Friday, September 5, 2008
McCain's Speech: The Maverick Returns
McCain gave a compelling speech last night telling Americans the basis of his candidacy: to take on the vested interests, to end the excessive partisanship, and to seek ideas from both parties to solve America's problems. McCain is no orator, and his speech came across as flat at times. However, at times it was moving. In the midst of describing how his Vietnam experience shaped him into the maverick that he is, he did the unexpected-- he said "they broke me." His story was not one of triumph, or of a man conquering all the odds, but rather one of being broken and having his old self give rise to a new self. To me, this makes him deserving of even more respect. In life growth usually comes not through accomplishment and strength and self-aggrandizement. It comes during those moments when life seems bleak, when opportunities seem nowhere, and when strength seems to be slipping away. At the end of that tunnel, provided we allow it, comes redemption, wisdom, and character.
Tuesday, September 2, 2008
McCain vs. Obama: Taxes Edition
Martin Feldstein, Professor of Economics at Harvard and former chair of the National Bureau of Economic Research, and John Taylor, Professor of Economics at Stanford, give their take on McCain's tax plans and how they compare to Obama's. To read, go here.
Sunday, August 31, 2008
Politics Recap
Oh how much can change in just one week! Obama gives a stirring speech in accepting his historic nomination as the Democratic candidate for President, and then McCain stuns the country by providing a little history of his own by selecting Alaska's young, female reformer Governor Sarah Palin!
Some of what Obama spoke of I agreed with and greatly appreciated. He spoke of America's enduring promise, and of the character of this country and of his hope that we can recapture the optimism that has been lacking during the past few years.
"What -- what is that American promise? It's a promise that says each of us has the freedom to make of our own lives what we will, but that we also have obligations to treat each other with dignity and respect.
It's a promise that says the market should reward drive and innovation and generate growth, but that businesses should live up to their responsibilities to create American jobs, to look out for American workers, and play by the rules of the road.
Ours -- ours is a promise that says government cannot solve all our problems, but what it should do is that which we cannot do for ourselves: protect us from harm and provide every child a decent education; keep our water clean and our toys safe; invest in new schools, and new roads, and science, and technology.
Our government should work for us, not against us. It should help us, not hurt us. It should ensure opportunity not just for those with the most money and influence, but for every American who's willing to work.
That's the promise of America, the idea that we are responsible for ourselves, but that we also rise or fall as one nation, the fundamental belief that I am my brother's keeper, I am my sister's keeper.
That's the promise we need to keep. That's the change we need right now."
That's about where my agreement ends (although I could nitpick and find disagreements in those paragraphs as well). Most of the rest of his speech was a mix of vague wishes, distortions about McCain's record and policies, and standard Democratic fare. Unsurprisingly, Obama tried to paint McCain as Bush's clone and heir, in part by pointing to McCain supposedly voting with Bush 90% of the time. It's a great line, except for the fact that it is a distortion. Not only is Bush not a legislator who casts votes, but in fact the vast majority of Senate votes are unanimous and uncontentious votes naming post offices, congratulating sports teams, and passing minor bills. To count these in any tally determining the similarity of two peoples' voting records is disingenuous and misleading. By this approach I would not be surprised if Obama "voted with Bush" over 80% of the time! Distortion number two came when Obama talked about the comments made by Senator Gramm, a former advisor to McCain, calling the country "whiners." Aside from the fact that Obama took the quote out of context, he also gave the impression that McCain agreed with the comments, despite McCain's actual immediate denunciation of the comments and Gramm subsequently leaving his position. Distortion number three came when Obama claimed that McCain defined the middle class as being anybody earning under $5 million a year. Anybody who watched McCain's actual comments on the matter, which came during the recent Saddleback forum, knows that McCain never defined the middle class, and made a joke about someone earning $5 million a year being rich, where he also joked that Obama would likely take it out of context (how prescient...).When it came to substance, Obama continues to prove that he is no post-partisan healer or policy innovator, but is rather just another standard liberal Democrat who can smooth over his positions with vague and inspiring rhetoric. Obama talked about McCain risking peoples's Social Security, but consider the fact: McCain would like workers to be able to put a portion of their payroll taxes into accounts with their names on it, far away from the legislators who currently are leading the system into bankruptcy. Obama, on the other hand, offers the same-old Democratic prescription for Social Security-- no reform, but more money and redistribution.
John McCain chooses Sarah Palin for VP
John McCain followed up Obama's speech with a bit of great timing and political theater of his own. Contrary to everybody's expectations, McCain bypassed Mitt Romney, Tim Pawlenty, and Joe Lieberman, among others, to pick Sarah Palin as his VP. She has her drawbacks-- she has only been in what I would call a major elected office for 2 years. However, she has many strengths-- she took on corrupt members of her own party in order to become Governor and before that as a member of the Oil and Natural Gas Conservation Commission, including some of their shady dealings with the oil companies, she is an expert when it comes to energy policy and a strong advocate for drilling and effectively using our natural resources, she has a compelling personal story which is different from that of the stereotypical Republican, and is a no-nonsense reformer and political maverick. In the coming days I am sure I will discuss this issue at more length, but my first impression: brilliant pick.
Friday, August 22, 2008
My Tome on Economics, Markets, and Society
These comments are with reference to the two articles I included in my post entitled "On Economics, Markets, and Society" several days ago.
The main thesis of the City Journal article, "Economics Does Not Lie," is that the field of economics has reached the status, in terms of objectivity and mathematical rigor, of a science, and that beyond this, economics has shown us that capitalism is the best economic system. While my own personal views are not far from this, there are some essential nuances and differences in reasoning that cause me to make the conclusions I make, and that could just as easily cause others to come to different conclusions.
Proposition 1: Economics is a science.
In particular, economics has now reached the level of scientific rationality. With this point I am in fairly strong agreement. I will call a discipline scientific if it follows the scientific method.
For the sake of comparison, I will place economists into three camps: string theorists, experimental scientists, and engineers. The "string theorists" group is for those economists who focus on economic theory, whether it be macroeconomic theory, microeconomic theory, or any other branch of economics where the work is almost entirely abstract and mathematical with little connection to actual data. The work of these economists forms the foundation for how economists view the world and gives rise to the models that "experimental scientists" use to compare to real-world phenomena. I call these economists "string theorists" because their work is highly theoretical (but do not confuse this with impractical or irrelevant), mathematical, and unverifiable without the work of the "experimental scientists." Just as string theorists seek to create a mathematical structure that unifies the various natural laws, theoretical economists seek to create a mathematical framework that explains the economic phenomena that we observe. While there are many philosophical discussions that I could envision arising from what I have said here, I will have to postpone that until later (and more importantly, until somebody actually asks a specific question that could steer the discussion).
The economists in the "experimental science" group do work that is most analogous to the work that most scientists do. Economists make an observation about some economic event, they collect data, make a hypothesis (usually in the form of constructing a model or using an existing one), and they test the hypothesis through the use of econometrics, statistics, and other mathematical forms of reasoning. What differentiates economics from most of the sciences, however, is that economists cannot control, let alone reproduce, the experiment (Actually, this is not entirely true. Nothing in principle prevents economists from reproducing an episode of hyperinflation or a Great Depression, but limits of practicality and ethics prevent them from doing so.) However, this does not mean that an "experimental scientist's" work is shielded from peer review, or that other economists cannot reproduce their results. Rather, it means that in some instances, the raw data is not reproducible, but every other step in the analysis can be reproduced. This is also true in some instances in other sciences, such as in the irreproducibility of the big bang or of macro-evolution.
Proposition 2: Most economists are free-market purists.
Before I address the 10 propositions that economics supposedly definitively teaches us, I want to address more generally the notion that economists are, as I said above, free-market purists. The short answer is that that is simply not true. Daniel Klein and Charlotta Stern conducted a survey of members of the American Economic Association (who tend to be academic economists) to determine their views on major public policy issues. Although the economists were far more accepting of free-market principles than, say, anthropology professors, and although the economists did agree on certain issues, such as the virtue of international trade, they tended not to fall onto any one side for most other issues. There was no unanimity regarding whether or not the government should increase redistribution, or whether the minimum wage should be increased, etc. Why is there so little agreement? Greg Mankiw gives his take here. I believe there are two essential reasons for why economists do not agree.
Reason 1: Different views of reality
Most of what Greg Mankiw mentioned in his post falls under this umbrella. There is no universal consensus on the size of tax inefficiencies, or on the size of externalities from pollution. As a result, economists can extrapolate from whatever papers they have read, filter that through their worldview, and come to a personal belief about how the economy functions. Of course, an intellectually honest economist can only do this so much.
Reason 2: Different values
To me, this is the biggest factor that causes economists to disagree with one another, and it is likely highly correlated with economists' different views of reality. Consider the example of international trade. It is accepted almost universally among economists that international trade increases the total net welfare of any country that participates in it. However, it is also generally accepted that within each country there will be winners and losers. It just happens to be the case that the sum of the monetary losses will be exceeded by the sum of the monetary gains. This means that in principle (though not so much in reality, at least right now) we could collect all the gains from trade and redistribute them in such a way as to make everybody better off. Seeing as this does not happen very much, we are left with winners and losers. Free-market economists, because of their values, may believe that the government should not have the right to prevent willing participants from engaging in mutually beneficial trade, and they may believe that the fact that trade yields a net gain is more important than the actual distribution of gains. Trade skeptics, on the other hand, may believe that the government should have the right to interfere with international transactions if doing so impacts the distribution of income in a way that they find desirable. This is simply a question of values.
Now, to briefly analyze and critique the ten propositions:
1. The market economy is the most efficient of all economic systems.
Actual economic theory does not support any such universal proclamation. It is true that in an economy with no information asymmetries, no externalities, no barriers to entry, and no industry concentration, the market allocation will be efficient (which means that there is no way to make anybody better off without making somebody else worse off). This is in fact the first fundamental theorem of welfare. This sounds like thin gruel compared to the statement that the market economy is the most efficient of all economic systems.
On the other hand, the Myerson-Satterthwaite theorem states that in a market with voluntary participation and asymmetric information about how much participants in the market value the good, there is no efficient mechanism of exchanging the goods. This means that even the market is inefficient here. Basically, there will be instances where mutually beneficial trade could occur between buyers but does not, precisely because of the information asymmetries.
Lastly, one issue that prevents the unfettered marketplace from being efficient is the issue of incomplete markets. In particular, for some goods (and bads) there are no markets in which they can be traded. For example, this can mean that individuals do not have sufficient ability to insure against various types of economic risk. In addition, this means that externalities arise, such as the externality arising from firms being able to pollute without taking into account the cost imposed on the rest of society.
Ironically, the article gives the example of cap-and-trade to support its statement that markets are efficient:
"Market mechanisms are so efficient that they can manage threats to long-term development, such as the exhaustion of natural resources, far better than states can. If global warming does become a real problem, for example, price mechanisms or a carbon tax would easily encourage a more efficient use of energy."
On the one hand, markets are so efficient that they can manage threats to long-term development. On the other hand, the government has to interfere with the economy in order to create a market to deal with the externality caused by pollution.
Modified principle: In most instances, markets, where they exist, tend to allocate resources in the most efficient manner. However, government can improve economic efficiency by creating markets where they do not exist, and by regulating markets to deal with the inefficiencies caused by information asymmetries.
2. Free trade helps economic development.
Mr. Sorman claims the following:
"In fact, economists have long understood the law of comparative advantage: whenever differences in the cost of producing goods exist between two countries, both will benefit from free trade, a mechanism that allocates their resources most effectively."
Mr. Sorman is correct that economists have long understood the law of comparative advantage, except that what he wrote down is not the law of comparative advantage. Instead,
"The principle of comparative advantage shows that even if a country has no absolute advantage in any product (ie. it is not the most efficient producer for any good), the disadvantaged country can still benefit from specializing in and exporting the product(s) for which it has the lowest opportunity cost of production."
In short, a country has a comparative advantage in a particular product if the trade-off within that country between producing that product and producing another product is better than that same trade-off within the other country. The example I like to think of is that of a lawyer and his secretary. Even if the lawyer is better than his secretary both at arguing cases and at typing documents on the computer (ie he has an absolute advantage in both areas), it would benefit the lawyer to hire the secretary to do his typing for him so that he can focus on the area where he has the comparative advantage, namely arguing cases. Since his comparative advantage is arguing cases, it must be that the secretary's comparative advantage is in typing documents on the computer, even though the lawyer has an absolute advantage in both areas. The key is that his trade-off between arguing cases and typing documents is much worse than hers-- he has to give up much valuable time arguing cases in order to type the documents, whereas since she cannot argue cases anyway, she does not have to give up time spent arguing cases.
My point here is not to quibble over economics definitions, but rather to distinguish between the actual source of the benefits of trade and that touted by pundits. The United States does not benefit from trade primarily because it can import cheaper products. Instead, the United States benefits from international trade because trade causes us to specialize in the production of goods and services that we are best at producing, while allowing us to import those products that other countries can better specialize in.
Aside from mentioning comparative advantage, the article also states that "Free trade not only generates the greatest possible growth; it tends to distribute it widely, both within nations and among them." This is not entirely true. Within a country, people working in the sectors in which the country has a comparative advantage will say their pay increase, whereas people in the other sectors will see their pay decrease (or they will lose their jobs). Since the United States has a high-tech economy, trade causes the pay of those with more skills (who tend already to be more well-off) to increase, while decreasing the pay of others. Therefore, in the United States, trade likely causes a (modest) increase in inequality. In less-advanced economies, the effect of trade is the exact opposite. Where Mr. Sorman is correct is in stating that free trade tends to distribute growth widely among nations. We have seen this as South Korea, Japan, Western Europe, and many other nations have seen their incomes converge to that of the United States.
Note: While most of what I have said is widely accepted among economists, I also recognize that there are more sophisticated models that may give rise to exceptions or even disagreements. Seeing as I am not an expert on these issues, I give you what I know and what economists generally agree with.
3. Good institutions help development.
I generally agree with what the article says on this topic, at least until it veers into the area of behavioral economics. I do not have much to add here, except to say that the economics of institutions is becoming an even more active field of research, and I look forward to learning more about it.
4. The best measure of a good economy is its growth.
The main problem I have with this proposition is not the content of the paragraphs that follow it, but the actual text of the proposition itself. There are many objective measures that we can use to assess the health of the economy. GDP is one of the most important measures, since it tells us the total value of all goods and services produced within the country. If GDP decreases, then that means we are producing less, which means there is less to go around. However, there is nothing in economics that dictates that growth is a better measure of a good economy than low inflation or a broad distribution of wealth. Nevertheless, I do agree as a matter of personal opinion that we should focus on having strong economic growth as a high priority, since without growth many economic debates would degenerate into zero-sum games where we fight over an unchanging pie.
5. Creative destruction is the engine of economic growth.
I agree.
6. Monetary stability, too, is necessary for growth; inflation is always harmful.
Economists are in wide agreement that inflation is harmful for the economy, and that one of the primary responsibilities of a central bank is to keep inflation low. Furthermore, high inflation typically means unpredictable inflation, whereas low inflation is usually less variable. High inflation rates discourage savings and investment because it makes the rate of return less certain and more likely to be lower than it would be if people expected the price level to be stable. In addition, inflation, by eroding the value of the dollar, makes the real value of nominal debt decrease. While this of course is of great help to debtors, high inflation expectations will make lenders less willing to lend, which hurts borrowers. Inflation also exerts a pernicious influence through the tax code, known as bracket creep. Since the income thresholds in the tax code are based on nominal dollars, inflation over time causes people to appear as if they are wealthier than they are, and therefore pushes them into higher tax brackets.
In a more abstract but equally valid sense, inflation is harmful because it drives a wedge between the social cost of money and the economic cost, whereas in economics we want social costs to equal economic costs. The social cost of money is the cost to actually produce money, which is effectively zero. The economic cost, however, is not zero, as inflation causes nominal interest rates to rise.
7. Unemployment among unskilled workers is largely determined by how much labor costs.
"So regulating the labor market (with a minimum wage, for example) adds to labor costs, economists acknowledge, and increases unemployment. No solution to excessive unemployment is conceivable without reducing such regulations."
Guy Sorman tries to generate a consensus that does not actually exist among economists. Even if labor markets are perfectly competitive, what Mr. Sorman says is not true. This is because if labor markets are perfectly competitive, wages will adjust so as to cause zero unemployment (or at least zero frictional unemployment). If firms have market power (or in the extreme, if a firm is a monopsony-- the analogy to a monopoly, except the firm being a single buyer instead of a single seller), then labor costs are not the only factor in determining unemployment. In such a setting, the minimum wage can actually increase efficiency in the labor market by bringing the market closer to perfect competition.
Even in labor markets that are not characterized by firms with a lot of market power, the minimum wage can have a more complicated impact on labor market outcomes. Some economic research, such as Daron Acemoglu's paper Good Jobs and Bad Jobs, suggests that minimum wages can induce firms to create higher paying jobs and invest more in training. This result is not universal, however, and there are many studies that point to the negative effects of minimum wages. Since minimum wages do increase the cost of labor, it is entirely reasonable to expect that firms will purchase less of that labor.
Minimum wages do not represent the only form of labor market regulations, however. I have no intention of discussing every bit of labor legislation, but I will say that Mr. Sorman hits the nail on the head when he talks about some of the labor market woes in Europe. Whenever the government makes it nearly impossible to fire a worker, such as in France, employers have a strong incentive not to hire. After all, if the economy worsens, or if the worker underperforms, the employer is already locked into the employment contract. This is one reason why in France unemployment is much higher than in the United States, and also why there is much more temporary employment there.
8. While the welfare state is necessary in some form, it isn’t always effective.
This statement, mostly by virtue of its vagueness, is true. Mr. Sorman's first statement says it all: "Economists recognize that government assistance always produces incentives that may affect, for good or ill, recipients’ behavior and well-being." Whether we are talking about unemployment insurance, welfare benefits, Medicare, or Social Security, these programs affect the marginal costs and benefits of saving, investing, going to school to get a more high-powered occupation, finding a job and working more. The reason for the success (at least partial success) of welfare reform in the 1990's was that it reduced the cost to earning more income and made it more costly to stay on welfare. Before welfare reform, it was actually possible to be in a situation where you were living on welfare, food stamps, and Medicaid, and if you found a job, you would lose enough eligibility so as to actually be worse off. Unsurprisingly, these kind of incentives lead to more people locked in dependency with little ability or motivation to get out of it.
None of this is to say that we should dismantle the welfare state. I will have to postpone fully delving into this issue until later, but needless to say, the key is to design a safety net that helps people get on their feet, and provides assistance and incentives to invest in themselves and move up the economic ladder.
9. The creation of complex financial markets has brought about economic progress.
I have already discussed this issue at more length in my posts about Fannie Mae, Freddie Mac, and government bail-outs. Nevertheless, in summary, the US benefits greatly from having sophisticated and fluid financial markets. At the same time, these markets, due to the extreme importance of transparency and information, and due to their strong interdependence with the rest of the US economy, are more fragile and in need of effective, efficient regulation.
10. Competition is usually desirable.
Without rehashing many of the points I have already made, I'll go ahead and simply agree.
Conclusion: Economics has evolved and developed substantially in the past few decades. Its methods have become more rigorous, mathematical, and objective, even while its conclusions in many areas remain debated and contested. None of this is to say that economists are completely devoid of consensus. On many of the big, philosophical issues of the day, economists will find that they have more in common with each other than not. However, economics is not at a point where it can dictate the best public policy. In fact, the field of economics itself will likely never be at such a point, since public policy choices rely on economic facts as well as values. What we can look forward to and aspire to is having economics more accurately and decisively weigh in on the workings of the economy and on the effects of different policy choices.
The main thesis of the City Journal article, "Economics Does Not Lie," is that the field of economics has reached the status, in terms of objectivity and mathematical rigor, of a science, and that beyond this, economics has shown us that capitalism is the best economic system. While my own personal views are not far from this, there are some essential nuances and differences in reasoning that cause me to make the conclusions I make, and that could just as easily cause others to come to different conclusions.
Proposition 1: Economics is a science.
In particular, economics has now reached the level of scientific rationality. With this point I am in fairly strong agreement. I will call a discipline scientific if it follows the scientific method.
For the sake of comparison, I will place economists into three camps: string theorists, experimental scientists, and engineers. The "string theorists" group is for those economists who focus on economic theory, whether it be macroeconomic theory, microeconomic theory, or any other branch of economics where the work is almost entirely abstract and mathematical with little connection to actual data. The work of these economists forms the foundation for how economists view the world and gives rise to the models that "experimental scientists" use to compare to real-world phenomena. I call these economists "string theorists" because their work is highly theoretical (but do not confuse this with impractical or irrelevant), mathematical, and unverifiable without the work of the "experimental scientists." Just as string theorists seek to create a mathematical structure that unifies the various natural laws, theoretical economists seek to create a mathematical framework that explains the economic phenomena that we observe. While there are many philosophical discussions that I could envision arising from what I have said here, I will have to postpone that until later (and more importantly, until somebody actually asks a specific question that could steer the discussion).
The economists in the "experimental science" group do work that is most analogous to the work that most scientists do. Economists make an observation about some economic event, they collect data, make a hypothesis (usually in the form of constructing a model or using an existing one), and they test the hypothesis through the use of econometrics, statistics, and other mathematical forms of reasoning. What differentiates economics from most of the sciences, however, is that economists cannot control, let alone reproduce, the experiment (Actually, this is not entirely true. Nothing in principle prevents economists from reproducing an episode of hyperinflation or a Great Depression, but limits of practicality and ethics prevent them from doing so.) However, this does not mean that an "experimental scientist's" work is shielded from peer review, or that other economists cannot reproduce their results. Rather, it means that in some instances, the raw data is not reproducible, but every other step in the analysis can be reproduced. This is also true in some instances in other sciences, such as in the irreproducibility of the big bang or of macro-evolution.
Proposition 2: Most economists are free-market purists.
Before I address the 10 propositions that economics supposedly definitively teaches us, I want to address more generally the notion that economists are, as I said above, free-market purists. The short answer is that that is simply not true. Daniel Klein and Charlotta Stern conducted a survey of members of the American Economic Association (who tend to be academic economists) to determine their views on major public policy issues. Although the economists were far more accepting of free-market principles than, say, anthropology professors, and although the economists did agree on certain issues, such as the virtue of international trade, they tended not to fall onto any one side for most other issues. There was no unanimity regarding whether or not the government should increase redistribution, or whether the minimum wage should be increased, etc. Why is there so little agreement? Greg Mankiw gives his take here. I believe there are two essential reasons for why economists do not agree.
Reason 1: Different views of reality
Most of what Greg Mankiw mentioned in his post falls under this umbrella. There is no universal consensus on the size of tax inefficiencies, or on the size of externalities from pollution. As a result, economists can extrapolate from whatever papers they have read, filter that through their worldview, and come to a personal belief about how the economy functions. Of course, an intellectually honest economist can only do this so much.
Reason 2: Different values
To me, this is the biggest factor that causes economists to disagree with one another, and it is likely highly correlated with economists' different views of reality. Consider the example of international trade. It is accepted almost universally among economists that international trade increases the total net welfare of any country that participates in it. However, it is also generally accepted that within each country there will be winners and losers. It just happens to be the case that the sum of the monetary losses will be exceeded by the sum of the monetary gains. This means that in principle (though not so much in reality, at least right now) we could collect all the gains from trade and redistribute them in such a way as to make everybody better off. Seeing as this does not happen very much, we are left with winners and losers. Free-market economists, because of their values, may believe that the government should not have the right to prevent willing participants from engaging in mutually beneficial trade, and they may believe that the fact that trade yields a net gain is more important than the actual distribution of gains. Trade skeptics, on the other hand, may believe that the government should have the right to interfere with international transactions if doing so impacts the distribution of income in a way that they find desirable. This is simply a question of values.
Now, to briefly analyze and critique the ten propositions:
1. The market economy is the most efficient of all economic systems.
Actual economic theory does not support any such universal proclamation. It is true that in an economy with no information asymmetries, no externalities, no barriers to entry, and no industry concentration, the market allocation will be efficient (which means that there is no way to make anybody better off without making somebody else worse off). This is in fact the first fundamental theorem of welfare. This sounds like thin gruel compared to the statement that the market economy is the most efficient of all economic systems.
On the other hand, the Myerson-Satterthwaite theorem states that in a market with voluntary participation and asymmetric information about how much participants in the market value the good, there is no efficient mechanism of exchanging the goods. This means that even the market is inefficient here. Basically, there will be instances where mutually beneficial trade could occur between buyers but does not, precisely because of the information asymmetries.
Lastly, one issue that prevents the unfettered marketplace from being efficient is the issue of incomplete markets. In particular, for some goods (and bads) there are no markets in which they can be traded. For example, this can mean that individuals do not have sufficient ability to insure against various types of economic risk. In addition, this means that externalities arise, such as the externality arising from firms being able to pollute without taking into account the cost imposed on the rest of society.
Ironically, the article gives the example of cap-and-trade to support its statement that markets are efficient:
"Market mechanisms are so efficient that they can manage threats to long-term development, such as the exhaustion of natural resources, far better than states can. If global warming does become a real problem, for example, price mechanisms or a carbon tax would easily encourage a more efficient use of energy."
On the one hand, markets are so efficient that they can manage threats to long-term development. On the other hand, the government has to interfere with the economy in order to create a market to deal with the externality caused by pollution.
Modified principle: In most instances, markets, where they exist, tend to allocate resources in the most efficient manner. However, government can improve economic efficiency by creating markets where they do not exist, and by regulating markets to deal with the inefficiencies caused by information asymmetries.
2. Free trade helps economic development.
Mr. Sorman claims the following:
"In fact, economists have long understood the law of comparative advantage: whenever differences in the cost of producing goods exist between two countries, both will benefit from free trade, a mechanism that allocates their resources most effectively."
Mr. Sorman is correct that economists have long understood the law of comparative advantage, except that what he wrote down is not the law of comparative advantage. Instead,
"The principle of comparative advantage shows that even if a country has no absolute advantage in any product (ie. it is not the most efficient producer for any good), the disadvantaged country can still benefit from specializing in and exporting the product(s) for which it has the lowest opportunity cost of production."
In short, a country has a comparative advantage in a particular product if the trade-off within that country between producing that product and producing another product is better than that same trade-off within the other country. The example I like to think of is that of a lawyer and his secretary. Even if the lawyer is better than his secretary both at arguing cases and at typing documents on the computer (ie he has an absolute advantage in both areas), it would benefit the lawyer to hire the secretary to do his typing for him so that he can focus on the area where he has the comparative advantage, namely arguing cases. Since his comparative advantage is arguing cases, it must be that the secretary's comparative advantage is in typing documents on the computer, even though the lawyer has an absolute advantage in both areas. The key is that his trade-off between arguing cases and typing documents is much worse than hers-- he has to give up much valuable time arguing cases in order to type the documents, whereas since she cannot argue cases anyway, she does not have to give up time spent arguing cases.
My point here is not to quibble over economics definitions, but rather to distinguish between the actual source of the benefits of trade and that touted by pundits. The United States does not benefit from trade primarily because it can import cheaper products. Instead, the United States benefits from international trade because trade causes us to specialize in the production of goods and services that we are best at producing, while allowing us to import those products that other countries can better specialize in.
Aside from mentioning comparative advantage, the article also states that "Free trade not only generates the greatest possible growth; it tends to distribute it widely, both within nations and among them." This is not entirely true. Within a country, people working in the sectors in which the country has a comparative advantage will say their pay increase, whereas people in the other sectors will see their pay decrease (or they will lose their jobs). Since the United States has a high-tech economy, trade causes the pay of those with more skills (who tend already to be more well-off) to increase, while decreasing the pay of others. Therefore, in the United States, trade likely causes a (modest) increase in inequality. In less-advanced economies, the effect of trade is the exact opposite. Where Mr. Sorman is correct is in stating that free trade tends to distribute growth widely among nations. We have seen this as South Korea, Japan, Western Europe, and many other nations have seen their incomes converge to that of the United States.
Note: While most of what I have said is widely accepted among economists, I also recognize that there are more sophisticated models that may give rise to exceptions or even disagreements. Seeing as I am not an expert on these issues, I give you what I know and what economists generally agree with.
3. Good institutions help development.
I generally agree with what the article says on this topic, at least until it veers into the area of behavioral economics. I do not have much to add here, except to say that the economics of institutions is becoming an even more active field of research, and I look forward to learning more about it.
4. The best measure of a good economy is its growth.
The main problem I have with this proposition is not the content of the paragraphs that follow it, but the actual text of the proposition itself. There are many objective measures that we can use to assess the health of the economy. GDP is one of the most important measures, since it tells us the total value of all goods and services produced within the country. If GDP decreases, then that means we are producing less, which means there is less to go around. However, there is nothing in economics that dictates that growth is a better measure of a good economy than low inflation or a broad distribution of wealth. Nevertheless, I do agree as a matter of personal opinion that we should focus on having strong economic growth as a high priority, since without growth many economic debates would degenerate into zero-sum games where we fight over an unchanging pie.
5. Creative destruction is the engine of economic growth.
I agree.
6. Monetary stability, too, is necessary for growth; inflation is always harmful.
Economists are in wide agreement that inflation is harmful for the economy, and that one of the primary responsibilities of a central bank is to keep inflation low. Furthermore, high inflation typically means unpredictable inflation, whereas low inflation is usually less variable. High inflation rates discourage savings and investment because it makes the rate of return less certain and more likely to be lower than it would be if people expected the price level to be stable. In addition, inflation, by eroding the value of the dollar, makes the real value of nominal debt decrease. While this of course is of great help to debtors, high inflation expectations will make lenders less willing to lend, which hurts borrowers. Inflation also exerts a pernicious influence through the tax code, known as bracket creep. Since the income thresholds in the tax code are based on nominal dollars, inflation over time causes people to appear as if they are wealthier than they are, and therefore pushes them into higher tax brackets.
In a more abstract but equally valid sense, inflation is harmful because it drives a wedge between the social cost of money and the economic cost, whereas in economics we want social costs to equal economic costs. The social cost of money is the cost to actually produce money, which is effectively zero. The economic cost, however, is not zero, as inflation causes nominal interest rates to rise.
7. Unemployment among unskilled workers is largely determined by how much labor costs.
"So regulating the labor market (with a minimum wage, for example) adds to labor costs, economists acknowledge, and increases unemployment. No solution to excessive unemployment is conceivable without reducing such regulations."
Guy Sorman tries to generate a consensus that does not actually exist among economists. Even if labor markets are perfectly competitive, what Mr. Sorman says is not true. This is because if labor markets are perfectly competitive, wages will adjust so as to cause zero unemployment (or at least zero frictional unemployment). If firms have market power (or in the extreme, if a firm is a monopsony-- the analogy to a monopoly, except the firm being a single buyer instead of a single seller), then labor costs are not the only factor in determining unemployment. In such a setting, the minimum wage can actually increase efficiency in the labor market by bringing the market closer to perfect competition.
Even in labor markets that are not characterized by firms with a lot of market power, the minimum wage can have a more complicated impact on labor market outcomes. Some economic research, such as Daron Acemoglu's paper Good Jobs and Bad Jobs, suggests that minimum wages can induce firms to create higher paying jobs and invest more in training. This result is not universal, however, and there are many studies that point to the negative effects of minimum wages. Since minimum wages do increase the cost of labor, it is entirely reasonable to expect that firms will purchase less of that labor.
Minimum wages do not represent the only form of labor market regulations, however. I have no intention of discussing every bit of labor legislation, but I will say that Mr. Sorman hits the nail on the head when he talks about some of the labor market woes in Europe. Whenever the government makes it nearly impossible to fire a worker, such as in France, employers have a strong incentive not to hire. After all, if the economy worsens, or if the worker underperforms, the employer is already locked into the employment contract. This is one reason why in France unemployment is much higher than in the United States, and also why there is much more temporary employment there.
8. While the welfare state is necessary in some form, it isn’t always effective.
This statement, mostly by virtue of its vagueness, is true. Mr. Sorman's first statement says it all: "Economists recognize that government assistance always produces incentives that may affect, for good or ill, recipients’ behavior and well-being." Whether we are talking about unemployment insurance, welfare benefits, Medicare, or Social Security, these programs affect the marginal costs and benefits of saving, investing, going to school to get a more high-powered occupation, finding a job and working more. The reason for the success (at least partial success) of welfare reform in the 1990's was that it reduced the cost to earning more income and made it more costly to stay on welfare. Before welfare reform, it was actually possible to be in a situation where you were living on welfare, food stamps, and Medicaid, and if you found a job, you would lose enough eligibility so as to actually be worse off. Unsurprisingly, these kind of incentives lead to more people locked in dependency with little ability or motivation to get out of it.
None of this is to say that we should dismantle the welfare state. I will have to postpone fully delving into this issue until later, but needless to say, the key is to design a safety net that helps people get on their feet, and provides assistance and incentives to invest in themselves and move up the economic ladder.
9. The creation of complex financial markets has brought about economic progress.
I have already discussed this issue at more length in my posts about Fannie Mae, Freddie Mac, and government bail-outs. Nevertheless, in summary, the US benefits greatly from having sophisticated and fluid financial markets. At the same time, these markets, due to the extreme importance of transparency and information, and due to their strong interdependence with the rest of the US economy, are more fragile and in need of effective, efficient regulation.
10. Competition is usually desirable.
Without rehashing many of the points I have already made, I'll go ahead and simply agree.
Conclusion: Economics has evolved and developed substantially in the past few decades. Its methods have become more rigorous, mathematical, and objective, even while its conclusions in many areas remain debated and contested. None of this is to say that economists are completely devoid of consensus. On many of the big, philosophical issues of the day, economists will find that they have more in common with each other than not. However, economics is not at a point where it can dictate the best public policy. In fact, the field of economics itself will likely never be at such a point, since public policy choices rely on economic facts as well as values. What we can look forward to and aspire to is having economics more accurately and decisively weigh in on the workings of the economy and on the effects of different policy choices.
Might Obama Actually Lose?
Gerard Baker has a reasonable summary of the Presidential race so far, and from a European nonetheless!
Tuesday, August 5, 2008
Awaiting 'The One'
This is one of the best political satire pieces I have ever read.
"And it came to pass, in the eighth year of the reign of the evil Bush the Younger (The Ignorant), when the whole land from the Arabian desert to the shores of the Great Lakes had been laid barren, that a Child appeared in the wilderness..."
Read the rest here.
Friday, August 1, 2008
Wednesday, July 30, 2008
On Economics, Markets, and Society
I have read a couple of good articles recently which touch on the issues of economics, markets, and society more broadly. In particular, what does economic analysis have to say for how society functions and how it should function? What are markets, and what does economics truly say about them, and how does that compare to the popularized slogans that we hear so often? How does the implementation of markets fit in with other societal goals that we want to achieve? Here are the articles that I have read recently and that I will address, to the best of my ability, point-by-point:
"What Fannie Mae and Freddie Mac Tell Us About Free Markets" - Harvard Business Review Editor's Blog
"Economics Does Not Lie" - City Journal
"What Fannie Mae and Freddie Mac Tell Us About Free Markets" - Harvard Business Review Editor's Blog
"Economics Does Not Lie" - City Journal
More Articles on Housing, and Fannie and Freddie
- McCain on Fannie Mae and Freddie Mac, courtesy of Lawrence Kudlow. I couldn't agree more.
- The dangers and consequences of the government directing industries and telling businesses what to do: here and here.
- An alternative view on government-sponsored enterprises.
This last line is highly deceptive: "Seventy-six years after it was created by a president whose administration was hostile to government intervention in markets, the FHLB stands as an enduring and (so far) effective example of socialism among capitalists." Quite to the contrary, the structure of the FHLB is far different from that of Fannie Mae and Freddie Mac, and far less socialistic. First of all, because its customers are also its members, the FHLB has a strong disincentive from acquiring an irresponsible amount of risk, which is precisely why it has "high standards." To see why the FHLB has yet to fail, note that "advances are heavily collateralized—the market value of mortgage collateral typically covers 125 to 170 percent of the advance. This protection explains why the FHLB System has never lost a penny on an advance." Still, the FHLB is not entirely without controversy, and it too likely encourages too much risk-taking on the behalf of its members, but the potential for problems is far less than for Fannie Mae and Freddie Mac. See the next article for a more in-depth explanation.
- Everything you could possibly want to know about GSE's, particularly Fannie Mae, Freddie Mac, and the FHLB.
I especially like this paragraph from the last article:
"The housing GSEs and their many advocates in the financial sector, in Congress and across the country argue that the housing GSEs have yet to cost taxpayers a nickel. They also note that stand-alone ratings of housing-GSE debt, that is, the bond ratings Moody’s and Standard & Poor would award absent implicit federal-government backing, are quite high. Finally, supporters point to the millions of Americans whose dream of home ownership became a reality due to housing-GSE activity. Because this reality is so vivid to most taxpayers, the downside of Fannie Mae, Freddie Mac and the FHLBanks is easy to overlook. An informed judgment about the proper scope of housing-GSE activity must take into account the potential costs of misdirected subsidies and financial instability."
Hmm, the GSEs have yet to cost taxpayers a nickel? A lot has changed since July 2004, and we should be wiser from it. There is no "wishing away" of risk simply by shifting it onto the taxpayer. We see now that because of Fannie Mae and Freddie Mac, we have had far too much irresponsible investment in housing at the expense of the stability of the financial markets.
- The dangers and consequences of the government directing industries and telling businesses what to do: here and here.
- An alternative view on government-sponsored enterprises.
This last line is highly deceptive: "Seventy-six years after it was created by a president whose administration was hostile to government intervention in markets, the FHLB stands as an enduring and (so far) effective example of socialism among capitalists." Quite to the contrary, the structure of the FHLB is far different from that of Fannie Mae and Freddie Mac, and far less socialistic. First of all, because its customers are also its members, the FHLB has a strong disincentive from acquiring an irresponsible amount of risk, which is precisely why it has "high standards." To see why the FHLB has yet to fail, note that "advances are heavily collateralized—the market value of mortgage collateral typically covers 125 to 170 percent of the advance. This protection explains why the FHLB System has never lost a penny on an advance." Still, the FHLB is not entirely without controversy, and it too likely encourages too much risk-taking on the behalf of its members, but the potential for problems is far less than for Fannie Mae and Freddie Mac. See the next article for a more in-depth explanation.
- Everything you could possibly want to know about GSE's, particularly Fannie Mae, Freddie Mac, and the FHLB.
I especially like this paragraph from the last article:
"The housing GSEs and their many advocates in the financial sector, in Congress and across the country argue that the housing GSEs have yet to cost taxpayers a nickel. They also note that stand-alone ratings of housing-GSE debt, that is, the bond ratings Moody’s and Standard & Poor would award absent implicit federal-government backing, are quite high. Finally, supporters point to the millions of Americans whose dream of home ownership became a reality due to housing-GSE activity. Because this reality is so vivid to most taxpayers, the downside of Fannie Mae, Freddie Mac and the FHLBanks is easy to overlook. An informed judgment about the proper scope of housing-GSE activity must take into account the potential costs of misdirected subsidies and financial instability."
Hmm, the GSEs have yet to cost taxpayers a nickel? A lot has changed since July 2004, and we should be wiser from it. There is no "wishing away" of risk simply by shifting it onto the taxpayer. We see now that because of Fannie Mae and Freddie Mac, we have had far too much irresponsible investment in housing at the expense of the stability of the financial markets.
Government Bail-Outs: How I see things
First, let me make the case that someone could make for the government to be willing to give bail-outs:
The government can and should act as an insurer against systemic risk and uncertainty to the economy. In particular, not only should the government provide assistance during times of natural disasters, but it should be willing to "bail out" certain financial institutions during times of financial panic. The argument here is familiar: some institutions are "too big to fail." If one of these institutions fails, then the resulting loss of liquidity and general panic (perhaps because that failure would signal to other market participants that some underlying economic condition is substantially worse than previously thought) would cause people to flee from their medium and long-term financial commitments, thereby putting a great strain on all other financial institutions. In essence, the failure of such a large institution can cause people to fear that other institutions are likely to fail, which becomes a self-fulfilling prophecy as people run to get their money.
*If* the government is to have this role as insurer, then the risk is that financial institutions will make excessively risky and poor investments so that when those investments work in their favor, they profit, and when the investments flop, taxpayers share the losses. This is the common moral hazard problem. If you insure someone against a risky event whose probability of occurring can be affected by the person's actions, then the person is less disinclined to take those actions, thereby making the risky event more likely to occur.
The "solution": if the government is willing to bail-out financial institutions, then it must regulate them properly to reduce moral hazard. Most importantly, the government must insist on complete transparency in the institution's dealings, so that investors can accurately gauge the level of risk that the institution is taking on. In addition, the government should probably insist on reasonably tight capital requirements (such as in the case of banks, which must retain on hand a certain percentage of deposits) to prevent excessive leverage.
What I personally prefer:
There are several disadvantages to having the government bail out individual private companies. First of all, unless there are explicit contracts between the federal government and any institution that it is willing to bail-out (basically, insurance contracts), then we have a two-pronged nightmare: 1) The government, being in principle willing to bail-out any firm that is "too big to fail," deems it necessary to heavily regulate the entire financial industry, and perhaps other industries, in order to prevent the moral hazard problem discussed above. Of course, in doing so it is inevitable that the regulation would be inefficient, politically tainted, and would reduce innovation and productivity in those industries, and 2) Big firms still manage to make investments that are unsound or excessively risky in nature while simultaneously being unable to make certain sound investments due to clumsy regulation, thereby spreading excessive risk onto the average investor along with sub-par performance. All of this leads me to oppose these sorts of government bail-outs.
Here is what we should do instead (subject to me learning more in the future)...
1) The government should require a drastic increase in transparency in our financial markets. The current asymmetries of information between investor, lender, and borrower are, in my opinion, the primary cause of the current credit crisis. In the mortgage market, many people were allowed to purchase homes without proof of income, and then their mortgages were repurchased by a Bear Stearns or Fannie Mae, bundled with other mortgages, and sold to third party investors. Normally, the initial bank would face the consequences of not knowing the buyer's private information about his or her ability to make payments on the loan. However, when the bank can then sell the mortgage to an unaccountable and huge government-sponsored enterprise like Fannie Mae, which has little incentive to manage risk since it knows that it is "too big to fail," the bank can shift the risk onto the eventual third-party investor who has no real idea just how much risk is inherent in many of the mortgages he just purchased (and, for that matter, does not really care since he too knows that Fannie Mae is too big to fail).
2) The government should cut loose Fannie Mae and Freddie Mac, and it should aggressively seek to ensure that our financial markets are as close to "perfectly competitive" as they can get. In essence, the government should do what it can to prevent, or at least minimize, the very existence of firms that are "too big to fail." The health and stability of our financial institution should not rely on a handful of firms, and instead of having firms that are "too big to fail," we should have firms that are "too little to matter." In principle, this does not actually mean that most financial firms would be small. Far from it. It simply means that the government should do what it can to lower barriers to entry into the financial industry, should reform and aggressively prosecute its antitrust laws, and should allow the process of creative destruction, unimpeded by monopoly or manipulation, to do its work.
3) The government should still in some capacity be lender of last resort. There are two main reasons for this. In the first case, the government as LLR can reduce the occurrence of what are called "sunspot equilibria." A sunspot equilibrium is where people in the economy have a belief that something will happen, react accordingly, and by reacting in that way actually cause the event to happen, even if it would not have otherwise occurred. A bank panic is a standard example of this. People fear, for whatever reason, that their bank will fail, so they run to the bank to withdraw their money, which in turn causes the bank to fail. If the government can credibly insure people against the risk of bank failure, then people will not run on the bank if they hear that it may fail, thereby making it less likely for the bank to actually fail. However, if the government is to do this, then it should also institute regulations to avoid the moral hazard problem that was previously discussed. According to economist Ricardo Caballero, "ex-ante policy recommendations typically center on prudential risk management. For example, in many analyses there are externalities present that drive a wedge between private and social incentives to insure against a financial crisis episode. Then, ex-ante regulations to reduce leverage, increase liquidity ratios, or tighten capital requirements are beneficial."
The second main reason for the government to be lender of last resort is to deal with economic situations of great uncertainty which are of a nature not previously seen. In these situations, people do not have any prior experiences or adequate models to reference, and are therefore more likely to react as if they are in a "worst-case scenario."
Once again, according to Caballero,
"an important dimension of the crisis is that there is uncertainty about outcomes. Agents cannot refer to history to understand how a crisis will unfold because the historical record may not span the event space. In such a case it is unclear whether any entity, either private or public, can arrive at the appropriate ex-ante risk management strategy, calling into question the feasibility of these policy recommendations. Instead, in our uncertainty model, the most beneficial ex-ante actions are ones which help to reduce the extent of uncertainty should a crisis occur. In some cases, this may simply involve making common knowledge information that is known to subsets of market participants – for example, making common knowledge the portfolio positions of the major players in a market."
To read Ricardo Caballero's paper titled "Collective Risk Management in a Flight to Quality Episode," go here.
The government can and should act as an insurer against systemic risk and uncertainty to the economy. In particular, not only should the government provide assistance during times of natural disasters, but it should be willing to "bail out" certain financial institutions during times of financial panic. The argument here is familiar: some institutions are "too big to fail." If one of these institutions fails, then the resulting loss of liquidity and general panic (perhaps because that failure would signal to other market participants that some underlying economic condition is substantially worse than previously thought) would cause people to flee from their medium and long-term financial commitments, thereby putting a great strain on all other financial institutions. In essence, the failure of such a large institution can cause people to fear that other institutions are likely to fail, which becomes a self-fulfilling prophecy as people run to get their money.
*If* the government is to have this role as insurer, then the risk is that financial institutions will make excessively risky and poor investments so that when those investments work in their favor, they profit, and when the investments flop, taxpayers share the losses. This is the common moral hazard problem. If you insure someone against a risky event whose probability of occurring can be affected by the person's actions, then the person is less disinclined to take those actions, thereby making the risky event more likely to occur.
The "solution": if the government is willing to bail-out financial institutions, then it must regulate them properly to reduce moral hazard. Most importantly, the government must insist on complete transparency in the institution's dealings, so that investors can accurately gauge the level of risk that the institution is taking on. In addition, the government should probably insist on reasonably tight capital requirements (such as in the case of banks, which must retain on hand a certain percentage of deposits) to prevent excessive leverage.
What I personally prefer:
There are several disadvantages to having the government bail out individual private companies. First of all, unless there are explicit contracts between the federal government and any institution that it is willing to bail-out (basically, insurance contracts), then we have a two-pronged nightmare: 1) The government, being in principle willing to bail-out any firm that is "too big to fail," deems it necessary to heavily regulate the entire financial industry, and perhaps other industries, in order to prevent the moral hazard problem discussed above. Of course, in doing so it is inevitable that the regulation would be inefficient, politically tainted, and would reduce innovation and productivity in those industries, and 2) Big firms still manage to make investments that are unsound or excessively risky in nature while simultaneously being unable to make certain sound investments due to clumsy regulation, thereby spreading excessive risk onto the average investor along with sub-par performance. All of this leads me to oppose these sorts of government bail-outs.
Here is what we should do instead (subject to me learning more in the future)...
1) The government should require a drastic increase in transparency in our financial markets. The current asymmetries of information between investor, lender, and borrower are, in my opinion, the primary cause of the current credit crisis. In the mortgage market, many people were allowed to purchase homes without proof of income, and then their mortgages were repurchased by a Bear Stearns or Fannie Mae, bundled with other mortgages, and sold to third party investors. Normally, the initial bank would face the consequences of not knowing the buyer's private information about his or her ability to make payments on the loan. However, when the bank can then sell the mortgage to an unaccountable and huge government-sponsored enterprise like Fannie Mae, which has little incentive to manage risk since it knows that it is "too big to fail," the bank can shift the risk onto the eventual third-party investor who has no real idea just how much risk is inherent in many of the mortgages he just purchased (and, for that matter, does not really care since he too knows that Fannie Mae is too big to fail).
2) The government should cut loose Fannie Mae and Freddie Mac, and it should aggressively seek to ensure that our financial markets are as close to "perfectly competitive" as they can get. In essence, the government should do what it can to prevent, or at least minimize, the very existence of firms that are "too big to fail." The health and stability of our financial institution should not rely on a handful of firms, and instead of having firms that are "too big to fail," we should have firms that are "too little to matter." In principle, this does not actually mean that most financial firms would be small. Far from it. It simply means that the government should do what it can to lower barriers to entry into the financial industry, should reform and aggressively prosecute its antitrust laws, and should allow the process of creative destruction, unimpeded by monopoly or manipulation, to do its work.
3) The government should still in some capacity be lender of last resort. There are two main reasons for this. In the first case, the government as LLR can reduce the occurrence of what are called "sunspot equilibria." A sunspot equilibrium is where people in the economy have a belief that something will happen, react accordingly, and by reacting in that way actually cause the event to happen, even if it would not have otherwise occurred. A bank panic is a standard example of this. People fear, for whatever reason, that their bank will fail, so they run to the bank to withdraw their money, which in turn causes the bank to fail. If the government can credibly insure people against the risk of bank failure, then people will not run on the bank if they hear that it may fail, thereby making it less likely for the bank to actually fail. However, if the government is to do this, then it should also institute regulations to avoid the moral hazard problem that was previously discussed. According to economist Ricardo Caballero, "ex-ante policy recommendations typically center on prudential risk management. For example, in many analyses there are externalities present that drive a wedge between private and social incentives to insure against a financial crisis episode. Then, ex-ante regulations to reduce leverage, increase liquidity ratios, or tighten capital requirements are beneficial."
The second main reason for the government to be lender of last resort is to deal with economic situations of great uncertainty which are of a nature not previously seen. In these situations, people do not have any prior experiences or adequate models to reference, and are therefore more likely to react as if they are in a "worst-case scenario."
Once again, according to Caballero,
"an important dimension of the crisis is that there is uncertainty about outcomes. Agents cannot refer to history to understand how a crisis will unfold because the historical record may not span the event space. In such a case it is unclear whether any entity, either private or public, can arrive at the appropriate ex-ante risk management strategy, calling into question the feasibility of these policy recommendations. Instead, in our uncertainty model, the most beneficial ex-ante actions are ones which help to reduce the extent of uncertainty should a crisis occur. In some cases, this may simply involve making common knowledge information that is known to subsets of market participants – for example, making common knowledge the portfolio positions of the major players in a market."
To read Ricardo Caballero's paper titled "Collective Risk Management in a Flight to Quality Episode," go here.
Tuesday, July 29, 2008
Fannie, Freddie, and the Government as Risk-Manager
I will first start off by mentioning that I am not (at least not yet) an expert on these issues, so my thoughts are subject to change as my knowledge grows on the subject. As a result of my lack of expertise, you may want read this, this, and this first. Here are my favorite excerpts:
From Joseph Stiglitz (who I normally disagree with):
"Much has been made in recent years of private/public partnerships. The US government is about to embark on another example of such a partnership, in which the private sector takes the profits and the public sector bears the risk. The proposed bailout of Fannie Mae and Freddie Mac entails the socialisation of risk – with all the long-term adverse implications for moral hazard – from an administration supposedly committed to free-market principles.
Defenders of the bail-out argue that these institutions are too big to be allowed to fail. If that is the case, the government had a responsibility to regulate them so that they would not fail. No insurance company would provide fire insurance without demanding adequate sprinklers; none would leave it to “self-regulation”. But that is what we have done with the financial system."
From Dick Armey:
"Actions by Fannie and Freddie management and their regulators this year precipitated the current crisis. Under pressure from the Democrat-controlled Congress, the Bush administration lifted Fannie and Freddie's portfolio caps in February and reduced their capital reserve requirements in March. In this year's stimulus bill, Congress went further and nearly doubled the size of the loans that Fannie and Freddie can purchase or guarantee.
As a result of this reckless expansion, the government-sponsored enterprises (GSEs) now touch nearly 70% of all new mortgages. At the same time, they are insolvent by most measures. The ostensible purpose of Fannie and Freddie is to provide liquidity to America's housing markets. In practice, they are the source of systemic risk and instability in a time of need."
More on Creative Destruction
I will continue to postpone any discussion of how we might approach the big issue of economic risk and security, but here is an excerpt from The New Palgrave (and in particular from Ricardo Caballero):
"Creative destruction refers to the incessant product and process innovation mechanism by which new production units replace outdated ones. This restructuring process permeates major aspects of macroeconomic performance, not only long-run growth but also economic fluctuations, structural adjustment and the functioning of factor markets. Over the long run, the process of creative destruction accounts for over 50 per cent of productivity growth. At business cycle frequency, restructuring typically declines during recessions, and this add a significant cost to downturns. Obstacles to the process of creative destruction can have severe short- and long-run macroeconomic consequences."
"Creative destruction refers to the incessant product and process innovation mechanism by which new production units replace outdated ones. This restructuring process permeates major aspects of macroeconomic performance, not only long-run growth but also economic fluctuations, structural adjustment and the functioning of factor markets. Over the long run, the process of creative destruction accounts for over 50 per cent of productivity growth. At business cycle frequency, restructuring typically declines during recessions, and this add a significant cost to downturns. Obstacles to the process of creative destruction can have severe short- and long-run macroeconomic consequences."
Thursday, July 17, 2008
Creative Destruction or Destructive Creation?
Nobody likes to lose their job, especially politicians. Particularly in the midst of our current economic difficulties, people worry about the impact that international trade, globalization, and competition can have on their economic security. I don't fault them for that. Politicians in the US and elsewhere often attempt to address that fear by making it more difficult to fire employees (such as in France, where the termination process can take more than 6 months and requires permission from a court), by restricting the ability of new firms to enter into an industry (either directly by adding layers of regulations and hurdles or indirectly by subsidizing incumbent firms), by restricting foreign access to markets, by making it more difficult for companies to sell their products, or by restricting entry into new occupations (such as by imposing licensure requirements).
In some occasions, these requirements appear reasonable. After all, who wouldn't want the assurance that the FDA provides when it checks the safety and efficacy of a new drug? However, in many instances, these particular attempts to increase economic security, particularly by restricting market entry or making it difficult to hire/fire employees, cause far more economic damage with little to no gain in economic security.
In short, we hurt ourselves by implementing these policies because doing so stops the vital process of creative destruction. We cannot expect new innovation as long as we shelter inefficient firms from competition or put up roadblocks that prevent companies from creating the most dynamic labor forces that they can. Does this mean we have to throw away economic security? No. I'll address that issue later. However, we cannot provide that security by pretending the forces that cause it are somehow bad or unnecessary.
Thursday, July 10, 2008
Four More Years?
Even though the 2008 Presidential campaign has been going on for a couple years now, and the general election campaign has been going on for over a month, we still have little to no true political discourse.Obama's motto: John McCain = Bush III. That's it! Debate over. Rather than contest the issues, Obama would prefer to link McCain (inaccurately in many ways) to Bush, talk about hope and change, and have the public vote for someone whose positions on the issues they know very little about.
For all that Obama speaks of change, what new, innovative policies is he even proposing?
Windfall profits tax: yes, maybe if we re-institute the failed (led to decreased production and higher imports from the Middle East) 1970s-era tax on profits, "Big, Scary Oil" (which "controls" only 5% of world oil supplies) will increase investment, research and development, production, and lower prices! Or, better yet, the government can nationalize the industry and emulate the other areas of the world which are paragons of energy production efficiency (Russia, OPEC, Venezuela).
Higher income taxes: "The rich must pay their fair share!" Of course, in Obama's world, a rich person's fair share is twice as big as everybody else's. Sure, there are wealthy people who evade taxes, and they do so by exploiting needlessly complex tax loopholes which exist because of our abuse of using taxes to enact social engineering. Even so, the rich pay a greater share of the tax burden even than their share of the economic pie. What else is lost in this discussion? Lowering tax *rates* is about increasing incentives for businesses, entrepreneurs, workers, and investors to engage in productive activity, ie innovation, the creation of wealth, and the starting of new enterprises. Hike taxes, crush incentives, lose jobs, shutter businesses. Maybe that can be Obama's motto.
I could go on and on, whether about education policy, or health care policy, or judicial philosophy, or foreign policy. I don't want to get across the wrong message, though. This isn't about demonizing Obama. Not everything Obama says is nonsense. Isn't it a bit convenient when somebody makes the argument that one political party is always right while the other one is always wrong? What we need, though, is a debate not based on slander, false associations, and obfuscation. Bush-Carter '08!
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