom of these Ukraine conspiracy theories required pressuring Kiev outside of official U.S. channels, something Trump apparently had few qualms about.

Finally, Donald Trump’s inclinations are unusually authoritarian by the standards of contemporary U.S. political culture. Scholars have been researching authoritarian personality traits in political leaders for decades. Authoritarians tend to share important psychological habits and decision-making styles. They have greater difficulty engaging in critical thinking, are more likely to blame scapegoats for societal problems, are given to superstition and stereotyping, place a high value on power and toughness, and tend to abuse and intimidate subordinates, thus suppressing an open and deliberative decision-making process.

Donald Trump exhibits all of these characteristics in spades. He demands loyalty from officials in federal departments that are supposed to be independent and nonpartisan. Trump has repeatedly attacked federal courts as illegitimate, and leveled ad hominem attacks against individual judges who had the gall to overrule his executive orders. He vilifies the press as “the enemy of the people.” He has recklessly accused the whistleblower of being a spy and Rep. Adam Schiff, who is leading the impeachment inquiry, of treason.

For President Trump to conduct his foreign policy in this way makes sense, given his character and his worldview, but that does not mean it is acceptable. It should make Americans rethink not just the expanded powers of the presidency, but U.S. foreign policy in general.

America’s outsized role in the international system is in part justified on the grounds that U.S. leadership is morally superior to the alternatives and that America is guided by higher principles. One need not confine oneself to the Trump years to appreciate the weakness of this claim.

But Donald Trump does clarify the danger. His ascendance to the highest office in the nation is per­haps the most compelling illustration of the hazards of vesting the pres­idency with so much unbridled power, both domestically and internationally. The presidency, and the global military presence it commands, must be cut down to size and properly checked by its co-equal branch. With or without Trump, any world order that depends for its survival on the whims of a single person in a single branch of gov­ernment in a single country is simply untenable.

On Wednesday, October 2, US District Judge Gerald McHugh ruled that the plans of a non-profit, privately-funded, harm reduction organization to establish a Safe Injection Site in Philadelphia do not violate federal law. A group that includes former Philadelphia Mayor and Pennsylvania Governor Ed Rendell was warned last year by then-Deputy Attorney General Rod Rosenstein that their plans to establish “Safehouse” would be a violation of federal law and would face a “swift federal response.” In February of this year, US Attorney for the eastern district of Pennsylvania Bill McSwain sought a declaratory judgment in federal court regarding the legality of the enterprise, arguing that Safe Injection Facilities (also called “Overdose Prevention Sites”) violate the federal “Crack House Statute.”

Governor Rendell spoke about Safehouse and the court battle at the Cato Institute’s conference on harm reduction in March of this year. Also on the panel discussing the matter were Clark Neily, Cato’s Vice President for Criminal Justice, and Darwin Fisher, Program Director of “Insite,” in Vancouver, BC, North America’s oldest Safe Injection Facility. You can view that panel discussion here. In their argument before the court, the Department of Justice called Safehouse an “in-your-face illegal activity.”

While the Justice Department intends to appeal the ruling, this is still a very encouraging development. Several other cities have been wanting to allow for the establishment of Safe Injection Facilities, including Seattle, San Francisco, Boston, and New York City. They are watching what happens in Philadelphia very closely.

As I have written here and in my Policy Analysis on harm reduction, Safe Injection Facilities have a more than 30-year track record of reducing overdose deaths, cases of HIV and hepatitis, and IV drug use in over 120 cities in Europe, Canada, and Australia.

Unfortunately, efforts to establish Safe Injection Sites in the US still have a battle in front of them. US Attorney Bill McSwain reacted to the judge’s decision by saying, “The Department of Justice remains committed to preventing illegal drug injection sites from opening. Today’s opinion is merely the first step in a much longer legal process that will play out. This case is obviously far from over.”

A recent corruption story in rural Virginia is rather stunning. The state is usually thought to have relatively clean government, but a Washington Post investigation by Antonio Olivo reveals something far different. The story—excerpted below—describes a wide-ranging scandal surrounding the Economic Development Authority (EDA) of Warren County, VA.

Local governments across the nation have EDAs, a key purpose of which is to hand out subsidies to favored businesses. EDAs are structured as quasi-independent from city and county governments to reduce transparency, and so they are ideal platforms for cronyism or corruption.

In a broad sense, subsidizing specific businesses is corruption in itself, even when local politicians and bureaucrats don’t line their own pockets. But they often do. This article regards an EDA official in Maryland stealing $6.7 million. In both the Virginia and Maryland scandals, it took years for the corruption to be uncovered. Why aren’t state governments auditing EDAs?

I have two solutions for this sort of local government corruption:

First, state legislatures should abolish EDAs and ban local governments from handing out narrow tax credits, loans, and other subsidies to companies. Having an in-government agency to help local businesses navigate tax and regulatory compliance might be a good idea, but having a secretive outside entity with little oversight handing out special favors is asking for trouble.

Second, Congress should repeal the tax exemption for municipal bond interest. These bonds create a strong incentive for businesses to lobby EDAs for loans rather than getting them in private markets. I understand that tax-exempt muni bonds are a core mechanism used by EDAs, and they create a bias favoring local government socialism over private enterprise.

Here are portions of the excellent Washington Post story:

Twenty-five years later, with the land cleaned up and Front Royal increasingly attractive to tourists and former city dwellers, officials announced plans for a data center and retail complex that would bring 600 jobs and act as a catalyst for other projects.

… The deal was brokered by Jennifer McDonald, a longtime Front Royal resident who directed the Warren County economic development authority. Washington-area developer Truc “Curt” Tran pledged to finance it with $40 million from wealthy immigrant investors and a $140 million federal contract his technology company had secured. As an added bonus, Tran would fund a police training academy overseen by longtime Sheriff Daniel T. McEathron.

But those were lies, documents in Warren County Circuit Court allege.

Tran never had the money to build the data center project on the 30 acres his company bought from McDonald’s agency for $1, a civil lawsuit alleges. And the training academy was one of several hoaxes that, prosecutors and civil lawsuits claim, allowed Tran, McDonald, McEathron and others to siphon away millions in public funds, which they allegedly used to buy properties, pay bills and gambling debts, and enrich relatives and friends.

… Now McEathron is dead, Tran is being sued by the economic development authority and there are state and federal investigations underway. McDonald faces 28 state counts of embezzlement, money laundering and obtaining money through false pretenses. She has denied the allegations and did not return interview requests, while Tran declined to comment through his attorney.

The claims against them, industry groups say, reflect the perils of weak oversight in economic development agencies — quasi-public entities that oversee large, complicated transactions, and whose boards often lack the financial savvy and investor scrutiny that protect their corporate counterparts. In Montgomery County, Md., an economic development official pleaded guilty this year to embezzling $6.7 million. The head of economic development in St. Louis pleaded guilty to steering lucrative contracts to the county executive’s political donors. In New Jersey, a grand jury is investigating how $500 million in tax incentives went to firms that, in part, allegedly lied on their applications.

… On Tuesday, the Virginia State Police announced that 14 current and former local officials — including all five county supervisors — were charged with misdemeanor misfeasance and nonfeasance “based on the individuals’ knowledge of and inaction [regarding] the EDA’s mismanagement of funds.”

… A soft-spoken resident of upscale Great Falls, Va., whose website boasts of contracts with the U.S. Office of Management and Budget, Tran wanted to turn part of the former Avtex Fibers manufacturing campus into a hub for cloud computing, with a three-building, $40 million complex that according to its business plan would include a restaurant, a coffee shop and a music store.

McDonald’s board approved a $10 million, 90-day loan. Tran promised funding from 80 foreign investors enrolled in the federal EB‑5 visa program, which offers applicants and their families a path to citizenship in exchange for the jobs their money helps create. Officials and residents gushed over the plan.

“This is our first step into a new era,” then-Mayor Timothy Darr said at a 2015 groundbreaking, as McDonald, Tran and [Rep. Bob] Goodlatte smiled nearby.

The regional Criminal Justice Training Academy was announced the following year. McDonald said an anonymous donor would provide $8 million, and told her board the donor was Tran, the civil lawsuit says. McEathron, a fellow Rotarian, would be in charge.

… It all seemed in­cred­ibly fortunate. Until late 2016, when some town officials and residents looked up Tran’s company online.

They found it hadn’t yet been allowed to solicit investments under the EB‑5 program. The $140 million federal contract appeared to be a mirage, with Tran receiving no payments from it. Skeptics asked increasingly pointed questions at public meetings, sparking warnings from Town Council members that the naysayers would blow Front Royal’s big chance.

… The Town Council authorized $1.7 million of infrastructure improvements for the Avtex site, and according to the lawsuit, McDonald allegedly paid Tran at least $1.5 million for construction costs without informing her board.

… In 2018, Front Royal’s finance director discovered a bigger red flag: The authority had overbilled Front Royal nearly $300,000 for its portion of debt service related to the Avtex site and a road improvement project. At a meeting about the discrepancy, McDonald nonchalantly said she had mistakenly falsified some invoices, Town Attorney Doug Napier recalled.

“She was not at all contrite,” Napier said. “It just shocked me.”

The revelation prompted a call to state police and an independent review of the authority’s books that uncovered a dizzying array of phony invoices, phantom projects, secret land deals and bank wire transfers to entities controlled by McDonald or her friends, according to a copy of the review completed in May by the Cherry Bekaert accounting firm. The probe was commissioned by the authority and is the basis of the criminal and civil proceedings.

McDonald allegedly billed the authority more than $50,000 to pay for renovating a vacant inn, then used those funds to pay credit card bills, according to the review. She is accused of doctoring invoices to secure $4.6 million for purchasing tax credits, then embezzling that money.

A plumbing company owned by her husband, Sammy North, allegedly collected at least $66,200 in secret payments, the review found. North has also been arrested, as was Donald F. Poe, a family friend accused of conspiring with McDonald to funnel $841,409 to his solar panel installation company for work the board didn’t authorize.

North did not return messages seeking comment. Ryan Huttar, an attorney for Poe’s company, said that his client performed the work it was hired to do and that it reimbursed the authority $335,000 when one job was canceled.

Attorneys in the civil lawsuit say McDonald allegedly convinced the authority to buy land from her aunt and uncle for a workforce housing project without disclosing that they were her relatives, and billed the authority an additional $130,000 in the transaction, most of which went to pay off what appeared to be her mortgage.

… McEathron wasn’t charged. But he may have felt the tide turning against him. He and McDonald had launched a real estate investment company called DaBoyz LLC in 2016, shortly after they announced the police academy. The firm used $3.5 million in authority funds to buy four properties, the independent review found. McDonald and McEathron also bought a three-bedroom home in Virginia Beach, which they rented to McEathron’s son and daughter-in-law, court records in the civil lawsuit show.

In one curious transaction, which lawyers for the authority say may have been an attempt to launder money, DaBoyz paid Rappawan, a construction company, $1.9 million for a large tract of land and then sold it back a month later for $1.3 million. Rappawan owner William T. Vaught Jr. declined to comment, citing the criminal investigations.

… McDonald was charged this summer with additional counts of money laundering and grand larceny. Her husband was arrested on counts of money laundering and obtaining money by false pretenses. The local grand jury, which was initially set to finish its work this month, requested another six months to investigate.

… Local activists, who had called for the state and federal investigations to be expanded, rejoiced at Tuesday’s announcement. “Somebody is finally listening,” said Salins, co-founder of the Warren County Coalition watchdog group. “It’s not every day that your entire government gets arrested. It’s so shameful.”

… And they had been demanding answers from Supervisor Tony Carter (R‑Happy Creek), another of the people charged in the recent indictments. Carter works for his mother’s insurance company, Stoneburner-Carter, which holds insurance policies on four properties owned by the authority and has collected about $46,000 in premiums since 2015, according to records obtained through a Freedom of Information Act request.

For years, the local government “has been skewed [in favor] of the elite and the ‘good ol’ boys’ club,’ ” [Kristie Atwood] said. “With luck, and these indictments, our community is going to turn around for the good.”

I hope she is right. But to make sure the “good ol’ boys’ club” is gone for good, Warren County citizens should press to abolish their EDA and to rely on clean and efficient government with equal and low taxes for all businesses to encourage growth and development.

While my fellow Fed-watchers have had their eyes firmly glued to the repo-market for several weeks now, I’ve been preoccupied with some other Fed monkey business: its plans to launch a new real-time retail payments service. Having recently testified before the Senate on that topic, I finally have some time to devote to add my two cents to what others have had to say about the Fed’s repo-market tribulations.

A Broken Floor

By the “repo-market imbroglio,” I mean, for those of you who haven’t been watching the repo-market at all, the Fed’s struggles of late to keep short-term private-market interest rates, including both the fed funds rate and rates on private repurchase agreements (or “repos”), from rising above—if not well above—the top of its fed funds rate target range.

The basic problem is that the IOER rate has been steadily losing gravity, (“gravity” being its power to keep money market rates orbiting around it) for some time. The following chart illustrates the point with reference to the effective fed funds rate:

Here the blue line shows how the gap between the fed funds rate and the IOER rate, which was originally negative, has grown since mid-2018, while the red line shows the four five-point “technical adjustments” to which the Fed has resorted in order to keep the funds rate from creeping above the upper limit of its target range. On September 17th, those adjustments, at last, proved inadequate, with the effective funds rate briefly bursting through the target upper limit. More disturbing still was the even sharper rise in repo rates that day, which had some borrowers paying 10 percent for secured overnight funds. In response to those spikes, the Fed began injecting fresh reserves into the banking system through its own repo offers. So far, as the next chart shows, banks have borrowed several hundred billion dollars of fresh reserves; and they are likely to keep borrowing them for some time.

What all this means is that, for the time being at least, the Fed’s “floor” operating system, which it decided to make permanent only this January, is broken. Under a proper floor system, temporary open-market operations shouldn’t be necessary. Instead, banks earn enough interest on their excess reserves to be content to hoard such reserves, and are in turn supplied with so many reserves that they never have to borrow them on the private market, let alone directly from the Fed. Because reserves are no longer scarce in this setup, marginal changes to the stock of reserves no longer influence market interest rates. Instead, the central bank adjusts the stance of monetary policy by changing the interest rate it pays on bank reserves, triggering an arbitrage process that results in corresponding changes to money market rates.

Simplicity is supposed to be the hallmark of this arrangement. As New York Fed Vice President and acting System Open Market Account (SOMA) manager Lorie Logan put it before things went sour, compared to arrangements that depend on routing open-market operations, a floor system is simple and efficient to operate. The interest rate the Fed pays on excess reserves serves as the primary policy implementation tool, with support from a standing facility that offers overnight reverse repos (ON RRPs) at an administered rate. There is no need to forecast specific factors affecting reserves or to conduct discretionary open market operations each day… Market forces keep the federal funds rate in the FOMC’s target range by allowing a wide range of counterparties to price trades against the alternative option of investing with the Federal Reserve.

In fact, as Stephen Williamson points out in his own excellent post on the repo-market mess, the scale of the Fed’s recent repo-market operations far eclipses that of its routine pre-2008 temporary open-market operations. It also overshadows the Fed’s unwind, which at its peak had the Fed withdrawing $50 billion in reserves each month.

A Dearth of Reserves

What went wrong? In brief, Fed officials found out that keeping the banking system flush with reserves, as a floor system requires, is harder than it sounds. More precisely, they discovered the hard way that even $1.4 trillion in excess reserves wasn’t sufficient to avoid a mad scramble for scrambling for cash.

That Fed officials were caught off guard by this discovery isn’t altogether surprising. After all, before the Fed switched to a floor operating system, banks managed with a grand total of less than $2 billion in excess reserves, or 1/​700th of their recent holdings! Yet under that old arrangement, with all its pesky forecasting requirements, the fed funds rate never wandered far from the Fed’s target, which was, moreover, a precise value rather than the generous 25-point bullseye the Fed gets to aim at today. Of course, individual banks often found themselves short of reserves in that arrangement. But when they did they could readily make up for those shortages, and do so without paying a premium, by borrowing on the fed funds market.

Of course, Fed officials understood that the new system called for substantially more reserves than the pre-crisis set-up did. They just didn’t know precisely what “substantially more” meant. Surely, they reasoned, banks wouldn’t need all the reserves provided to them through the Fed’s crisis-era QE programs. So some unwinding seemed appropriate. But just how much was unclear. Hence the Fed’s decision to proceed gingerly and, ultimately, to suspend its unwind sooner than expected in response to mounting evidence that reserves were getting scarce again.

That those symptoms of reserve scarcity started to show while there were still almost $2 trillion in reserves outstanding made it natural to suppose that, instead of an aggregate reserve shortage, what was being witnessed was a distributional problem only, reflecting a breakdown of some kind in the market’s ability to get reserves where they were needed. “Apparently,” Williamson observes,

banks holding reserves were foregoing large profit opportunities to lending in the repo market and fed funds market, and fed funds market lenders were similarly lending unsecured overnight and foregoing large profit opportunities to secured lending in the repo market. … The problem is that overnight markets – particularly in the United States – are gummed up with various frictions.

But it turns out that most of the “frictions” in question consist of regulations that have substantially boosted the demand for excess reserves, particularly among the largest banks. Five of those banks hold about 90 percent of all outstanding excess reserves; and once one allows for all the liquidity regulations to which those banks are subject, the possibility that they can’t afford to part with any of them becomes increasingly plausible.

What regulations? Basel III’s Liquidity Coverage Ratio (LCR) requirement is the most obvious culprit. According to it, large banks, meaning those with over $250 billion in total assets or over $10 billion in on-balance sheet foreign exposure, must hold enough High Quality Liquid Assets (HQLAs) to fund their anticipated cash outflows for 30 days. Under Basel’s rules, both U.S. government and agency securities and excess reserves qualify as level 1 HQLAs. But when reserves yield more than Treasuries banks have every reason to prefer them. Thanks to an inverted yield curve for which the Fed itself bears some responsibility, using excess reserves to meet LCR requirements has been a no-brainer since June:

Shadow Liquidity Regulation

But none of this explains why the big banks didn’t fund the private repo market as repo rates rose sharply above the Fed’s IOER rate. After all, since the repos we’re talking about are temporary swaps of reserves for Treasury securities, banks that engage in them don’t reduce their HQLAs. Yet they stand to profit when repo rates spike. But the LCR requirements were far from the only liquidity requirements big banks had to meet. “Banks,” JPMorgan CEO Jamie Dimon said at the peak of the turmoil, “have a tremendous amount of liquidity, but also have a tremendous amount of restraints on how they use that liquidity.” As Francisco Covas and Bill Nelson explain in a recent BPI post, besides Basel’s LCR requirements the very largest U.S. banks are also “subject to non-public liquidity stress tests, non-public liquidity requirements associated with their resolution plans, and non-public ad hoc examiner mandates.”

Bill Nelson first drew attention to those ad-hoc examiner mandates almost a year ago, causing yours truly to complain in turn that Fed supervisors were, perhaps unwittingly, placing artificial limits on the Fed’s ability to shrink its balance sheet, as it was endeavoring to do at the time. In particular, as Zoltan Pozsar explains in a remarkably detailed and prescient May 2019 essay, which I can’t do justice to here, “increased supervisory focus on intraday liquidity increased banks’ demand for reserves just as the taper was destroying them” (my emphasis). Pozsar also delves into liquidity requirements connected to banks’ resolution plans, which grew out of Dodd-Frank’s “living will” provisions. Suffice to say that those requirements, besides being much stiffer than ordinary LCR requirements, can only be satisfied by excess reserves. Finally, as if all this weren’t enough, some banks, including J.P. Morgan, are subject to a capital surcharge that depends on the extent of their repo lending.

The bottom line is that regulators have managed to raise the biggest banks liquidity needs enough to compel them to sit on most of the banking system’s seemingly huge stock of excess reserves, and to do so even as repo markets present them with an opportunities to earn five times what those reserves are yielding just by lending them out overnight.

And Shadow Reserve Drains

While regulatory requirements, assisted by an inverted yield curve, have been ramping-up banks’ demand for excess reserves, other factors have caused the supply of excess reserves to shrink considerably more than Fed officials bargained for. As the next FRED chart shows, between October 2017, when the Fed began its unwind, and September 17th, when the repo market started to go haywire, the Fed had shed about $600 billion in assets. Excess reserves, on the other hand, fell by almost $780 billion.

Two causes, also shown in the chart, account for the overall discrepancy. The first and better known has been an accumulation of Treasury General Account (TGA) balances. The less well known contributor to the reserve drain has been an increase, practically all of it coming from Japanese banks, in the size of the New York Fed’s “foreign repo pool.” The basic story is the same for each: unlike most of us. but like depository institutions, both foreign central banks and the U.S. Treasury can have accounts with the Federal Reserve. But when they accumulate balances in those accounts, they remove a corresponding amount of reserves from the banking system. (For more details, see this excellent just-released essay by BPI’s Bill Nelson.)

A final factor that helped set the stage for last month’s reserve shortage was the Treasury’s need to fund the Trump administration’s $1 trillion fiscal 2019 deficit. That meant having primary dealers underwrite a like amount of newly-issued Treasuries. Because the Primary Dealers Act of 1988 obliges those dealers to get a “reasonable price” for Treasuries they underwrite, they typically submit bids at a range of prices on their own accounts. They can therefore find themselves acquiring substantial security inventories to dispose of gradually following the initial offering. But dealers have only so much money on hand, in so-called “clearing” accounts they keep at the Bank of New York Mellon, with which to finance their Treasury inventories. Because they only intend to carry such inventories for short periods, dealers naturally look to the repo market for additional funding and to replenish their depleted clearing accounts. Thanks to the inverted yield curve (again!), the demand for new Treasury securities hasn’t exactly been brisk. Dealers’ inventories and their demand for short-term funds by which to finance them have grown accordingly. On the very day of the repo spike, the Treasury placed about $50 billion in securities on the market, causing primary dealers in turn to purchase and then repo a substantial portion of those securities.

So there you have it: a host of developments adding to banks’ demand for excess reserves, while others gradually chipped away at the stock of such reserves. Add a spike in primary dealers’ demand for short-term funding, a coinciding round of tax payments that transferred as many reserves to the TGA, and binding intraday liquidity requirements at the banks holding a large share of total system excess reserves, and you have the makings of last month’s perfect repo-market storm.

Solutions: Shallow and Deep

On second thought, “perfect storm” is not the right metaphor, since such a storm is a freak event that’s unlikely to be repeated. What happened in the repo market is, in contrast, quite likely to repeat itself, and might be repeating itself as I write this were the Fed not repeatedly offering fresh reserves to the money market. Perhaps “climate change” is more like it.

In any case, so far as Fed officials are concerned, adding still more excess reserves to a U.S. banking system that once seemed to be drowning in them is the only way to fix things. In place of ongoing ad-hoc repo operations, the Fed ultimately intends to (1) establish the Standing Repo Facility (SRF) it has been contemplating for a while now, and (2) to begin expanding its balance sheet once again. Word on the street has it that the SRF will be up and running sometime early next year. As for renewed Fed balance sheet growth, Chairman Powell has already suggested that it’s coming, and odds are the FOMC will announce new purchases at this month’s meeting. Joe Gagnon expects the Fed to purchase about $250 billion in securities over the coming six months; but don’t be surprised if it buys even more.

But are these really the only solutions? The answer is that they are so only assuming that the Fed must stick to a floor system of monetary control. But a floor system is only one of many alternative operating systems the Fed could rely upon; and one need only recognize this to see, not only that there are other ways for the Fed to regain control of interest rates, but that some of those other ways make a lot more sense than the Fed’s preferred solution.

Two options in particular come to mind. One is to leave the banking system with a systematic liquidity deficit that makes it systematically dependent upon the proposed Standing Repo Facility. Implementing monetary policy would then be a simple matter of adjusting the overnight rate implicit in the terms of the SRF’s full-allotment (that is, unlimited) collateral purchases and sales. According to Ulrich Bindseil (p. 51), this sort of arrangement, which was long employed by the Reichsbank, and is similar to the way the Fed operated when it was first established, is actually “the simplest way to steer short term interest rates.” Besides making further outright security purchases unnecessary, the set-up would dispense with the need for a rate target “range” and the Overnight Reverse Repo Repurchase arrangement used to define and policy that range’s lower limit. Under it, excess reserves could still bear interest, though at a rate set below the SRF rate. Finally, to deal with financial crises, the SRF could be supplemented with a broader facility that would offer liquidity to banks in exchange for non-Treasury collateral at rates set using “product-mix” auctions designed to price risk and allocate emergency funds efficiently.

Alternatively, the Fed could replace its floor system with a corridor system. That means keeping the SRF rate above the Fed’s target, while setting the interest rate on reserves below it, and resorting to daily open-market operations to limit target rate variations within those boundaries. This solution is more challenging, owing to the very large open-market operations that might be needed to accommodate “autonomous” changes in the stock of reserves connected to changes in either the TGA balance or the size of the foreign repo pool. But the Fed could reduce that difficulty by placing caps on both the foreign repo program and the TGA, forcing the Treasury, through the latter change, to once again make use the TT&L (Treasury Tax and Loan) program for their originally intended purpose, namely, “reducing uncertainty about the supply of reserves in the banking system and simplifying the Fed’s implementation of monetary policy.”

[Cross-posted from Alt‑M.org]

The Cato 2019 Welfare, Work, and Wealth National Survey finds a solid majority (58%) of Americans favor a proposal that would allow parents to use a “voucher to enroll their children in a private school” with “government helping to pay the tuition” while 40% oppose.

Full survey results and report found here.

African Americans, lower-income Americans, high school graduates, and Republicans are most likely to favor letting parents use vouchers to send their kids to private school.

More than two-thirds (69%) of African Americans support school vouchers, compared to 56% of White and Latino Americans.

Nearly three-fourths (73%) of people with annual incomes below $20,000 and 64% of high school graduates support school vouchers. But support drops among those with incomes above $20,000 and college graduates to 55% and 52%, respectively. Nevertheless, slim majorities continue to favor the proposal.

Republicans (68%) and independents (61%) are more supportive of school vouchers than are Democrats (47%). Instead, 50% of Democrats oppose such a proposal.

School vouchers divide Democrats. A strong majority (61%) of liberal Democrats oppose school vouchers while a solid majority (60%) of moderate Democrats favor them.

55% of Americans Would Prefer to Send Their Kids to Private School; 59% of Democrats Prefer Public School

About 90% of children in elementary and secondary schools attend public schools.[1]But a majority (55%) of Americans would rather send their kids to a private school. This may help explain why a majority of Americans support vouchers for private school.

Majorities of Latino (57%), White (54%), and Black (51%) Americans prefer that their kids receive an education through a private school. But, young Americans stand out with their preference for public education. A slim majority (52%) of those under 30 prefer public to private school. However, Americans over 30, including those 30–44 (51%), 45–54 (56%), and over 55 (61%), would prefer private school.

There are striking partisan differences. More than two-thirds of Republicans (68%) and a majority (59%) of independents would rather send their kids to private school. However, a solid majority (59%) of Democrats prefer public school for their kids. This share rises to 65% among strong liberals.

25% of Americans Rate Their Local Public School as “Bad”

One reason why many Americans may prefer private schools is that they believe their local schools are of low or mediocre quality. A quarter (25%) of Americans currently rate the educational quality of schools in their neighborhoods as “somewhat” or “very bad.” Another 47% rate their local schools as “somewhat good,” and 27% say their schools are “very good.” Notably, lower income families are more likely to rate their local schools poorly. For instance, 37% of low-income respondents currently receiving welfare benefits rate their local schools as “bad.”

61% of Americans Support Tax Credits for Those Who Donate Toward Private School Scholarships

It is more expensive for a parent to send their children to a private school than a locally assigned public school. However, 61% of Americans favor a proposal to offer a tax credit to people or businesses “who donate to scholarships to help parents send their children to private school if they choose.” Another 37% oppose this proposal.

The proposal enjoys wide demographic and post-partisan support. Majorities of Black (62%), Latino (65%), and White (60%) Americans, as well as Democrats (52%), independents (66%), and Republicans (69%) all favor tax credits for donations to private school scholarships.

The issue, however, divides moderate and liberal Democrats. Two-thirds (67%) of moderate Democrats support the tax credit proposal while 56% of liberal Democrats oppose.

65% of Americans Support Offering Higher Salaries to Math and
Science Teachers

Nearly two-thirds (65%) of Americans support offering higher salaries to math and science school teachers and 34% oppose. This proposal also enjoys post-partisan support: 71% of Democrats, 63% of independents, and 59% of Republicans favor raising salaries for math and science teachers.

Read more of the survey report here.

The Cato Institute 2019 Welfare, Work, and Wealth Survey was designed and conducted by the Cato Institute in collaboration with YouGov. YouGov collected responses online March 5 to 8, 2019 from a representative national sample of 1,700 Americans 18 years of age and older. The margin of error for the survey is +/- 2.2 percentage points at the 95% level of confidence.

Sign up here to receive forthcoming Cato Institute survey reports.

[1]“Table 105.20: Enrollment in Elementary, Secondary, and Degree-Granting Postsecondary Institutions, by Level and Control of Institution, Enrollment Level, and Attendance Status and Sex of Student: Selected Years, Fall 1990 through Fall 2027,” Digest of Education Statistics, National Center for Education Statistics, U.S. Department of Education, https://​nces​.ed​.gov/​p​r​o​g​r​a​m​s​/​d​i​g​e​s​t​/​d​1​7​/​t​a​b​l​e​s​/​d​t​1​7​_​1​0​5​.​2​0​.​a​s​p​?​c​u​rrent=….

The Fall 2019 edition of the Cato Journal, the Cato Institute’s interdisciplinary journal of public policy, is now available online. This latest issue’s contributors tackle a range of timely topics—from Modern Monetary Theory, to the Supreme Court’s shifting stance on executive authority, to the politicization of the Federal Reserve, to the myths surrounding the meaning of an “optimal” top tax rate. You’ll find summaries of the articles on monetary matters—and links to their full text—here. Below is a run-down of two of this issue’s other highlights, with links to their full articles as well.

“Restructuring the U.S. Postal Service”

Chris Edwards, the Cato Institute’s Director of Tax Policy Studies and editor of down​siz​ing​gov​ern​ment​.org, calls for an overhaul of our current postal system modeled after several recent European privatization initiatives. Now on the verge of collapse, the United States Postal Service (USPS’) asset revenues have dropped by 5% over the past nine years, while its liability costs have skyrocketed by 167%. This situation, Edwards explains, is not wholly unique to the USPS: postal services around the world are struggling to reinvent themselves in the face of technological innovation and declining letter volumes. As a result, countries like Sweden and Germany are opening their postal markets to private competition and operational flexibility—and seeing remarkable increases in efficiency, affordability, and overall quality. Recommending that the USPS follow their lead, Edwards outlines four incremental reforms that the USPS should implement in the short term while it prepares to shift its services to the private sector in the long term.

First, however, Edwards details the economic and operational challenges currently facing the USPS. Some of these are external: technological innovation is winnowing public demand for letter delivery—once a massive source of revenue for the USPS, which enjoys a “legal monopoly” in that market. At the same time, package delivery—a market in which the USPS faces private competitors—is becoming an increasingly lucrative industry for those competitors, thanks in no small part to the “e‑tail” boom. The USPS’ other challenges, however, stem from its hybrid business structure. As a government-owned industry, it “enjoys a range of other benefits” that private corporations do not (like tax exemptions, legal immunities, and even certain regulatory powers). At the same time, the government “ties the hands of the USPS in many ways that prevent it from operating like a private enterprise.” Branches lack the authority to close unnecessary offices, adjust prices, or modify operating schedules to reflect shifts in demand. The awkward combination of privileges and prohibitions ultimately raises costs and lowers value for taxpayers and USPS branches themselves. After discussing the successful privatization initiatives now underway across several European postal markets, Edwards prescribes a similar set of remedies for Congress to adopt in crafting its own reform agenda for the USPS: allow it to close low-volume post office locations and “move… toward private sector labor and compensation standards”; reduce the scope of the USPS’ Universal Service Obligation (USO); prohibit it from cross-subsidizing its competitive services with revenues from its monopoly ones; and eventually, promote greater competition by making the USPS one player within a much more diversified, and far more innovative, postal delivery market.

“How the Supreme Court Promotes Independent Presidential Power”

Finally, Louis Fisher, a Constitutional Scholar at the Project on Government Oversight and a Visiting Scholar at the William and Mary Law School, reviews the alarming reversal of Constitutional precedent that has characterized many of the Supreme Court’s “war powers”-related decisions from 1936 onward. The U.S. Constitution grants Congress “express and implied authority in matters of war and foreign commerce,” Fisher begins, and for the first 147 years of its existence, Supreme Court precedent reflected Constitutional intent. Beginning with the 1936 case of United States v. Curtiss-Wright, however, the Court began to incrementally and systematically chip away at Congress’ statutory powers to initiate war and regulate foreign and interstate commerce, relegating the primary authority for these actions to the executive branch instead. “This determination to elevate the president above Congress,” writes Fisher, “inflict[s] substantial damage to democratic principles, the system of separation of powers and checks and balances, and constitutional government.” His article explores the series of flawed premises, judicial errors, and misconceptions about Presidential authority—especially in military affairs—that for nearly a century have inflated the power of the presidency at the expense of our Constitutional principles.

After cataloguing a number of 19^th century Supreme Court decisions that preserved the primacy of legislative discretion in military and commercial affairs, Fisher turns to the inflection point that reversed this trend: Justice George Sutherland’s discovery of the “sole organ doctrine” (which, as it happens, was not really a “doctrine” at all). Writing for the Court in its 1936 ruling on United States v. Curtiss-Wright, Justice Sutherland misinterpreted a phrase lifted from a speech—not a judicial decision—that Chief Justice John Marshall had delivered more than a century earlier, and under completely different circumstances, wherein Marshall had called the president “the sole organ of the nation in external relations.” By invoking (or perhaps creating) the so-called sole organ doctrine, Justice Sutherland endorsed the dubious theory that the executive holds “‘plenary and exclusive’ authority over foreign affairs.” Despite the fact that “Sutherland’s sole-organ theory was patently false,” however, it rapidly became canon, to the extent that the U.S. v. Curtiss-Wright ruling has since been called “the birth of the imperial presidency.” Fisher traces the ever-lengthening shadow of Curtiss-Wright and its misappropriation of the “sole organ doctrine” to the Nazi saboteur case (1942); the Japanese internment cases (1943–44); the Jerusalem passport case (2002); and several others. He also documents the scattered history of deviations from this new norm, but notes that even after the Supreme Court finally “jettisoned the sole organ doctrine” in 2015, it “proceeded to create a close cousin,” whose effects have arguably been just as damaging.