I'm reading Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon by Gretchen Morgenson and Joshua Rosner. It's an account of the collapse of the subprime mortgage market at the beginning of our current economic mess. The book tells the story at an odd level of detail: It doesn't give a lot of details about the characters and institutions involved, but neither does it present a broad economically-informed description of what was going on.

For example, mortgage originators were making bad loans to unqualified borrowers and then selling bundles of these loans as mortgage-backed securities to Fannie Mae, Freddie Mac, and a host of investment banks. The book emphasizes over and over that these loan originators had a poor incentive to produce high-quality (or at least honestly-described) mortgages because they knew they wouldn't be holding on to them. This is an obvious agency problem, and I couldn't understand from the book why the investors weren't on the lookout for it.

Yet about 2/3 of the way in, the authors mention that under the terms of the securitization agreement, the originators had to buy back all loans that were materially misrepresented and all loans where the borrower defaulted early in the loan's term. In other words, the purchasers had sought to protect themselves from agency risks by requiring the originators to shoulder substantial default risks. In that case, why didn't the originators pay more attention to the quality of the loans?

As it happens, according to the book, the loan portfolios were so toxic that the originators would have gone bankrupt if forced to buy them all back, which would have cut off the flow of new loans, so the investment banks didn't force them to take a loss. But that just raises more questions: Could threatening bankruptcy really have been the originators' plan for protecting themselves from the consequences of their poor loans? How did the investment banks not see that coming?

So far, when it comes right down to it, I've reached two conclusions:

(1) Unscrupulous sociopaths can make a lot of money in the financial markets, especial during the manic phase of an asset bubble.

(2) I've got to figure out how to get a piece of that.

Update: Not directly connected, but I've just noticed that Charles Mackay's Extraordinary Popular Delusions and the Madness of Crowds is available as a Kindle download for only $0.99. It's a classic work about asset price bubbles and other types of craziness. And it was published in 1841. If nothing else, spend the 99 cents (or just get it free here) to read the extraordinary story of the seventeenth century Dutch tulip bulb craze.

Here's something I never thought about before: It's time to stop using pennies.

Aside from its actual subject -- the uselessness of pennies -- this video is also worth watching because it's a terrific example of how to make an argument. It's clear, it's concise, and in four minutes and 31 seconds I went from not thinking about pennies to being completely convinced they should be eliminated. They fail as money.

And frankly, the nickel doesn't look to good either. Let's just drop the last digit from prices and be done with it.

(Hat tip: Alex Tabarrok)

[Update: I am relieved to note that the Google+ page referenced below below does not actually belong to Paul Krugman. It is a fake. The author offers an explanation, "hope it will enlighten many..." blah, blah, blah, but it was kind of an annoying stunt. It's true that Krugman has said similar things in the past, but that's all the more reason not to make stuff up.]

I first got interested in economics when I read a magazine article about Paul Krugman and decided to check out a few of his books. I read Peddling Prosperity and Pop Internationalism back-to-back, and I still use the phrase Accidental Theorist to refer to people who claim to disdain fancy theories and rely on common sense. Even though I disagree strongly with some his politics, I always assumed it was safe to respect him as an economist. Especially after that Nobel prize, right?

Which is why it pains me to see him say this on his Google+ page:

People on twitter might be joking, but in all seriousness, we would see a bigger boost in spending and hence economic growth if the earthquake had done more damage.

There are a number of ways to explain why this is an economically silly thing to say. Perhaps the simplest is to ask, "Why do we need an earthquake?" If the earthquake didn't do enough damage, why not just send in the Army Corp of Engineers to dynamite a few buildings? Or just ask dissatisfied Americans to riot in our business districts for a few weeks. Maybe tell the fire departments of our major cities not to put out fires so quickly.

Rebulding after a disaster doesn't turn the disaster into a net economic gain because all the productive output goes into replacing wealth that was destroyed in the disaster. If this sort of thing worked, unemployed people could solve all their problems by waking up every morning and hammering holes in the walls of their home and then paying themselves to spend the rest of the day patching the holes.

This is known as the broken windows fallacy, and it's a really, really well-known error in economic thinking. It grates when I hear pundits and politicians say this sort of thing. But when a trained economist says it, that's just painful. Seriously, Paul, are you reading what you're writing?

I'm really tired of hearing about the debt ceiling, and I've avoided contributing to the cacophony so far, but I just have to get this off my chest. It's not so much that I think one side is right and the other side is wrong. Rather, I think everyone who created this mess deserves a kick in the ass from every America. Unfortunately, parts our current problem are the result of some really bone-headed thinking long ago, and the culprits aren't around any more. Let me explain...

First of all, consider how the national debt arises. It happens because government spending is greater than government revenue, and the amount of the debt is equal to the difference between spending and revenue. In mathematical terms,

debt = spending - revenue

Now let's consider where each of those terms comes from.

The spending term is essentially the entire federal budget. Sometimes it's a specific amount to be spend on a particular budget item, such as the budget for the FBI, or the cost of running an infantry division, and other times the spending is authorized in the form of an entitlement, such as social security or medicare. The budget is incredibly complex and detailed, and it is essentially authorized by Congress.

The revenue term is essentially federal taxes, including payroll taxes, income tax, gas tax, phone tax, tariffs, fees, and any other way the government can think of to squeeze money out of us. Parts of it vary with the activity of our economy, but all of it is essentially authorized by Congress

The debt term is the amount of money the government is allowed to borrow. Ever since the Public Debt Acts passed around 1940, it has been subject to an upper limit (the infamous ceiling) set by Congress.

At this point, anyone with a background in math (or science or engineering or economics or business...) should see a very obvious problem: The system is overdetermined.

We've got a system of three variables related by an equation that uses all three variables. In a situation like that, once you know any two variables, you can always solve for the third one. If you know spending and debt, you can solve for revenue:

revenue = spending - debt

And if you know revenue and debt, you can solve for spending:

spending = revenue + debt

And as we said at the outset, if you know spending and revenue, you can solve for the debt:

debt = spending - revenue

In other words, once you determine any two of these numbers -- perhaps by passing a budget and a tax plan, thus determining spending and revenue -- you have mathematically determined the value of the third one as well.

In this case, Congress has spelled out the spending plan and the revenue plan, which of course implicitly determines the debt. Our Congress, however, also spells out the debt (or at least an upper limit to the debt), which means they have determined more of the variables than they should. The system is overdetermined. And as is often the case with overdetermined systems, there is no exact solution. Thus the current crisis.

The only way to fix this is that something in the system has to change to make the equation work with the numbers. The equation itself is an accounting identity, so it can't be changed, which means that one of the variables has to change. Normally, it's the debt that would be changed, by raising the debt ceiling, but this time there's an argument. Republicans want to hold the debt fixed and change spending instead, and in return, Democrats are now arguing that a revenue increase is in order.

This is no way to run a country.

None of this would be necessary if Congress hadn't tried to control all three variables in the budget equation at the same time. Unfortunately for those of us yearning to kick the bums out of office, the current members of Congress aren't entirely to blame. Much of the problem goes back to the Public Debt Acts passed between the Great Depression and World War II, which established the debt ceiling. And the problem may extend all the way back to 1787, when the United States passed its Constitution, which gave Congress the power to spend money, raise revenue, and "borrow Money on the credit of the United States."

Still, it's a stupid mistake that could be easily fixed by removing the debt ceiling entirely and, if necessary (and I suspect it is) passing a law that specifically authorizes the Treasury to borrow money to meet the debts that arise as a result of the spending and revenue plans passed by Congress. This takes nothing away from Congress, since they are still in complete control of the other two variables of the equation.

Well, it takes one thing away from Congress: It takes away the ability to do a lot of stupid grandstanding by taking the federal budget hostage. If the Tea Partiers want to reign in the federal deficit -- something which, broadly speaking, I agree needs to be done -- the proper way to do it is by controlling federal spending. (Or, if you lean that way, you could do it by raising the taxes.) But that would require specifying exactly which spending you propose to reduce, which will surely anger the voters who benefit from it.

The federal debt ceiling, however, is a single number with no internal parts assigned to constituencies. That makes it much safer politically. So we have this massive Republican opposition to raising the debt ceiling, but when it comes to actually cutting spending, there's little agreement within the party how to do it. Finding an agreement with the Democrats will be even harder.

My prediction, by the way, is that the Republicans and Democrats will cut a deal to raise the debt ceiling before anything drastic happens. Of course, in order to reach that agreement, each side will have to receive something good in return, and there's a pretty good chance that (a) the final bill will be larded full of many pages of special provisions designed to win support from various members of Congress, (b) no one will really know what it says, and (c) it will somehow end up costing us more than if we'd simply raised the debt ceiling.

This is no way to run a country.

You've all heard about Donald Trump's weird obsession with Obama's birth certificate, right? Pretty crazy, huh? You ain't seen nothing yet. The real crazy shit will come when Trump starts explaining his policy proposals.

That's not a prediction. It's a memory:

CNN

November 9, 1999

Billionaire businessman Donald Trump has a plan to pay off the national debt, grant a middle class a tax cut, and keep Social Security afloat: Tax rich people like himself.

Trump, a prospective candidate for the Reform Party presidential nomination, is proposing a one-time net worth tax on individuals and trusts worth 10 million or more.

By Trumps calculations, his proposed 14.25 percent levy on such net worth would raise 5.7 trillion and wipe out the debt in one full swoop.

(That was back when we thought 5.7 trillion in debt was a lot.)

There are several kinds of crazy going on here, but I might as well start with the fact that Trump seems to think we won't notice this:

The tax also would lead to the repeal the current federal inheritance tax which really hurts farmers and small businessman and women more than anything else, Trump said.

The federal estate tax also hurts the Trump family. A one-time 14.25% tax is a lot better for him than the 50% or so bite the estate tax was taking at the time. With Trump's net worth estimated at $5 billion, the math works out that he would be investing about $750 million in one-time tax in order to avoid a $2.5 billion estate tax when he died, which would have been a pretty good deal for the Trump family.

Then there's the question of how to determine someone's net worth. Bank accounts and brokerage statements are easy, and real estate isn't much harder. But it can be tricky to determine the value of something like out-of-the-money options, and more complex derivatives can be a nightmare. (Remember that the current financial crisis was caused because a lot of people, some of them very well informed, consistently guessed wrong about the value of real estate derivatives.) This would be a recipe for both tax injustice and tax evasion.

And when the net-worth tax bill comes due, where will people get the money to pay it? They'll have to liquidate some of their assets and try to sell them, at a time when the nation as a whole is dumping $5.7 trillion dollars worth of assets on the market. There's no way that won't cause a lot of problems.

Before any of that happens, however, people will start trying to protect their assets by converting them to something that is more easily hidden, or which the government's asset valuations are likely to underestimate. Or maybe they'll just try to move their assets out of the country. This too will cause problems in the financial markets.

The competition to sell or move assets is likely to be something of a stampede since there will be an advantage to acting quickly, before everyone else's actions depress the market. In fact, just the fact that a (semi-)serious candidate for president was talking about confiscating wealth was probably enough to encourage some people to liquidate their assets or take them out of the country.

In other words, Trump's tax proposal is so bad that just talking about it can hurt the economy.

I don't know what Houston criminal defense lawyer Mark Bennett's politics are, but over the past couple of months he's been experiencing a classic example of the sort of thing that turns people into libertarians: Out of the blue, the government--in the form of the State Bar of Texas--wants to outlaw his business model. He usually charges clients a flat fee, but now the State Bar is proposing changes to its ethics rules that would prohibit flat fees.

(Supporters of the proposed changes apparently claim they're not trying to prohibit flat fees, and the discussion got all lawyer-y real fast. Here's an example. I'm not going to get into that.)

As I understand it, the basic premise of the new rules is that while lawyers can demand an advance payment of their fee, the money doesn't actually become theirs until they've earned it. And if they don't earn it all, they have to give it back. That sounds reasonable, but Mark Bennett has an argument for why flat fees are good for clients which I'd like to talk about. I don't know much about lawyering or the law business, but that won't keep me from rambling on for a bit. I think it's a fascinating little lesson in economics.

There are two relevant facts about the practice of criminal law which I think have helped shape how Bennett handles fees. First of all, it's very hard to predict initially how much a criminal defense is going to cost by the time it's over. Lawyers can reasonably guess that a routine first-time DUI stop is probably only going to take a few hours of billable time, and that a money laundering case with 400 hours of wiretap evidence is going to be a long battle, but in most cases, there's a lot of variability, and many of the factors that determine the level of effort won't be known during the initial consultation with the client.

Second, once a lawyer has worked a case for a while, he can't easily back out. He'd need permission from the judge, and he's unlikely to get it without a really good reason. Not getting paid is not a good reason, as far as the judge is concerned. So once a criminal lawyer takes on a case, he's committed to defending the client, and he's committed to the entire labor cost of the trial. (He may be the only labor involved, but his time is still his cost of doing business, and he's going to want to get paid for it.) In other words, even if a criminal lawyer charges by the hour, his minimum unit of commitment is always the entire duration of the case, including any trial. (There are exceptions, but I hear they're unusual.)

Third, criminal defendants tend not to pay their bills once the lawyer starts work. This means a lawyer discussing representation with a client can get a reasonable amount of money up front as a condition of taking the case, but if the case turns out to require more money than that, he has very little chance of getting it from the client. Most criminal clients don't have any more money, they're unlikely to get more money, and even if they get it, they have little incentive to pay it since their lawyer isn't allowed to walk away from the deal.

This all means that a criminal defense lawyer who bills by the hour is facing a no-win billing scenario: If the initial deposit he demands up front is not enough to cover the true cost of the case, he's going to run through his client's money before the case is over and end up working the rest of the case for free. On the other hand, if the case ends quickly and he has money left over at the end, he has to give it back. Breaking even is his best case scenario. The average case is much worse.

(Criminal defense lawyers rarely if ever bill by the hour, but some might bill in stages, such as X dollars for pre-trial work and Y dollars more if there's a trial. However, just because their billing units are larger than an hour doesn't mean they aren't stuck in the same scenario. They're still charging for their effort, not for the job.)

The only way for a lawyer to avoid losing money in this system is to require every client to provide an initial deposit large enough to cover the entire worst-case cost of the case, including a complete trial.

The problem with that is that most cases don't go to trial, so most cases will never end up requiring that much effort. The lawyer would be asking clients for large amounts of money up front, which some clients will be unwilling (or unable) to pay. He'll be losing clients--and they'll be passing up his services--even though in most cases (i.e. those that do not go to trial) they could have afforded it.

Let's make up some numbers to illustrate how this works. To keep it simple, let's use big round numbers and pretend that there's only one type of case. Assume it costs our lawyer $20,000 worth of his own labor to take a case to trial, but only $10,000 to take a case that ends without a trial (plea, dismissal, or something else), and let's assume that only 1 case in 10 goes to trial.

So, out of his first 10 cases, our lawyer will take in $20,000 in advance fees for each case up front. He'll have to keep that money in a separate escrow account of some kind. In nine of the cases, he'll have to give the clients back $10,000 each, for a total of $90,000, but in the tenth case he'll get to keep the entire $20,000. In summary, he takes in $200,000 in advance fees, refunds $90,000 of it, and keeps the remaining $110,000 as revenue.

Observe that over ten cases, our lawyer has an everage revenue of $11,000 per case. In other words, our lawyer could make the exact same amount of money by charging every defendant $11,000 per case regardless of whether it goes to trial or not. This is the economic basis of the flat fee. It requires less up-front money from the client, it's easy to understand, and it's simpler for the lawyer to handle.

So what could possibly be wrong with a flat fee? A couple of things:

First, it creates economic pressure for the lawyer to plead clients out instead of going to trial because he makes money faster that way. But on the other hand, if the lawyer uses staged fees, he has an incentive to take more cases to trial to increase his revenue. I don't think these kinds of problems can be eliminated under any payment system. There's always going to be an inherent conflict over fees, because the lawyer always wants to earn more and the client wants to pay less. At some point, the client has to trust his lawyer to do the job properly.

(The bar could probably mitigate this problem through better transparency, such as publishing every lawyer's history of case outcomes. Potential clients could learn to avoid hiring a lawyer who's plead out his last 50 clients).

The second problem is that it could appear to bar regulators that the lawyer is taking unearned money from some clients to pay for services for other clients. In the example above, the lawyer could be accused of taking $1000 that he didn't earn from each of the clients that plead out and using it to cover his losses on the client that went to trial.

In fact, that is exactly what he's doing. But so what? He promised to defend each client for a specified fee, the client accepted the deal, and he delivered on his promise. There's nothing fraudulent about this. Lots of businesses work this way.

The key to understanding what's really going on is to realize that a criminal defense lawyer who works for a flat fee is actually selling two services disguised as one. Obviously, he's selling his legal services: The labor he does to complete the job. Less obviously, however, he's also selling trial insurance. He's agreeing to take on the financial risk of bringing the case to trial.

Every client who pays $11,000 is paying $10,000 for the pre-trial stage of the case, plus a $1000 insurance premium which will cover the cost of going to trial, should that prove necessary. As with most insurance, the client is buying some peace of mind. He knows that no matter what happens in the case, it's not going to cost him (or his family) any more money. And when the time comes to sit down with his lawyer and decide whether to take a plea offer or go to trial, he can make the decision based on the state of the case, without regard for the cost of trial.

Actually, the flat-fee lawyer in this situation should get something extra out of the deal besides the $1000 extra per client. That $1000 only covers his expenses, but insuring the client against the financial risk of a trial is a valuable service for which clients should be willing to pay an additional fee, so he might be able to charge $1100 instead. On the other hand, if the flat-fee arrangement saves him an hour of haggling with the client over the trial fee later--or the risk of being forced by the court to defend the client without a fee--that could make it very attractive for the lawyer as well. He might be willing to lose a little money on the flat fee in order to buy himself a little peace of mind.

Almost every service you buy is sold under similar terms. Get your hair styled, and it's the same price for a broad range of styles, even if some are more difficult to achieve than others. Buy a new set of tires, and they'll quote you a price for installation that covers most of the things that can go wrong. Decide you need breast implants, and you can get a doctor to quote you a fee that includes all immediate complications, and maybe some of the less immediate complications as well.

Sometimes, especially when you're buying a product instead of a service, they don't call it insurance, they call it a guarantee. Buy a cell phone, and they'll guarantee it against defects for a year. You may think of this guarantee as a promise of quality, but to the seller--who knows how often defective products are sold--it's essentially insurance to cover the cost of replacing defective products. That's why for a small extra fee, they'll sell you an extended guarantee that covers things that aren't their fault, such as if you break it, lose it, or drop it in the toilet. In other words, you're buying insurance for your cell phone much the way you buy collision insurance for your car.

In fact, it might be a more accurate to describe fixed-fee criminal defense as a type of guarantee, given that most cases end in pleas. Our lawyer is charging his clients $11,000 for negotiating the best possible plea deal, and he guarantees that the case will not go to trial. In the unfortunate event that a trial becomes necessary, the lawyer will do it for free.

Update: On re-reading this, I realized I haven't quite tied it all up. Remember that the original issue raised by the proposed Texas State Bar rules was that a lawyer could be accused of keeping client money that he hasn't earned if the number of hours worked is too small to justify the fixed fee.

There's some legal argument over whether a lawyer and client can contractually agree that the fee is earned upon receipt, or at some very early point in the case, regardless of how much effort the lawyer has put into the case. I can't begin to follow that argument or figure out who's right as a matter of law.

But regardless of what the law says, the flat-fee lawyer is performing a significant service for his client by assuming the financial risk of a trial, and therefore he really does earn rather a lot of his fee the moment he signs the contract.

Mark's review of Michael Lewis's The Big Short: Inside the Doomsday Machine sounds interesting. I generally find finance and economics difficult to read about, but I may give the book a go.

From the sound of it, the author and I seem to have a couple of similar arguments about what is wrong with the efficient market. One premise I like to start with is that efficient markets require free and open knowledge of the marketplace. This is the reason corporations and, pretty much anything you can invest in, have reams of information regularly produced and distributed as mandated by the SEC.

In business school, intro finance courses spend most of their time explaining how to read all of these reports. (If they went beyond that, I must have fallen asleep by that point in the lectures.) In theory, this is what keeps everyone in the marketplace aware of what is going on, and allows the efficient market to work. I believe this system has been running into trouble for a couple of reasons.

One is touched upon in your description of what Lewis calls fraud. Even when it isn't called fraud, fudging the numbers in quarterly and annual reports seems to be standard operating procedure these days. If you can't hide the numbers anymore, just spin off a new corporation and hide the numbers there. Much of this seems to be legal, though I would still call it fraud. The purpose is to deceive investors and cloud the reality of the marketplace. You can't do this forever, but people can become millionaires or billionaires in a very short time, so the deception doesn't need to hold for too long. In this respect corporations, and to some extent the markets they are traded in, become like a game of musical chairs. The last investor standing loses. The last investor is often the one who thinks their investment is long term.

"Short term thinking" goes beyond simply not seeing that your investment isn't good in the long run. Short term thinking can be a money-making trading strategy that investors can keep using in the long run. The concept of day trading is based upon catching (very) short term trends. Buy (or short) a stock in the morning, perhaps because you anticipate a reaction from a news item, then sell in the afternoon before the long term impacts can be digested by the market. This sort of very short term view, it seems to me, is starting to become more prevalent in the markets.

I don't mean that there are more and more day traders, but that the entire market is now looking for shorter and shorter returns on investment. When you chat with traders and ask them about their long term investments, you often hear statements like "Sure this is long term. We may even keep it more than a year!" Technology, in particular computer networking, allows for the rapid dissemination of information and traders are treating every week, or even day, as if that were the day quarterly statements for an investment came out. The actual quarterly and annual reports are increasingly becoming nothing more than when you happen to update some of the numbers in your trading model instead of being an indicator of whether you want to keep the investment or not.

As the investment horizon is shortened, this way of thinking must start to become part of the corporate culture as well. After all, ultimately the management of a corporation is working for the investors as represented by the board of directors. Since wealthy individuals need to diversify their investments (to protect against the unpredictability mentioned by Lewis) very few individuals have controlling interest in any major corporation anymore. Large investment funds have replaced the individual and now have the influence to affect corporate management.

Something else I was taught in graduate business school, way back in the ancient mists of time, was that top corporate management was mainly supposed to concern itself with the far future of the firm. They were to think 10 to 20 years into the future, or even beyond. Wealthy individual investors in the past often shared this view and often hoped to maintain their investment for decades. This culture became so ingrained that business schools taught that top managers should shun any short term projects.

Do you think that there's an investment fund out there today that is capable of thinking of a corporate investment beyond 1 year? Beyond 5 years? Probably not, and, under the free market, they are correct to focus on the short term. Any long term investment will wax and wane over time and anyone who is interested in becoming a millionaire this year will ask why the fund failed to sell before any drop and buy before any gain. The fund will only grow if they pursue a (winning) short term strategy, and the corporations will only get investment funds if they deliver on short term promises. The large-fund controlled board will hire management that can deliver. The market works, so to speak, just not the way that is best for the future.

So yes, I see the fraud (legal and illegal) as a major impediment to the efficient market, but I also see the market working against its own future by an obsessive (valid?) focus on short term returns and trades as enabled by modern computer networks and databases and encouraged by the efficient market itself.

I think we should become fund managers who get paid for transactions. You do have the windyinvestments.com domain reserved, right? The more transactions we make the more money we earn. We need to be sure to tell our clients to never hold onto an investment for more than a week or so...

Of course we probably don't have the seed money for this. With the kind of money we could put together we wouldn't be called fund managers, we would be called loan sharks. Charles Ponzzi had a way around that, but it's only legal if you are deemed to big to fail by the government.

To my co-blogger Ken:

I haven't seen you in a while, so we haven't had time to talk about any of the usual stuff, therefore I'm taking this opportunity to submit a modest proposal for your consideration.

As you know, one of the areas where we disagree about economics issues is the subject of the efficient market hypothesis. I tend to believe those economists who say that the free market is efficient, that is, it makes the best possible use of materials and information.

Obviously, this isn't perfectly true. In fact, it can't be, because the reason for believing there are few inefficiencies is because people will spot them and take advantage of them for profit, which tends to eliminate them. Further, there are all sorts of inefficiencies caused by things like monopolies and asymetric information. Still, I usually believe the efficient market hypothesis explains much of the market.

You, on the other hand, seem to believe there are a number of persistent inefficiencies that aren't being eliminated. In particular, you ascribe a lot of inefficiency to short-term thinking in the capital markets.

My response to this has always been to ask why the long-term players don't just buy the stuff the short-term guys are undervaluing. Or why don't they take a short position on the stuff the short-term guys are overvaluing? If the short-term guys are pressuring a company's management into squeezing the company for short-term gains, why don't some smart traders buy the company and make even more money by holding it for the long term? If short-term thinking is a problem, why aren't the long-term investors picking up the money?

I've just been reading Michael Lewis's The Big Short: Inside the Doomsday Machine. Everything in it could be wrong--I have no way to tell, but people I trust say it's right--but I think it sheds some light on our conflict. The book is about the subprime mortgage crisis, as seen from the point of view of the handful of traders who took very big bets against subprime mortgage bonds. It's a very good read, and I highly recommend it to anyone who wants to understand how we got into this mess.

If the subprime mortgage crisis is a representative example, the short answer to why markets are inefficient seems to be that you are right about there being too much short-term thinking. The major subprime investors were enjoying the cashflow from the mortgage payments (or from various derivatives) far too much, and this made it hard for them to see the dismal future ahead.

As to my question of why someone didn't clean up with a little long-term investment, I think The Big Short sheds a bit of light there too. The natural enemy of long-term investment is unpredictability, and this unpredictability arose for three reasons:

• First, there was a lot of fraud going on. Home owners, mortgage originators, rating services, and investment bankers lied like mad to create the subprime bond market. This is essentially a problem of asymmetric information. Who could invest long-term when you're not sure what's really going on?
• Second, large amounts of money were controlled by relatively small numbers of traders, so it only took a few stupid people to invest billions of dollars in a losing proposition. This blew the economic assumption of rationality right out of the water.
• Third, once a few people started making money from subprime loans, traders faced a lopsided incentive system: If they didn't invest in the subprime market and it made money, they'd look like fools to their bosses and investors. But if they did invest in subprime bonds and the market went sour...well, nobody else saw that coming either, right?

In short, the market was inefficient due to fraud, stupidity, and cowardice.

According to Lewis, one surprising outcome of this mess is that most of the traders on either side of the subprime market made out okay. Win or lose, they earned millions in fees and incentives. Even Howie Hubler, who Lewis says lost more money than any other single trader in Wall Street history, took home millions of dollars and apparently landed okay.

Ken, I don't know if Lewis is right, and I don't know if I've correctly understood everything I've read, but if I've got this right, I can see only one inescapable conclusion: You and I need to become traders.

-- Mark

In graduate school I had the most trouble staying awake in finance lectures. I always thought finance had to be just about the most boring topic ever.

I see some [foreign investment funds] looking for returns of 20 or 25% at a time when fellatio is close to zero.

I guess I was just doing finance wrong.

There's one bad policy pattern that politicians tend to repeat over and over, and according to Nathan Koppel at the Wall Street Journal, this time they're inflicting it on lawyers:

The Mississippi Supreme Court is considering a proposed rule to require lawyers in the state to provide at least 20 hours of pro bono work.

The rule has been proposed to try to help the thousands of low-income residents in the state who can not afford a lawyer in civil matters, according to this article in The Clarion-Ledger.

This is one of those proposals that seems at first like common sense: Lawyers are empowered by the state to do things that allow them to make a lot of money, therefore they should be required to give some of that back to the community. As is often the case, however, common sense is a poor guide.

The key to understanding why this is a bad proposal is to recognize that forcing someone to work is economically almost the same as paying them a free-market wage to do the work while at the same time raising their taxes by exactly enough to cover their wages. In other words, a proposal to force lawyers to provide legal services to poor people is logically nearly equivalent to two simpler proposals: (1) The indigent should receive free legal services, and (2) lawyers should pay higher taxes.

Now, both of those policy proposals might be good ideas. What I object to is the unnecessary linkage of these two unrelated policy proposals. If it's a good idea for the government to provide more free legal services to poor people, then it doesn't matter where the money comes from. And if there's a good reason lawyers should pay a larger-than-currently-normal share of taxes, then it doesn't matter how the money is used.

The sensible way to provide legal services to poor people is to pay for them out of the public treasury. Then you let the ways-and-means folks figure out where to get the money. Maybe they can cut spending somewhere else, or maybe they can raise taxes. Heck, maybe they can even raise the cost of a law license. But these are two separate decisions. Linking them is a purely political maneuver.

(Since it's the Mississippi Supreme Court that's doing this -- and make no mistake, you don't get to be a judge without politics -- there's also the fact that the courts don't have the power to levy taxes. That's a pretty good reason for them to want to combine these issues, and also a pretty good reason why they shouldn't be allowed to do so.)

I hedged above, saying this proposal was "almost the same" and "nearly equivalent" to the pair of simpler proposals because there's one crucial difference: The judges' proposal requires payment in kind. Rather than simply paying additional tax money equivalent to 20 hours of billable time, the lawyers are required to work it off.

Scott Greenfield gives a wonderful explanation of why this is stupid:

The problem, unfortunately, is that mandatory pro bono doesn't necessarily match up well with the public need.  Let's say a civil litigator takes on, pro bono, representation of a poor litigant.  The 20 hour obligation won't get the litigant to resolution, but could get him in deep enough to make his life a serious mess.  It could get the lawyer to go the quickie route rather than litigation, knowing that his 20 hours will end long before anything can be accomplished.  It could leave the indigent defendant worse off than he started.

Then there are transactional and criminal lawyers being asked to provide civil representation.  They may have some knowledge of diverse areas of law, but sufficient to provide meaningful representation?  Hey, it's not like these are paying clients.  So what if we're nothing more than warm bodies in the well?  Is this really what the Mississippi Supreme Court has in mind?

The core problems with forced pro bono is the disconnect between the lawyers' competencies and the clients' needs and the number of hours mandated versus the number of hours required to see a matter to completion.  It's the difference between providing real services and the appearance of services.  Lawyers aren't fungible, and one size does not fit all.

That's exactly right. Lawyers aren't fungible. But you know what is fungible? Money. In fact, solving problems like this is why money was invented.

This sort of taxation-in-kind policy is the public policy version of a barter system, and it has all the same coordination problems. In a barter system, if you want to buy a good or service, you have to find someone who has that good or service to sell, and who also wants something you have to sell. If you're coming to ye olde towne square looking to trade candles for horseshoes, you better hope that there's a blacksmith who needs candles. If he's already got all the candles he needs -- which may be none at all -- then your candles are worthless to him, and he'll probably hang on to his horseshoes until he can get something better for them.

The Mississippi lawyer plan is like that, only worse, because the lawyers are being forced to sell services they may not know how to provide to people who may not really want them. It's as if the king declared that horseshoes could only be bought with candles and nothing else. If you're a chicken farmer, you're going to have to waste a lot of time making some pretty crappy candles in order to get your horseshoes.

Actually, the Mississippi plan is even worse than that, because if you're a chicken farmer looking to buy horseshoes from people who can only take candles in trade, you can at least go find a candlemaker and trade your chickens for his candles.

This suggests an improvement to the Mississippi plan that might make it workable: Establish a system of tradable pro-bono credits. I'm sure there are plenty of mergers-and-acquisitions lawyers who would happily pay a few thousand dollars a year for somebody else to fulfill their pro-bono work for them. And I'm equally sure there are plenty of lawyers who would love to spend their whole year helping low-income people if they could pay for it by selling their excess pro-bono credits to the mergers-and-acquisitions lawyers.

This would do everything the Mississippi plan would do -- the poor people would get their legal assistance, and the lawyers would be paying for it, just as the proposal's authors seem to want -- but it would provide better service, and probably at a more reasonable cost to the lawyers. The original policy idea is so bad that this really is a case where a few changes can be a win for everybody.

This is an ad for a book, but it's also pretty much my take on the human condition.

Despite all the complaining on this blog, I really am something of an optimist.

I don't know if you'll learn anything new from this, but for its format it's a pretty accurate summary of the economic debate:

(Hat tip: Radley Balko.

Over at Popehat, blogger Ezra has a suggestion for future awards of the Nobel Peace Prize:

I submit that the prize be awarded each year in perpituity to the nation of Bhutan. In 1972 their king uttered the simple phrase "Gross National Happiness is more important than Gross Domestic Product." Since then, Bhutan has systematically and doggedly worked towards increasing the happiness of it's people. This is not some hippy-dippy rainbows & unicorns idea. It is deeply Bhuddist and something the entire government works towards.

Think about that, a government that is actually concerned about the happiness of it's people, and is serious enough about it to put the resources of the government into better facilitating that happiness (heh, sorry libertarians..) It's fascinating to me to see a country take the same principles and statistical management we put into capitalism and focus it on something "touchy-feely." For that effort alone Bhutan deserves the award.

It's interesting to look at some of the items measured by the Center for Bhutan Studies in calculating their GNH index:

Emotional balance indicators
Spirituality indicators
Family vitality indicator
Socialization indicator
Kinship density indicator
Dialect use indicator
Traditional sports indicator
Community festival indicator
Artisan skill indicator
Value transmission indicator
Basic precept indicator
Folk and historical literacy indicator
Ecological degradation indicator
Ecological knowledge indicator
Afforestation indicator

I should note that I've cherry-picked some of the sillier ones. The GNH also includes a number of reasonable indicators for factors such as health and time use. Still, the sillier ones make it easier to game the numbers.

I think we can forgive Ezra for being charmed by the idea of a government that tries to make its people happy, especially after 8 years of a government that treated us like we might suddenly attack them with exploding footwear. It wouldn't be as good a story if the facts in Bhutan turned out to be a little ugly.

As it turns out, the facts in Bhutan are a little ugly. The folks at Freedom House have this to say:

Reversing its long-standing tolerance of cultural diversity, the government in the 1980s began imposing restrictions on Nepali speakers, also known as Southern Bhutanese, ostensibly to protect the culture of the ruling Ngalong Drukpa ethnic group. In 1988, the government began stripping thousands of Nepali speakers of their citizenship. The newly formed Bhutanese People's Party (BPP) responded in 1990 with sometimes violent demonstrations, prompting a government crackdown. Tens of thousands of Southern Bhutanese fled or were expelled to Nepal in the early 1990s, with credible accounts suggesting that soldiers raped and beat many villagers and detained thousands as "antinationals."

That was all under King Wangchuck the 4th, the same guy who made the pronouncement Ezra quotes approvingly above. I'm guessing that Bhutan's Gross National Happiness measurement probably didn't include ethnic minorities.

As you'd expect, Bhutan doesn't have a terribly free press either, nor freedom of assembly. Protestors and the journalists who report their activities are at considerable risk of arrest.

As Wangchuck 4 gave way to Wangchuck 5, freedom in Bhutan has improved somewhat. Amnesty International is reporting some progress, and with the new constitution and national elections last year, Bhutan is now a constitutional monarchy, which has prompted the folks at Freedom House to upgrade its rating from Not Free to Partly Free.

Bhutan's ecomony is weak, with a per-capita GDP of only $5200 in 2008. That's just slightly more than one third of the per-capita GDP of Mexico. Nevertheless, this is a huge improvement over Bhutan's 2006 figure of only $4100, making Bhutan technically the fastest growing economy in the world.

With figures like that, it's not hard to see why King Wangchuck was hoping to get people to ignore the GDP.

Over at Simple Justice, Scott Greenfield has taken time off from bashing marketers to bash coupon settlements. That's when some lawyers initiate a lawsuit against a corporation on behalf of a large number of people, and then settled for a payment that allows the corporation to send out some sort of redeemable coupon instead of cash.

In this case, it's the Ford Explorer rollover settlement, as summarized by the WSJ Law Blog:

The AP has a story out Monday taking a sort of retrospective snapshot on the Ford Explorer rollover class-action litigation. As part of a settlement reached last year, the nearly 1 million class members covered by the lawsuit each received the opportunity to claim a coupon worth either $300 or $500 toward the purchase of a new Ford vehicle. As of June 2009, according to the piece, only 75 people had used the coupons, at a cost to Ford of $37,500. The plaintiffs' lawyers, meanwhile, took home $25 million in fees and expenses.

Coupon settlements are a giant conflict of interest between the class-action lawyers and the people in the class.

To see why, consider a literary agent who's charging 15% to sell a book for an author. Suppose that by putting in an extra 100 hours of work, he could get the author an extra $100,000 on the book deal. That would earn him an extra $15,000 in commission, which works out to $150 an hour. If the agent values his own time at more than $150 an hour---presumably because he could earn that much working on another author's book---then he has no incentive to keep working. It's to his financial benefit to take the quick deal. But then his client is out the other $85,000.

This conflict is unavoidable whenever someone earns a fraction of the value of their work. It's why executive headhunters always push job-seekers to take the first offer, it's why real estate agents don't get sellers the price they want, and it's why factory workers don't work as hard as the factory's owners wish they would. It's also why lawyers working on a contingency fee are likely to settle for a smaller amount than their clients would prefer.

Coupon settlements are an especially egegious form of this problem for several reasons.

First, clients don't get to pick their lawyers, a judge does. I'm a little vague on the process, but I don't think the judge puts a high priority on the lawyers' proposed fee structure.

Second, clients have no bargaining power. Even though they usually have the ability to opt out of the class, there's nowhere else to go. By the nature of a class action, a mass lawsuit is the only effective remedy. Clients have almost no leverage to force the lawyers into a more equitable agreement. (As Scott Greenfield points out, there are people working to change that.)

Third, return business is not an issue. Some of the other examples I've given---such as literary agents and contingency-fee lawyers---hope to gain return business from the client and will therefore work harder on his or her behalf. Essentially, their true commission for doing well consists not only of the immediate commission, but the chance to earn future commissions. This makes them work harder for their clients. Class action lawyers have no such motivation.

The biggest problem with coupon settlements, however, is the difficulty in evaluating the value of the coupons at the time of the settlement.

It's easy to evaluate the coupons retrospectively, once we have information about their redemption rate. In the Ford Explorer case, members of the class have so far redeemed coupons worth $37,500. I think that's the cost of one tricked-out Ford Explorer. It's hardly a settlement for the lawyers to be proud of. It's probably not a settlement worth $25 million dollars either.

Even if that grows to $100,000 before all is said and done, the math is still pretty dismal: The lawyers won $25,100,000 in the lawsuit and kept $25,000,000 of it for themselves. That's a 99.6% fee.

The math probably looked a lot different at the time of the settlement. One million class members receiving coupons worth $300 to $500 each could add up to half a billion dollars, making the $25 million legal fee seem reasonable.

I suppose there are some who would argue that it's not the lawyers' fault if the class members failed to take advantage of the $500 million award. The thing is, the value of the coupons depends on what you can get for them, and so far that's just $37,500. I think an economist would regard this as the final, revealed, true value of the coupons.

Since lawyers are supposed to act in the best interests of their clients---the class members---they should also regard the revealed value to the clients as the only value that counts. I can't see any other intellectually honest way to look at it.

It would be naive to think that no one saw this coming. I think the key is to look at who had the most information about the value of the coupons at the time of the settlement. In order, they are:

• The class members. As the people who would receive the coupons and use them (or not), they knew more about their value than anyone, due to the fact that their behavior determines the value.
• Ford Motors. I'm sure Ford knows its customers and understands how they behave. The automaker may make mistakes and get fooled by its customers, but it still knows them better than anyone except the customers themselves.
• The lawyers. They spent a lot of time on this case and must have had a pretty good idea what would happen.
• The judge. He pretty much has to take the lawyers' word for what's good for their clients.

Since the class members are kept from direct involvement (with a few exceptions), the most knowledgable parties are the defendant, Ford Motors, followed by the lawyers. Naturally, they got the sweetest deal. Morally (although probably not legally), the lawyers essentially colluded with Ford to betray their clients.

Reason's Brian Doherty raises the alarm about Justine Varney, the new head of the Justice Department's Antitrust Division. According to a Wired article, she might be planning to go after Google.

The technology industry, she said, was coming under the sway of a dominant behemoth, one that had the potential to stifle innovation and squash its competitors. The last time the government saw a threat like this--Microsoft in the 1990s--it launched an aggressive antitrust case. But by the time of this conference, mid-June 2008, a new offender had emerged. "For me, Microsoft is so last century," Varney said. "They are not the problem. I think we are going to continually see a problem, potentially, with Google."

....Varney was suggesting that Google was repeating Microsoft's expansionist behavior. Instead of dominating the desktop, Varney said, Google was starting to colonize the emerging cloud-computing industry, amassing "enormous market power" and potentially creating an ecosystem that customers would be powerless to escape.

Google is an innovative company that has made all our lives better. For almost any problem I encounter in any part of my life, the solution begins with Googling something. I guess that's a monopoly, but it's also good customer service.

Lawyers and economists say that things get complicated...when Google moves beyond search and into Web services like online spreadsheets and video sites. Because its search and advertising algorithms are secret, there is no way for competitors or partners to know whether Google tweaks results to direct traffic to its own properties over theirs. Enter a street address into Google's search engine, for instance, and Google Maps tops the results. Type in "Britney Spears" and Google News comes up before People magazine or TMZ .com. (Google-owned YouTube tops the video results, above MTV and MySpace.)

Again, this is good customer service. Google is providing the answers people want.

If Google is using its search position to promote its other businesses, that could leave it open to charges of illegal bundling and leveraging--the same charges that Microsoft faced for packaging its browser onto the Windows desktop.

And the charges were just as stupid then as they are now. Not that that would stop the Justice Department and their war against winners.

Columnist Steve Chapman has a piece today complaining that the coming increase in the minimum wage will cause unemployment:

Come Friday, the federally mandated minimum wage will jump to $7.25 an hour from $6.55 -- an 11 percent increase. At a time when employers are laying off workers, Washington is going to make it more expensive to keep them.

If you're a minimum wage employee, your job will pay more, but only if it still exists. These days, most companies are scrutinizing every position on the payroll to make sure it's worth the cost. Raise the toll, and some employees will find they are no longer valuable enough to make the cut.

Increase the price of something, and people will buy less of it. This is solid economic thinking, based on well-established theories of demand. In this case, however, it may be wrong.

The problem is, when economists go looking for statistical evidence that this actually happens in the real U.S. economy, they have trouble finding it. One study even found that raising the minimum wage raises employment.

One possible explanation is simply that it's hard to put together a good empirical study of this effect. Low-wage employment is buffetted by so many factors that it's difficult to pick out the results of just the change in minimum wage. There could be a real increase in unemployment that is simply being missed in the noise. That doesn't mean it's doing no harm. We're just not seeing it.

Another possibility is related to the problem that the minimum wage...isn't. At least not for everybody. A variety of employees are excluded, including some workers at seasonal amusement or recreational facilities, workers at small newspapers or on small farms, workers involved in fishing or newspaper delivery, babysitters, people working as companions to the elderly or infirm, and anybody who receives part of their income as tips. An increase in the minimum wage could cause people to shift into these kinds of jobs instead of going unemployed, and there is evidence that it does.

(Oddly, Chapman actually complains about this---that increasing the minimum wage drives people into below-minimum-wage jobs---without acknowledging that this mitigates the job-destroying effects of increasing the minimum wage.)

Another possibility is that employers and employees could cheat by not recording all hours worked. This makes it look like the employee is receiving the minimum wage when the effective rate is actually lower. This is illegal, but an employee whose other choice is unemployment isn't likely to complain.

Yet another explanations is that employers may compensate workers in ways that don't show up in the accounting, such as providing supplies like work gloves and soap, allowing a more flexible work schedule, maintaining a break room, or tolerating on-the-job drinking. When the minimum wage is raised, employers could take back some of it by reducing these other forms of compensation.

Other possible explanations are more esoteric. For example, it's possible that labor market imperfections play a role. People who work for minimum wage are likely to be limited in their ability to find jobs. In particular, the cost of commuting or moving may be so high as a proportion of their income that they can only take jobs in a small geographical area around where they live.

This could so limit their job market that they essentially create a labor monopsony around themselves---effectively allowing all their potential employers to conspire to pay them less than the free market rate. Increasing the minimum wage might require these employers to pay them more, but because they are below the market equilibrium price, the increase in wage rate won't reduce the quantity demanded, and unemployment will not be affected.

On the other hand ("on the other hand" is a required phrase for all economics writers), note that if these explanations are true (with the exception of the last one) the reason an increase in the minimum wage doesn't cause unemployment to rise is that it doesn't actually increase worker income. That is, it does no harm because it does no good.

Yes, You Do Have Staff, But You've Got to Be Staff, First Too Both First and Too

Twitter, the Favor Economy, and the Power of Crowds

You've seen the ad:  some bozo, trying to project competence and connections, tells a potential customer:  "I've got people to handle that."  By which he means he can look up folks in the Yellow Pages, hire some, and take his chances that they can deliver.  After all, they bought an ad in the Yellow Pages, and that takes, competence, commitment, and a checkbook.  Well, a checkbook. Credit card, maybe.

You can do better.  Hell, I do better, and I'm, well, just a guy.  Look it up.

Before I get to twitter, let me tell you about a friend of mine, who I'll call Bob.  (That's not his name; that is his face.) We met something like fifteen years ago, when he was dating another friend of mine, and we've hung out a fair amount, since. 

There are folks who call me a Renaissance Man, but well, Bob's downright Heinleinian:  he can (and does) pilot airplanes, maintain cars, fix stuff, build houses from the foundation up (he's done that, and can do any of the tasks required in all of that), sail a small boat (although it did tip over, that time I went with him, throwing us into the icy cold waters of Lake Minnetonka; then again, I was at the helm), load his own ammunition, and Ghu knows what else.

Some years ago (long past the statute of limitations; chill), he decided that the house he owned then was eighteen and a half inches too short -- he had a cool stove that wouldn't quite fit -- so late on a Friday evening, he and his brother, Al (also not his name) tore off one side of it, put in all the framing and other stuff, including the additional flooring, and put the side back up and had it all painted and sealed up, better than what code requires, by Monday morning.

I could tell you a lot of Bob stories, but let's leave it that he can do damn near anything that can be done with one's hands, and that, from time to time, I've asked a favor or two of him.  The one thing that he can't do is maintain his own computers, and -- very rarely -- I get a call asking just how one farbles a glimrod under Vista, or whatever, and for two reasons, I get to farbling his computer's glimrod.

Yes:  I'm making out a like a bandit, and if I told you more of the stories --

"Yes?"
"Hey, Bob?  It's Joel.  I know it's 2:30 in the morning, but there's water pouring out of the ceiling in my kitchen, and -- "
"I got it. Put on a pot of coffee."
"That'll stop it?"
"Nah.  But I'm on my way, and a cup of coffee would be nice.  Don't worry.  We'll get it done."

-- you'd get it, even more.  (Yes, we do have fun; there was the time that we tracked a stolen car through city streets... yes, "tracked," not "followed." )

I also do some other stuff that Bob thinks is a good thing to be doing -- some of the political stuff -- and while he always makes himself available to help out in that when he can, he's of the opinion that, say, the writing and blogging is something that I can do pretty well, and that he can't do it near as well, and would rather folks like me who enjoy it spend time on.  Works for me.

I don't want to overanalyze this -- well, more than I already did -- but it's a pretty common thing: friends do favors for friends, and it all makes the world a better place.  Other than the fact that we enjoy hanging out together, both Bob and I do pretty well -- not just by the favors that we do for each other, but by those we do for others. 

Not a big deal, but a friend of Bob's once needed a quick carry class; he called me and asked me, and yeah, she got a quick carry class.  I'm not asking for a medal, which is just as well -- nobody offered me one, after all.  I just want to make the point that this doing stuff for folks stuff won't go only in one direction.  For long; you know the kind of person who acts as though they think a favor is something that you do for them, because they're too busy with their own lives, and all.  How well does that work out for them? 

Which brings me to twitter.

A few months ago, I followed the lead of some friends-who-I've-never-met-in-the-flesh, and -- while I thought it was silly -- took out a twitter account.  Mainly, I use it as an ongoing party line, a way to play with other kids while I'm doing something else, and that's fun.

But . . .

You'll see it now and then.  A tweet something like, say:

Request: anybody got a link to a good javabuttons generator? I'm thinking something like http://twurl.nl/vcpzki , but Open Source.

Which was quickly followed by:

Check this site out. Tons of great java ideas if you have never been here: http://www.dynamicdrive.com/

Which is how I ended up with javabuttons and a neat nav bar over here, over the weekend. I like it. 

Here's another one of mine.  I'd been looking into a lawsuit in another state (never mind quite why) and tweeted:

Anybody got a shortcut to information about case C 05-04532 JW in US District Court Northern District of California, San Jose Division?

A few minutes later, an attorney (I'm grateful, but I'm not going to name him without permission, lest other folks think that they get to importune him for legal research -- and I'll get back to that in a minute, I promise), tweeted:

Ask, and ye shall receive. http://is.gd/B7NB

And, if you go to the link, you'll find -- as I did -- that it was just the document I wanted, and would have looked for myself, if I'd known where to.  (I don't know exactly where he got it, or how -- but it's public information, and if I had access to the sort of tools he has at his fingertips and the knowledge of where to find that sort of stuff that he's developed, I could have found it, too.  And if my zayda had breasts, he would have -- but I digress.)

But I don't, and I didn't. I just relied on whoever was a: listening on the party line that is twitter, b: had, in the past, found what I contributed interesting or valuable (in his individual opinion; nobody else gets a vote, and that particularly goes for me) enough to take some time out of his day to look something up for me, and c: -- and this is one of the keys -- wasn't being importuned by me for "yet another favor," without me doing anything for anybody else in return, because, at least among some of the folks I meta-hang-out-with, I've contributed enough (in their opinion; mine doesn't count) putting a few work credits into the favor economy is worth the trouble, to them, even though, smart folks they are, they're probably thinking the same thing that I am when a neat query comes across:

Cool.  I can find that.

So, yeah:  the world in general -- and twitter, in particular -- is full of folks who know stuff, many of whom  will be happy to lend a hand, from time to time, and all you have to do to tap in on it is, well, obvious: Go out and do stuff.  Have fun.  Talk to folks; solve interesting problems.  Get your own work credits in, but have fun with it. Help folks, and put a call out there for assistance.

It'll be fine.  Trust me.
 

 

This is the long-awaited (mostly by me) fourth post in my series about the stimulus bill. I would have got it posted earlier, but I've been kind of busy. (You might want to read the first three parts about GDP, Fear, and Spending.)

Recall that under the theory behind the stimulus, recessions happen when consumers decide to reduce their consumption to try to save cash for an uncertain future. Individually, this is often a wise decision, but collectively, the crash in consumer demand leads to a drop in production which leads to unemployment. A stimulus plan is designed to replace the lost consumer spending with government spending, with the goal of keeping production and employment from slumping so drastically.

The fundamental problem with this approach is a simple matter of microeconomics. Think about what happens when you buy something for yourself---a shirt, or a hot dog, or a music CD: You trade your money to get something you like. In particular, you trade your money for something you like more than the money you traded for it.

Say you go to the store to buy a shirt. You find one you like, and based on its fit, comfort, and appearance, you figure it will improve the quality of your life enough that you'd be willing to spend $30 on it. So, if it costs more than $30, you will leave it on the hanger, but if it costs less than $30, you'll take it.

Good news! It's priced at $25. You pay the clerk and take the shirt home. You've now got a shirt that's worth $30 to you, but you only spent $25 on it. You have made a net improvement in the quality of your life, to the tune of $5.

The difference between what you spent and what you got out if it is called consumer surplus, and it's very important: Nearly all the benefits of our modern economy eventually show up as consumer surplus, with the result that most Americans live better than medieval lords. (Sure, they had servants, but we have antibiotics, clean water, and the internet.)

Sure, consumers sometimes make mistakes---that new Bon Jovi album that wasn't as wonderful as you'd hoped---but nevertheless, when you spend money on yourself, you tend to spend it pretty well. There are two important reasons why this is so.

First of all, you are a world-class expert on yourself. When you bought that shirt, you knew the right size, the right color, the right fit, the right style of collar, the right material and so on. You might not know everything, but you know more than anyone else. And although you may have guessed wrong about that Bon Jovi CD, nobody else could have guessed better.

There are a few areas---professional services such as medicine and law, for example---where this may not be true, but for most purchases, from nail polish to televisions to homes, you are the expert on fulfilling your own needs and desires.

The second reason you spend so well on yourself is that nobody in the world is more motivated to make wise choices on your behalf than you are. If you let somebody else make these choices, you tend to run into agency problems---the people making the choices tend to serve themselves rather than you.

(For example, send someone shopping for your groceries, and instead of returning with products that closely match your grocery list, they may return with the products that were easiest to find.)

Consumers spending for themselves are having their purchasing decisions made by the best-motivated and most well-informed individuals available. The same cannot be said when politicians and government bureaucrats make purchases on your behalf. In a nutshell, this is the libertarian argument against stimulus spending.

For that matter, this is the libertarian economic argument against all government spending.

It helps to imagine the purest case of stimulus spending, which is usually described as hiring half the unemployed to dig holes and the other half to fill them. This will certainly have the effect of pumping money into the economy, as the diggers and fillers spend their hard-earned salaries, but the entire first-order effect of the stimulus is useless. All that hard labor produces nothing that improves anyone's quality of life.

This is the libertarian's fear of government spending: Government bureaucrats are likely to waste the money because they are neither motivated enough nor well-informed enough to spend efficiently. Since government spending pulls resources away from more efficient private industry, the result is a net loss of production. And that would be bad.

However, there's an escape clause: During a recession, production is below it's theoretical limit, which means that valuable people and resources are sitting idle, waiting for someone to put them to work. Clearly, giving them work, even stupid work, can't possibly pull them away from something more valuable.

That's why so many economists agree that one of the best ways to stimulate the economy is to extend the amount of money given out through unemployment insurance. It's a direct handout of money to the people hardest hit by the recession, it doesn't tempt them away from real jobs, they'll probably have to spend most of it on consumer goods which spreads the money around, and since they're spending for themselves, they'll spend it wisely.

The next best stimulus plan is probably a tax cut of some kind, perhaps aimed at people near the bottom of the income distribution who are most likely to put it to good use. One way to do this is by giving block grants to state and local governments so they won't have to balance their budgets by taxing their residents to death. These taxes are often much less progressive than federal income tax so they hit the poor kind of hard.

These two stimulus measures---unemployment payments and tax cuts---are likely to be successful because they leave the decision making to the smartest people in the economy, the consumers.

Unfortunately, that's not how the stimulus package works. I'll explain what goes wrong in my next post.

It's been a few weeks since I've done any long-form blogging, but the normally sensible Reason website just linked approvingly to a Washington Post op-ed by Robert J. Samuelson that cries out for a response. He's talking about Obama's "green" energy plans and how we improve our economy:

Since the dawn of the Industrial Age, this has been simple: produce more with less. ("Productivity," in economic jargon.) Mass markets developed for clothes, cars, computers and much more because declining costs expanded production. Living standards rose. By contrast, the logic of the "post-material economy" is just the opposite: Spend more and get less.

Consider global warming. The centerpiece of Obama's agenda is a "cap-and-trade" program. This would be, in effect, a tax on fossil fuels (oil, coal, natural gas). The idea is to raise their prices so that households and businesses use less or switch to costlier "alternative" energy sources such as solar. In general, we would spend more on energy and get less of it.

I don't like most of Obama's economic agenda, but Samuelson's "spend more and get less" argument is incredibly silly. It only seems to work because he's conveniently ignoring the environmental benefits of Obama's plan---cleaner air and a cooler planet.

It's true these energy sources are more expensive, but contrary to what Samuelson says, we'd be spending more to get more: Instead of just getting the energy, we'd be getting the energy plus a better environment.

It's always easy to argue against a policy if you dismiss its benefits. I wonder, does Samuelson think a VHS video tape recorder is better than a digital video recorder because the VHS machine records up to six hours on a tape, but the DVR can't record tapes at all? Is buying a Tivo spending more to get less?

(It's arguable that cleaner energy won't solve global warming, but that's not the argument Samuelson is making. He's not saying that global warming theory is wrong, he's just assuming away the economic importance of pollution, which allows him to reach silly conclusions.)

The prospect is that energy and health costs may rise without creating much gain in material benefits. That's not economic "progress." Rebating households' higher energy costs (as some suggest) with tax cuts does not solve the problem of squeezed incomes. Given today's huge and unsustainable budget deficits, some other tax would have to be raised or some other program cut.

Samuelson is a little forgetful. Earlier, he described cap-and-trade as "a tax on fossil fuels." Obviously, the tax rebates to households could be paid for with the tax on fossil fuels. There's no reason a cap-and-trade (or carbon tax) program can't be revenue-neutral.

(On the other hand, there are rumors that Obama wants to give away the emissions permits instead of selling them. This would still raise energy prices due to scarcity, but the money would become a windfall to the energy companies instead of being available to help the poor.)

What defines the "post-material economy" is a growing willingness to sacrifice money income for psychic income -- "feeling good." Some people may gladly pay higher energy prices if they think they're "saving the planet" from global warming. Some may accept higher taxes if they think they're improving the health or education of the poor.

It amazes me that someone who writes editorials for a living would deride production that yields a psychic benefit. Why does he think people read his work if not for the psychic benefit?

Once you get past the basics---food, shelter, and clothing---almost all of our economy is driven by psychic benefits. Why else do we have tasty food, colorful clothing, comfortable homes, and sporty cars if not for the psychic benefits? Why do we have multi-billion dollar music, movie, television, and video gaming industries? Why do we have bars and ballgames and strip clubs if not for the psychic benefits?

When you get right down to it, don't you buy food for your children because of the psychic benefit of knowing your children aren't starving to death? Samuelson's distinction between material and psychic benefits is pointless, and not at all useful for policy analysis.

Unfortunately, these psychic benefits may be based on fantasies. What if U.S. cuts in greenhouse gases are offset by Chinese increases? What if more health insurance produces only modest gains in people's health?

Sure, the psychic benefits could be mistaken fantasies, but so could most of the material benefits. What if your new car is a lemon? What if your new clothes tear at the seams the second time you wear them? What if you buy the new Bon Jovi CD and it's not as good as you hoped it would be?

We cannot build a productive economy on the foundations of health care and "green" energy. These programs would create burdens for many, benefits for some. Indeed, their weaknesses may feed on each other, as higher health spending requires more taxes that are satisfied by stiffer terms for cap-and-trade. We clearly need changes in these areas: ways to check wasteful health spending and promote efficient energy use. I have long advocated a gasoline tax on national security grounds. But Obama's vision for economic renewal is mostly a self-serving mirage.

[Emphasis added.]

The economic argument for national security spending is that there's a free-rider problem: You can't sell national security in the free market because it's impossible to provide it only to the people who pay for it. Everyone benefits, so everyone should pay for it through a system of taxation.

The problem is that the exact same argument applies to air pollution and global warming: You can't sell clean air and a cooler planet in the free market because it's impossible to limit the benefits only to people willing to pay for them. Yet Samuelson is willing to have people endure higher energy costs for one but not the other.

There could very well be a reason for this. If he delved into the details of each policy, Samuelson might be able to show that the benefits to national security are far more certain than the benefits of clean energy. But he doesn't.

There are all kinds of problems with Obama's economic policies (e.g. the double counting that he uses to claim the benefits of both clean energy and the labor required to produce it), but Samuelson's complaint isn't one of them.

I know I still owe my readers a post on what can go wrong with the stimulus, but I found something interesting about the bailout. Kip Esquire posts the following context-free tweet:

If A owes B $2, and B owes C $2, and C owes A $2, and nobody has any money, then the required bailout is not $6, but $0. Just saying...

It's an excellent point. As a nation, all of us being in debt to each other should not be a very big problem. However, thoughtful supporters of government intervention would argue that while the bailout need not be $6, a figure larger than $0 might still be helpful. To understand why, consider the plight of C.

C has an idea for a business venture that could earn him some income. However, the venture needs some startup cash, and C is broke. Worse, C owes A two dollars. Meanwhile, M still has a bit of cash. Normally, M would be willing to lend C the money, but M is worried about C's creditworthiness in light of his inability to pay A. In theory, C has money coming from B, but in this troubled, debt-ridden economy, that income is not a sure thing: B might never pay. So M refuses to make the loan, C doesn't start his new venture, and the economy stagnates because the credit market is stuck.

Until one day, G steps in to save the day with a bailout package. G will loan A one dollar. A uses the dollar to pay off half his debt to B, B then uses the dollar to repay C, and C uses it to pay A. Now A owes B $1, and B owes C $1, and C owes A $1. Maybe this reduction in debt is enough to get M to make the business loan that C is hoping for. If not, A still has the dollar, and they can pass it around again to drive debt down some more. Eventually, C gets his business loan, A repays the dollar to G, and the economy is back on track.

This happy tale has a few unhappy complications. First of all, G doesn't actually have any money to lend. Instead, G either (a) sends men with guns to take the money from P, or (b) borrows the money from M, who is willing to lend G the money only because M knows that G can always repay the loan by sending men with guns to take the money from P.

Second, in addition to A's debt to B, A also owes $2 to D, $2 to E, $1 to its executives for their lucrative bonus plan, and $3 to China. When it gets its dollar from G, it pays those other guys instead of B and the credit market is still stuck. G has to loan A several more dollars before A finally decides to pay B.

Third, B hates being broke so much that when B finally gets a dollar from A, B decides to hang onto it rather than paying C and being broke again. G will have to pour even more money into the system to get B feeling comfortable enough to pay C and break the credit crunch.

Or maybe everybody just goes bankrupt and G has to rob P to pay M.

For those of you who had trouble following this little explanation, A through E are various banks and businesses, G is the government, and M is the private money lending market. Oh, and we the people are P. We're the ones who get robbed at the end.

I disagree with a lot of what Lindsay Beyerstein writes, but she's still one of the most thoughtful people on my blogroll. However, she gets a bit goofy when it comes to labor unions. Consider yesterday's post about the Employee Free Choice Act:

Management groups object to majority signup (aka "card check") for the simple reason that it would make it easier for workers to have a union if they want one. The anti-EFCA groups make it sound like card check would be a departure from the status quo under which the right of the worker to a secret vote is respected.

Far from being an exotic reform proposal, unionization by card check is already an option.

In fact, every unionization effort starts with organizers collecting the signatures of workers who are interested in forming a union.

If organizers can get at least a third of the workers in a shop to sign up, then the union can ask management for permission to represent those workers at the bargaining table. One third is just the legal minimum. In practice, organizers don't try to organize shops without strong majority support. It's just not worth their time.

At this point, the employer has the option of recognizing the union based on the card check. Alternatively, the employer can demand a National Labor Relations Board election.

Let's be real. Employers don't ask for NLRB elections to preserve right of their workers to democratic self-determination.

Well, no. That's not why employers ask for NLRB elections. But so what?  NLRB elections still preserve right of their workers to democratic self-determination.

Forced elections buy management time to bring in high-priced union-busting consultants who teach the bosses how to propagandize workers and fire organizers.  Such tactics are illegal, but under the status quo, the penalties are trivial and enforcement is negligible.

So fix that. If you want to support workers and you believe unions are a solution, then improve enforcement and increase the penalties. In fact, the EFCA already includes provisions to do both of those things.

Under the status quo, the employer gets to decide whether there will be an NLRB election.

Lindsay's right. That's pretty silly. Unionizing should always require an election. It's bad enough they're forcing employees to join the union when they don't want to. They should at least use a proper democratic process.

Under Employee Free Choice, the employees choose how their votes will be counted.

That's not really true. They only get to have a secret-ballot NLRB election if the majority of employees insists on it. Got that? Employees will have a non-secret vote to decide if they want a secret vote. If a majority of employees want a non-secret vote, the rest of the employess are forced to reveal their vote---allowing outside parties to influence their vote---even if they don't want to.

The right to a secret ballot is useful only if it belongs to each individual voter. Neither the union nor the company should be able to take it away.

Update: I'm trying to debate Lindsay about this in the comments to her post. I say card check is a fundamentally bad idea, she says it's good because it offsets the advantages of the employers. We're clearly talking past each other.

In the two previous posts in my amateur exploration of the stimulus (GDP, and then Recession), I explained what a recession is and what many economists think causes one. Now I'm going to try to explain my understanding of what a solution has to do, and why some people think a stimulus package is a good idea.

(This series of posts is my first attempt to write anything about macroeconomics, so if I've screwed this up, let me know in the comments.)

The problem, as you may remember, is that the population has a whole is trying to save money and is therefore not spending any. This reduction in aggregate demand leads to a decline in production and therefore in employment, causing much misery.

(There are some other theories about how recessions happen, but this theory is the one that seems to be behind the current stimulus package.)

The solution, in general, is to find a way to push aggregate demand back up to the normal level. This will happen naturally as struggling people and firms bid down wages and prices. With the same amount of money chasing lower priced production, consumption will eventually rise again.

But "eventually" is a long time. Is there something we can do to speed things up?

The best solution would be to have the CIA fire up their mind control machines and force all Americans to increase their consumption purchases back to the level they would have consumed at if there wasn't a recession. Since everyone's spending will support everyone else's income, we should skate right over the recession.

There are two problems with this approach. First, there's no such thing as CIA mind control (or so they told me to say). Second, people should only resume normal consumption to the extent that they reduced consumption due to fear of a systemic economic problem. To the extent that people reduced consumption due to fear of an actual personal economic problem---losing a big client, working on a product that has gone out of style, getting too old to star in porno films, etc.---they should continue the prudent path of reducing their consumption. This second problem also affects every other approach we will explore.

If we can't use CIA mind control to force consumers to spend more, perhaps we can simply persuade them, either by talking up the economy or by directly asking people to consume more. I'm pretty sure that President George W. Bush had this in mind when shortly after the 9/11 terrorist attack he clumsily urged Americans to "go shopping."

It seems doubtful that talking up the economy will actually work. When an elected official or one of his minions starts talking about how great things are, we tend to assume that he's just campaigning for re-election.

On the other hand, we seem to respond fairly predictably to fear, so I think our leaders can really hurt the economy by talking it down. It can't have helped consumer confidence in their economic future when Treasury Secretary Henry Paulson practically wet himself over the bank crisis.

If we can't force people to spend more, and we can't talk them into it, maybe we can trick them into it by making them feel richer. Crank up the presses at the Bureau of Printing and Engraving, print up $1 trillion in hundred-dollar bills, and send about $3000 in cold hard cash to every man, woman, and child in America.

It won't make anyone any richer---printed money has no intrinsic value, and printing a lot of it has no immediate effect on GDP---but maybe it will make people feel richer. They'll become more free with their money and buy more stuff, aggregate demand will rise, and people will go back to work to produce all the stuff we're buying. The recession will be over.

With a few tweaks, this is actually the first workable idea I've described. In fact, we already have the Federal Reserve working on it. Rather than mailing out packages of cash, the Fed manipulates the money supply through large-scale transactions in goverment securities, loans to member banks, and adjustments to certain banking regulations, with the goal of driving down the interest rates banks charge each other for short-term loans of cash. This has the same effect on the money supply as sending out piles of cash, but it's far easier to do.

In fact, the Federal Reserve has been doing this for decades, lowering interest rates to fend off a recession, and then raising them to fend off crippling levels of inflation. (Increasing the money supply doesn't directly increase GDP, so if there's more money chasing after the same amount of stuff, it drives up prices.)

The problem is, the Fed has nowhere to go. The current target interest rate is essentially 0%, meaning the Fed is happily pumping up the money supply whenever it can. This has never happened before. Clearly, while manipulating the money supply---monetary policy---is a workable idea, it's not enough to fend off the current recession.

(Some people think the real problem is that having the Federal Reserve manipulate the money supply is not a workable idea, and that any appearance of success is just blind luck. This seems unlikely to me, but it's not something I'm confident about.)

The failure of the Fed to fix the problem with monetary policy leads us to reconsider one of the ideas I mentioned earlier: Forcing people to spend money.

The good news is that even the crazy people in Washington realize they can't create a Department of Spending to send out men with guns to force us all to spend money. The bad news is that they don't need to. They have the IRS.

Recall my line diagram:

Instead of encouraging us to spend more money, the government can simply take the money from us and spend it directly. If we won't push our spending up from the red line to the blue line, they'll take our money and do the necessary spending on our behalf.

This doesn't require quite as much spending as you'd think, because the same multiplier effect that helped speed the crash will also help with the recovery. The people who benefit directly from the government spending will go on to spend some of the money they receive, which will add to somebody else's income, who will go on to spend more money, and so on. This allows a relatively small amount of spending to make a difference.

The multiplier effect also adds a complication, because different ways of spending the money will likely have different multipliers. Pundits are discussing whether government spending has a better multiplier than private spending, whether poor people have a better multiplier than wealthier people, and whether you get a better multiplier from one quick burst of spending or from a long-term spending program.

Next: Problems with the stimulus.

This is the 2nd post of my amateur exploration of the reasoning behind the stimulus bill. I think I do okay writing about microeconomic issues, but this is my first real attempt at discussing macroeconomics. There's a distinct possibility that some of this is very badly wrong, or worse, so badly written that it's not even wrong.

My last post explained what happens to Gross Domestic Product during a recession. Normally, our GDP should be steadily increasing as indicated by the theoretical blue line in the graph below, but instead it takes an unexpected dip like the red line below, taking our standard of living with it.

This happens without any obvious cause such as a disaster that destroys our productive capacity. As I explained, it seems to happen out of some sort of collective madness which just makes us stop working.

It turns out that's actually pretty close to the explanation that many economists accept. It goes something like this:

Suppose you're an ordinary laborer in the normal economy, just working for your paycheck, saving a little, and spending the rest on the usual sorts of things---food, shelter, clothing, transportation, health, entertainment, and so on.

Then one day something happens that makes you think your income is going to take a dip in the next year or so. Maybe your company announces it's going to close the plant you work in, or maybe you're in sales and you lose your biggest customer. Whatever it is, something makes you think your income is going to decline, possibly all the way to zero, in the near future.

The obvious, sensible, rational response is to start trying to save enough money now to get you through the rough times ahead. You do this by cutting back expenses. You buy fewer video games, eat out less, rent from netflix instead of going to the movies, cancel the Hawiian vacation you had planned, and put off replacing your old car. You take the money you save, and you put it in the bank.

You are not the only person affected by your decision to cut back expenses. All the people you bought from will feel the pinch too. Your decision (at least in theory) reduces the income of the clerks at the video game store, the servers and chefs at the restaurants you patronize, the staff at the movie theater, the airline and hotel you would have used for your trip, and your car dealer and the employees of the plant that makes the car.

These people, facing the decline in income, make cutbacks of their own, passing the misery on to the people they buy stuff from, and so on, and so on. Through this multiplier effect, your change in spending habits has a small but far-reaching effect on the economy around you. Likewise, changes in other people's spending habits have a small but real effect on your income.

On the other hand, these effects are somewhat mitigated by the banks. When people save their money in a bank, the bankers promptly lend it out to other people who, unlike the savers, are trying to increase their spending by borrowing money. And just as your cutbacks were multiplied into your economic sphere, their increase in spending provides money to the people they buy from, allowing them to spend more as well. Most of the time, spread out over the millions of people in our economy, it all works out about the same.

The problem comes when, for some reason, everybody becomes worried about their future at the same time---perhaps because of a sudden shock in oil prices, or a stock market crash, or a wave of bank failures---so everybody tries to save money by cutting back on expenditures at the same time. Since everybody's expenses affect everybody's income, the decision to cut back spending leads to a nation-wide reduction of income, also known as a recession.

The banks are no help because with everybody saving, nobody wants to borrow money, then when the recession hits, nobody has money to put in the bank. (In the current crisis, the credit markets have frozen up, so nobody is lending money that would boost consumption.)

To make matters worse, everybody can see what's happening. Even people who hadn't been afraid for their incomes before the recession will begin to worry about the economy, and they will start cutting their expenses, further deepening the recession. In this way, a vague fear of the future can transform itself quickly into a recession that's happening right now.

Our economy does not adapt to a recession smoothly. The math behind a recession shows that if everybody agreed to a small reduction in income, we should be able to slip through without increasing unemployment. But for reasons that are complicated and puzzling to economists, income is "sticky" downward---nobody wants to be paid less---so instead of incomes dropping evenly, many people's incomes barely drop at all, while other people lose their incomes completely when they get laid off.

There are other theories that can explain how recessions happen, ranging from the likely-to-be-true-in-some-cases to the ravings of lunatics, but this is the explanation that will eventually lead us to the justification for the stimulous bill.

Next: Some solutions.

I want to bloviate about the economy and the stimulus a bit, so I'm going to try to explain our current unpleasantness as I understand it. My economic knowledge is purely amateur, so if you think I'm wrong, let me know. (And if you think my explanation is so bad it's not even wrong, let me know that too.)

The U.S. Gross Domestic Product (GDP) is, roughly speaking, the value of everything produced in the United States in one year including all the goods and services that make our lives better---from food, clothing, and medicine, to booze, music, and television. GDP is not the economist's final end-all measure of success, but it's probably the best estimate of success. (GDP also includes the production of capital goods, exportable goods, and whatever the government does, but those don't participate much in the story I'm trying to tell.)

In normal economic times, GDP increases slowly as time goes by. In part, this is simply because the U.S. population is increasing and therefore the size of our labor force is increasing. More workers are producing more goods and services.

GDP also grows because of increases capital. Note that to an economist, capital does not mean money. Rather, capital is the means of production, anything that makes it possible for workers to produce stuff for someone to consume.

A can of tuna in your pantry is the final consumer good, and a tuna fish in the ocean is raw material, but everything used to turn that fish into that can of tuna is capital, including the fishing boat used to catch the fish, the forklift that move the fish into the canning plant, the canning plant itself and all the canning machines, the tools used to repair the canning machines, the trucks used to carry the cans to the supermarket, the supermarket itself, the grocery cars, the cash registers, and the parking lot where you place the bags of tuna cans in your car.

(The actual cans containing the tuna are not capital because they are used up in the process of production. Similarly, such consumable supplies as the energy used to run the factory, the fuel for the delivery trucks, and the paper for the cash register are also not capital. They're just inputs to the process of making the final product.)

Finally, not only are more people working in more factories (labor and capital), but the factories are becoming more efficient, which makes the people more productive, thus raising the GDP. In other words, GDP also grows because our technology is improving.

So, if you chart GDP over time---five years, say--it's supposed to look something the blue line on this graph:

Most of the time, that's what happens. There are a few bumps and squiggles, as well as some seasonal variation, but actual GDP tends to follow the slow theoretical upward path pretty steadily, and year after year our lives get a little better. Over a few decades, the effect accumulates like compound interest, and our lives get a lot better.

Every once in a while, however, something strange happens: Instead of the nice theoretical blue line dicated by labor and capital growth, the actual GDP takes a dip for year or two, as shown by the red line in this graph:

We call this a recession. Since the quality of our lives depends on the goods and services we consume, the sudden dip in available goods and services reduces the quality of our lives.

We don't normally think of it that way, however, because of a simple fact about the GDP: All of us earn our incomes from our part in producing the GDP. So we don't experience it as a drop in available consumer goods, we experience it as a drop in the income we have available to purchase consumer goods.

In a way, that doesn't so bad. Look at the red line in the graph above. The bottom part of the recession dip is still above the position of the blue line at the left edge of the graph. This illustrates an interesting point: For a healthy, growing economy like ours, a recession is like taking our standard of living back in time, and usually not more than a few years back. Even if we lost a whole decade, were things really that bad in 1999?

No, but a recession to 1999 levels could still be fairly painful. First of all, our standard of living has been rising slowly for the last 10 years, but a recession would be a sudden shocking drop, which is much harder for people to handle. Second, the loss of income isn't spread evenly across the entire workforce. Instead, most people sail through the recession with hardly any loss in income, but a few people experience devastating losses, losing their jobs and declaring bankruptcy. Third, the loss of income isn't spread across industrial sectors. Some sectors manage to grow during a recession, while many stagnate, and a few of them (usually those already teetering on the edge of relevancy) vanish completely, taking the careers of thousands of people with them.

That's what a recession is like, and in a fundamental way, it's a very strange phenomenon. Remember, GDP growth is caused by increases in labor, capital, and technology. So you'd expect that one of those is decreasing in order to make GDP decrease, but which one is it?

It's not the workforce. No plague has wiped out millions of workers. And as we all know, unemployment goes up during a recession, meaning that there's plenty of labor available, but there isn't anything for them to do.

It's not capital. No nuclear war has destroyed our industrial cities. Investment does slow down during a recession, but the existing capital goods aren't destroyed. During a recession there are tons of closed factories, empty offices, parked trucks, unused generating capacity---all the tools to produce goods and services for consumers---just waiting for someone to put them to good use.

It's not technology. No hoards of religious fanatics have suppressed our science as a offense to their god. Technology has been improving for centuries without any backsliding. We haven't suddenly forgotten how to make stuff.

So what the heck is going on? For some strange reason, we've started producing less and less instead of more and more. It doesn't make sense. The factories are built, the workers are eager, and we know what we should be doing...but we're not. Our economy has been overcome by madness.

Update: I have modified the second paragraph to reflect Kip's correction in the first comment below.

Next: An explanation.

Obama is displaying some of that weird anti-corporate attitude that has been worrying me:

President Barack Obama issued a withering critique Thursday of Wall Street corporate behavior, calling it "the height of irresponsibility" for employees to be paid more than $18 billion in bonuses last year while their crumbling financial sector received a bailout from taxpayers.

Then there's Biden, who just seems to say whatever flits through his head at the moment:

Vice President Joe Biden also chimed in, saying the level of bonuses "offends the sensibilities."

"I mean, I'd like to throw these guys in the brig," Biden said in an interview with CNBC.

You may be wondering, as I was, why paying $18 billion in bonuses is a bad thing. After all, Obama and the Democrats in Congress are planning to spend over $800 billion on various projects to stimulate the economy and stir up consumer demand. Doesn't the $18 billion in bonuses also stimulate the economy?

A later paragraph makes it all a bit clearer:

Obama said he and Geithner will speak directly to Wall Street leaders about the bonuses, which threaten to undermine public support for more government intervention as the economy keeps reeling.

So the real problem here is that the American public might not like Obama's plan to give billions of dollars of our money to failing companies. What's next? Following Bush's lead in the Iraq war by scolding the news media for reporting that the stimulus funds are being wasted?

What's irresponsible and shameful here is giving hundreds of billions of government money to private businesses. Whining about how they spend it doesn't help. Just don't give them the money.

Said Obama about Wall Street leaders: "There will be time for them to make profits, and there will be time for them to get bonuses. Now is not that time."

The arrogance here is amazing. Did it ever occur to these buffoons that not every department of every financial company is in ruin, meaning that some of these people must have earned those bonuses? Or that you have to pay bonuses to keep good people? Or that for many workers, a so-called "bonus" is actually a regular part of their pay?

I worry that this is only the beginning. I'm afraid that once government "stimulus" money starts flowing into every economic sector, the folks in Washington are going to think they should run it all.

Update: This AP wire story explains it nicely:

To President Barack Obama, Wall Street's $18.4 billion in bonuses is "shameful." To thousands of bank employees who don't sit in corner offices, that money helps pay the bills...

While Wall Street investment banks and other financial firms make headlines for the millions paid out to certain executives, more modest bonuses go to workers from human resources representatives to secretaries as well as employees who actually made money for their companies last year.

...

A product manager at one investment bank said she is cutting corners after her 2008 bonus fell by 38 percent, even though her job performance exceeded expectations and her division posted a profit. To save money, she's raising the deductible on her health insurance to lower the premium, shopping around for less expensive car insurance and cutting back on small luxuries.

"My bills haven't gone down by 40 percent," said the worker[.]

Adam Lass at Contrarian Profits has this grim advice:

The deep recession expected in 2009 will likely lead to higher rates of crime. Adam Lass says investors can play this trend by picking up shares of commercial jails. Florida-based Geo Group (NYSE:GEO) operates in several countries and is rapidly expanding its detention facilities. Adam says investors could be in line to double their money by the summer.

I don't know anything about the Geo Group, but there's a straightforward economic argument that I should invest in the prison industry---I get something good either way: If Lass is right, and the prison industry expands in the near future, I'll make a lot of money. On the other hand, if the prison-industrial complex implodes and dies, I will get to experience the joy of watching the prison-industrial complex implode and die.

In other words, I'm hedging my investment, balancing the financial and psychic rewards.

The AIDS viatical business in the late 1980's is another example of this kind of hedge. If you invested in these viatical settlements---paying a large lump sum to someone with AIDS in return for the right to collect their life insurance payment when they died---you probably lost money when anti-retroviral drugs started knocking AIDS back and lengthening the lives of AIDS patients. On the other hand, it wasn't a total loss because you got to live in a better world where AIDS was no longer a death sentence.

Note that these kinds of investments are only hedges if you invest in something you hate. If you think putting ever increasing numbers of Americans in prison is a great idea, then investing in the prison industry is a high-risk investment: If the prison business fails, you lose a lot of money, and you have to endure all the people getting out of prison.

It's this kind of thinking, of course, that makes people think economists are crazy. Who in their right mind would tie their fortune to a business they hate? Personally, I'd rather invest in something I like, so that if it wins, I get both the money and the joy of winning. High risks are part of the price for high rewards.

Still, if you hate some company---Microsoft, Wal-Mart, Halliburton---consider investing a few thousand dollars in it. That way if it hasn't gone out of business ten years from now...at least you'll have the money.

(Hat tip: Guither)

I'm not as upset as some people about Chrysler taking out an ad in the Wall Street Journal to thank us for the money. Sure, they're thanking us by spending $100,000 of our own money, but really, that's a drop in the bucket. Besides, they'll pay it all back, in theory.

On the other hand, Mark Cuban has a great idea how to get our money back if they give us trouble:

I could watch that all day.

I've been wanting to write a bunch of posts about the crisis in the auto industry and why I think a bailout is a bad idea, but I haven't had time, so here are a few quick observations.

Automakers are not like power companies.

One of the arguments for bailing out the financial sector was that banks are like the electric power companies: Everything else depends on them. Letting the banks fail would be like letting the electric power companies fail, plunging our nation into darkness, our cities into chaos, and our economy into a death-spin.

Unlike most power companies, the automakers are not monopolies. Altogether they supply about half of the domestic market, with the rest coming from American subsidiaries of foreign automakers and imports. If they go out of business, those other companies will step into the market.

Also unlike the power companes (or the financial sector) the millions of vehicles we have on the road will keep working even if their manufacturers go out of business.

Bankruptcy does not mean Out of Business.

The "Big 3" automakers might be out of money, but they still have all their produtive assets---assembly plants, distribution networks, car designs, valuable brand names, spare parts for cars already on the road, a pool of suppliers, access to a skilled labor pool, and so on---and those assets could be put back in use by whoever gets them from the bankruptcy proceedings.

In fact, since U.S. bankruptcy law recognizes that functioning companies are more valuable to creditors than the mere sum of their assets, a bankrupt automaker would almost certainly emerge from bankruptcy intact, with reduced debts, new owners, and probably new management.

Demand will continue to require a supply.

Even if all the "Big 3" automakers went completely out of business, much of the demand for their products will remain. For example, with millions of cars already on the road, there will be a demand for spare parts for years to come. Someone will snap up that business and keep it going.

Also, people will still want cars, and the remaining automakers will need a way to ramp-up production fast enough to meet demand. To do this, they will almost certainly have to use the resources freed by the bankrupt automakers---factories, trained workers, existing parts suppliers.

In fact, since not even the "Big 3" are total failures, they will probably buy up entire car lines. For years we'll be seeing new models of Toyotas and Hondas that look just like some of the cars made by by the late Ford, Chrysler, and GM.

We don't have to help the auto industry to help auto workers.

If we want to do something about the "human cost"---workers losing their jobs, retirees losing their pensions---then the best approach is probably to make keyhole interventions. If we're worried some people will suffer, then we should help those people.

Pump funding into the Pension Benefit Guaranty Corporation. Provide additional unemployment payments to auto workers who lost their job, help them find a better place to work. We don't need to bail out the entire industry to help the people who work in that industry.

We can experiment.

If we're still worried about the dire consequences of failure of the auto industry, then let's not make the decision all at once. Before we give the auto industry billions of dollars to prop it up for a few more months, let's try an experiment: Let's let one of the "Big 3" automakers go bankrupt.

If I'm wrong, and it turns out to be real bad, we can still bail out the other companies. But if I'm right, the bankruptcy of one of the automakers will either have little effect, or else it will give the remaining companies a boost in profits. Maybe the failure of the worst-performing automaker would solve the industry's problems.

Don't let this happen.

This has been making the rounds, and it sums up my feelings about the bailout pretty well:

Source: The BEAST

A parable:

A few days ago, I was mugged by a white guy who stole about $300 from me. Then just yesterday, a black guy tried to mug me, but I got away. Am I a racist for not letting the black guy mug me?

Some people say that since we bailed out the fatcat investment bankers, it's unfair not to bailout the labor-intensive Detroit auto industry. I disagree. It's not about fairness. It's about not getting mugged again.

In response to my brief hand-off to Moby Kip's post about why we shouldn't bailout the big three automakers, somebody calling himself an Authentic Connecticut Republican (I'm assuming they're rare there) posted a long pre-written screed, complete with bold text. I was about to delete it when I realized...it wasn't all as crazy as it looked.

Here we go:

While the sanity of blowing cash around and running the national debt up even further is questionable; it seems inevitable - so this time let's target unemployment, create AMERICAN jobs and pump up the economy all at one time.

"Creating jobs" always sounds good, but it's not that easy to do, and it's not really something the government should be trying to do. It's just not a good target for government efforts.

Consider the following:

Manufacturing costs of motor vehicles are 65% labor (i.e.: W-2 income), that's not all direct but due to suppliers. GM alone has over 1300 suppliers. (That's a lot of jobs!)

1 in 10 Americans makes all or part of their income due to the automobile industry.

Money turns over 5 times in a year.

Thus a vehicle with a manufacturing cost of 20K produces 13,500 in W-2 income which in turn becomes a total of 65K in 12 months due to the 5 turnovers. (This isn't magic, it's simply how the economy works.)

I've never understood how these "turnover" and "multipler" effects are supposed to work. They matter when you're managing the money supply---because a slowdown in turnovers is the same as a contraction of the money supply---but I don't understand why it matters where the money goes once the car is built.

The other point is that this kind of math can be done for every industry and company in the U.S. economy. Most of those aren't as big as the auto industry so "saving" them wouldn't help the economy as much, but then again they would also be a lot cheaper to save. Maybe we could save 50 or 100 smaller industries.

For that matter, why not leave the $25 billion in the pockets of the taxpayers? With 150 million people in the labor force, that leaves an extra $160 in everybody's pocket. Won't it turn over five times there too?

Our domestic car makers are saddled with legacy costs, most of which will reduce dramatically in 2010 due to contract changes. They need to survive to get there.

No they don't. The legacy costs also go away today if the automakers go bankrupt today.

Our own over-zealous government with a virtual alphabet soup of regulatory agencies has been no help either.

Foreign competitors have worked off-shore collectively to meet various US gov't. imposed emission and safety standards, thus dramatically reducing those R&D costs. American car companies are prohibited from that by our FTC.

If that's true, it sucks, but why does that mean they should they get my money?

Make no mistake; it's no surprise that once again government has been a major part of the problem.

Here's the solution.

Instead of either shipping cases of cash off to car makers; or sending us all another check:

Send out a voucher for say $1,000 good on a motor vehicle for the percentage of the vehicle that's domestic. (Civic = 70% Ford Explorer=80%)

Let those not interested in a new car sell or give away their vouchers (Ebay would be loaded with them in no time flat) and those that are so inclined can use as many as they can get their hands on up to the full MSRP of the vehicle.

I think that's...a very good idea.

I'd rather we don't bail out the carmakers, but if we're going to do it, this is a pretty good way. The domestic content requirements combined with tradability would mean that the carmakers still get the money, but the allocation among carmakers would still be driven by market forces.

The question of how to allocate the bailout money among the carmakers is a horrible problem that I haven't heard discussed much. I'm not sure that maximizing consumer value is the best approach, but I suspect it's better than whatever the folks in D.C. are planning. If they even tell us the plan.

I was planning to write a post on the foolishness of bailing out the big domestic auto makers, but Kip Esquire has already written it for me. This is an important point to remember:

"Bankruptcy" is not the same as "liquidation." No one is seriously suggesting that General Motors be liquidated, all its plants shuttered, all its equipment left to rust and all its employees let go. Any obfuscation on this point is disingenuous fear-mongering.

Read the whole thing.

So, that big emergency bailout that Treasury Secretary Paulson said we needed in such a hurry? Now he's saying we didn't need it after all.

WASHINGTON - The government has abandoned the original centerpiece of its $700 billion rescue effort for the financial system and will not use the money to purchase troubled bank assets.

Treasury Secretary Henry Paulson said Wednesday that the administration will continue to use $250 billion of the program to purchase stock in banks as a way to bolster their balance sheets and encourage them to resume more normal lending. He also announced that the administration was looking at a major expansion of the program into the markets that provide support for credit card debt, auto loans and student loans.

Essentially, Paulson is admitting he didn't know what he was doing when he panicked us into giving him all that money.

So now the government will spend only $250 billion and use the remaining $450 billion to pay down the deficit.

Hah! Just kidding. No, they want to spend it on something else, anything else. They don't even know what yet:

Paulson said the administration is exploring other options, including expanding the program beyond banks to nonbank financial institutions which provide essential credit to both businesses and consumers. He suggested that capital could be provided to institutions on a matching basis in which the government would supply money to those able to raise money on their own.

And for a bunch of Republicans who are supposed to be against big government (I know, I know) they still don't understand that they are screwing up the economy by not leaving it alone:

"Our financial system remains fragile in the face of an economic downturn here and abroad," Paulson said. "Market turmoil will not abate until the biggest part of the housing correction is behind us. Our primary focus must be recovery and repair."

Yes, the housing correction is the primary cause and, yes, it will cause trouble until we've dealt with it, but "market turmoil will not abate" until you stop rearranging $100 billion chunks of it by fiat, forcing the market to react to your every whim!

The bailout money also should be used to support efforts to keep mortgage borrowers from losing their homes because of soaring default levels, he said.

Uh, keeping the housing market from correcting itself is not how you put the housing correction behind us. (Although, if we're going to just throw money at the problem, which appears to be the plan, this is probably not the worst place to throw it. I can't believe I'm saying this.)

Elsewhere, Paulson praised a new set of guidelines issued Wednesday by the Federal Reserve and other bank regulators, saying that they addressed a crucial issue of making sure that banks continue to lend at adequate levels.

The guidelines urge institutions to continue lending to credit worthy borrowers and to work with mortgage borrowers to avoid defaults. In addition, the guidelines encourage the banks to set dividend payments for shareholders and compensation for executives with the current crisis in mind.

This is turning out just like my rent control example (just skip down to it). The banks aren't responding to the incentives in the way the government wants them to, so the folks running the government are involving themselves more and more in the market to try to control it. If this keeps up, by summer the feds will be denouncing bankers for their greed and indicting them for not following the ever-changing rules.

A few months ago, John McCain was lambasted by some of the punditry for his commenting that the fundamentals of our economy are strong. I never had a problem with what he said. The fundamentals of our economy were strong: Unenployment wasn't very high by historic standards, our farms and factories and business offices were still well-maintained and up-to-date, our workforce was well trained, our productivity continued to increase, as did our GDP. There were problems with high gas prices and the sub-prime loan market, but everything else was fine.

Then Treasury Secretary Paulson and a lot of other politicians begain to say some very frightening things, and as I noted, that could have a lot of unpleasant consequences, including a lot of tight regulation and government meddling in the market. Suddenly the DOW went crazy, banks stopped making loans, and consumers stopped spending so much. Now, as I also noted, everyone is taking a wait-and-see attitude---hoping the craziness will end soon---and that's going to hurt us.

The latest numbers show that our economy started to faulter in the third quarter, and as I understand it, much of the trouble came in the latter half of September, right after Paulson started screaming like a frightened child.

Here's a great interview of UCLA economist Lee E. Ohanian saying pretty much what I've been saying, only he really knows what he's talking about:

I'm not just making this stuff up.

A few days ago, Treasury Secretary Paulson was using heavy-handed tactics to make banks take billions of tax dollars. Now there's this:

WASHINGTON - An impatient White House served notice Tuesday on banks and other financial companies receiving billions of dollars in federal help to quit hoarding the money and start making more loans.

"What we're trying to do is get banks to do what they are supposed to do, which is support the system that we have in America. And banks exist to lend money," White House press secretary Dana Perino said.

Though there are limits on how much Washington can pressure banks, she noted that banks are regulated by the federal government.

"They will be watching very closely, and they're working with the banks," she said.

This is what I was talking about in my earlier lengthy post that no one commented on (not that I'm bitter). In a situation this complicated, it's hard to predict what will really happen when you make a change. The economy is a complex system and the players think for themselves.

This is why we can give these banks a few billion dollars only to discover they don't want to loan it out again. I think I understand why.

My favorite analogy to explain why failing banks needed to be bailed to relieve the credit crunch was that it was like a huge traffic jam where some of the cars were idling so long that they ran out of gas and were now blocking the rest of the traffic. You have to give some of the cars more gas, but it won't help to give gas to the drivers that wisely planned ahead for traffic and still have plenty of gas. You have to give the gas to the cars driven by people who have run out.

But if you're one of the drivers who just got a few gallons of gas, your thinking might go like this: I thought I was doomed, but now I have enough gas that I just might be able to crawl through this traffic to reach the next exit. However, I notice that the government is giving gas to a lot of other drivers. That should clear up all this traffic, so if I wait here and do nothing until everyone else has driven away, I should be able to reach the next exit at high speed, using very little of my precious gas. Then I'll have some left over for other things.

Of course, if every bailed-out driver thinks that way, giving them free gas won't do a thing to get traffic moving.

In other words, banks don't want to lend out the government money because they've just used it to plug a huge hole in their balance sheet. If they loan it out, they'll be right back where they started, but with even more outstanding loans. Better to let the other banks make the loans and get the economy moving, then make your loans into a safer market.

Here's another telling note:

Treasury Secretary Henry Paulson has said the money was aimed at rebuilding banks' reserves so that they would resume more normal lending practices. But reports then surfaced that bankers might instead use the money to buy other banks. Indeed, the government approved PNC Financial Services Group Inc. to receive $7.7 billion in return for company stock and, at the same time, PNC said it was acquiring National City Corp. for $5.58 billion.

Great, huh?

You know...the government doesn't actually have this money sitting around somewhere. They have to borrow it first in order to give it to the banks. How long until one of the bailed-out banks closes the loop by investing in U.S. Treasury notes?

Economist and New York Times opinion columnist Paul Krugman just won the Nobel Prize for economics. Despite his controversial opinions in the Times, he really does deserve this award. I was going to explain why, but Arnold Kling does a much better job of it.

His theories on international trade tend to recommend more government intervention than traditional trade theory did, but they also explain anomalies that the traditional theory couldn't account for. Even so, he was careful to point out that many populist demands for trade protectionism do not meet the requirements of his theory.

Krugman is responsible for my own interests in economics. I read an article about him in some magazine, and decided to read one of his books. I can't remember which one it was---I've read several more since then---but it was back when he wrote about economics more than politics. I found it fascinating, and I kept on buying more economics books.

It started with Bear Stearns. Just a few billion dollars to take the edge off.

Then Fannie and Freddie gave their lives over to the drug completely, followed by AIG.

Suddenly everbody wanted a hit, they soaked up the drug to the tune of $700 billion dollars, and we thought it was over, but they kept wanting more, and the pushers keep supplying them:

The Federal Reserve announced Tuesday a radical plan to buy massive amounts of short-term debts in a dramatic effort to break through a credit clog that is imperiling the economy.

...

The $99.4 billion daily market for this crucial financing, which relies on investors rather than banks, has virtually dried up. Most investors have become too jittery to buy paper for longer than overnight or a couple days.

I don't know who first coined the phrase "junkie economy," but it's sure appropriate. I don't know how we expect the financial players to restructure themselves when we keep enabling their behavior.

Radley Balko has a few comments about some of the stuff that's made it into the bailout bill to sweeten the deal and get enough votes. Check it out.

I think the mental health provisions were part of the original bill that the Senate hijacked for the bailout. (For some procedural reason, it's easier to amend an existing bill than to introduce a new one.)

[Update: I've been reading a lot more about the crisis, and a lot of what I say here is wrong. For example, I assumed that financial experts knew how to evaluate the structured deals and investment vehicles, and therefore that the uncertainty arises because of the difficulty in valuing real estate. Apparently, however (and I could be wrong again), the uncertainty problem is not the real estate, or even the mortgages. It's that the financial experts were in fact unable to evaluate the subprime risk in the structured deals and investment vehicles they had built.]

This post is something of a think piece. I want to try to explain the free market approach to the current crisis, as I understand it. This is not an educational piece. I'm not writing this for your benefit. I'm just thinking out loud as a way to try to improve my own understanding of the situation. I hope I've got some of this right. Let me know if you think I've screwed it up...as I probably have.

The central problem of economics is how to allocate production and consumption most efficiently, and free-market economists believe the free market is the best solution. In the ideal case, this is not particularly controversial: Using rigorous mathematical models of some fairly reasonable definitions of "free market" and "best solution," it's easy to prove that a perfect free market will allocate resources perfectly.

Of course, our real-life markets are not perfect, and economic controversies arise over how much inefficiency is caused by those imperfections and what to do about them.

The current crisis is almost by definition the result of some sort of market failure. It started because there seems to have been a systematic error in the way that financial institutions evaluated the risks in the sub-prime mortgage market. If just a few banks had made mistakes, that would be the normal operation of the market, where businesses make their bets on what will work, and sometimes lose. It's the industry-wide nature of the losses that make this a market failure of some kind.

The reasons for this are not very clear to me. One theory is that financial managers are subject to herding effects. This happens because investors judge the skill of managers based on how they perform relative to other managers in the same sector. Consequently, managers can protect their jobs by doing the same thing as everybody else, thus insuring themselves against unusually severe failures. But not against widespread failure.

Another theory I've heard is that's it's a technology failure, in the sense that the statistical models that predict the performance of mortgages turn out not to apply well to sub-prime loans. You'd think lenders would realize this, but another theory suggests that behavior of the sub-prime market changes when lots of home buyers enter the market (possibly through a herding effect among home buyers---"The Johnsons can afford their expensive house, so maybe we can too!"). Since the sub-prime market had never before been this large, no one had detected this effect and incorporated it into the models.

Yet another theory is that incentive structures within banks encouraged managers to understate the risks of sub-prime loans in order to appear more profitable. However, that doesn't explain why senior management failed to realize that managers had such incentives, after all, they created the incentive system. Also, other businesses have investments with hard-to-quantify risks---movie studios, software developers, nightclub owners---and they haven't seen the same kinds of widespread failures.

Still another theory is that government regulation caused the problem. Government regulation is always a likely suspect for industry-wide problems because idiotic managers can only bring down the companies they work for, but idiot regulators can bring down the whole industry. In the case of the housing mess, it seems likely that government pressure to make mortgage loans to poor people has contributed to the mess. It's possible that the government pushed the entire industy into unprofitability.

This is all water under the bridge. The mortgage mess is already well underway, and there's not a lot we can do about it. We've moved on to the second phase of the crisis, which is the problems facing financial institutions that are holding all these bad loans. They seem to be having trouble getting rid of them.

That's where the Henry Paulson would like the U.S. Treasury to step in. He may believe that sellers are dumping mortgage-backed securities on the market so fast in an attempt to gain liquiditiy that they have overwhelmed buyers and forced prices below the realistic value of the underlying mortgage assets. In this case, a very large financial entity, such as the U.S. Treasury, could buy the securities in bulk right now and re-sell them later as buyers start stepping up with more reasonable offers.

Another possibility is that this is a type of market failure due to assymetric information. The ultimate value of these securites depends on the values of the homes they represent, so to properly evaluate a particular mortgage-backed security might require assessing the values of a lot of property.

To understand this theory of what's going on, it helps to think of a really exotic market such as the antiquities trade. If someone offered me some sort of Egyptian tomb carving for $7500, I would have no idea if it was a great deal or a cheap modern knock-off. Since the person making the offer knows I don't know how to evaluate Egyptian artifacts, and I know that he knows I don't know, I'd assume it's a rip-off and I wouldn't buy it. In fact, no matter what the asking price, I'd assume it was more than it's worth, and I wouldn't buy it.

Mortgage backed securities are a bit like those antiquities. The institutions that have money to buy them don't have knowledge of how to evaluate them. All that knowledge rests with the institutions that are holding the mortgages right now, and which got us into this mess in the first place.

So, buyers are too filled with fear, uncertainty, and doubt to offer what the sellers are asking, and sellers are unwilling to lower their asking prices, presumably because they believe the goods are worth more than the offers they are receiving. The market is frozen.

The theory is that if buyers had more time to sort things out, they would gather enough information to overcome their uncertainty, and their offers would rise to more realistic levels. But with the financial system crumbling, we don't have more time, so Paulson wants the Treasury to step in and buy the securities at a higher price than their last offer, thus injecting cash into the system and keeping our financial system from crashing.

Some supporters of the bailout plan argue that it could turn out to be a money-making opportunity for the government. Once the market is liquid again, the Treasury can start selling the securities back to private investors. With money flowing and enough time to do the job right, investors will be able to evaluate mortgage-backed-securities better, eliminate their uncertainty, and make an offer that is closer to the true value. The Treasury will make a profit off the higher-priced sale.

The problem with this argument is that the current market offers may already be at the true value of the securities. Buy buying above that price, the Treasury would be losing money on every transaction. Wha it comes down to is that to believe mortgage-backed-securities are a good investment at the current asking price is to believe that Paulson is right and the entire securities market is wrong.

And if mortgage-backed-securities are so hard to evaluate, how is the Treasury going to do it? It's not like they have people around who do that every day. I think Paulson has said they'd just hire the people to do it, but if it was that easy, wouldn't there be a lot of investment funds out there adding mortgage experts to their staff so they can earn those profits that everyone is saying the Treasury could be making?

So what if we don't have a bailout? The big fear on everyone's mind is a credit meltdown. As the value of asset porfolios plummet, financial institutions find it hard to borrow cash. Who would want to lend money these days to a company holding large amounts of mortgage-based securities? Or to another company holding stock in a company holding large amounts of mortgage-based securities? Or to a company that has a large oustanding loan to a company that holds stock in a company holding large amounts of mortgage-based securities? You get the idea.

With nobody willing to lend money, companies that want to borrow are going to have a tough time, and we're not just talking about financial institutions. Developers won't be able to get construction loans, so new buildings won't be built and construction workers won't earn wages. Manufacturing companies may discover that they can't get loans to buy raw materials. They won't be able to build their products, and their suppliers won't be able to sell them anything.

Companies with routine cashflow problems will find that they can't meet payroll because no one wants to lend them the money for a few weeks until payments from sales come in, and their customers won't pay them on time because they haven't received their own payments. People will find that mortages are hard to get, car loans are expensive, and their credit card company just lowered their limit. Department stores will not be able to borrow the money to stock up for Christmas.

Some people think it could take ten years before the credit markets are rebuilt and our economy starts growing again. It's a recipe for another Great Depression.

But is it for real? According to strict microeconomic theory, the story I've just told is preposterous. Borrowers take out loans because there are things they want to do with the money. Lenders make loans because they're willing to put off doing anything with their money right now in the hope of having more money to do stuff with later. Nothing in my tale of woe changes the motivations of the borrowers or the lenders.

Banks and brokerages and money market funds are all just part of the vast mechanism by which borrowers and lenders find each other and coordinate their transactions. It's complicated because borrowers have thousands of different ways to put the money to use, and all of them have to be matched to various lenders' desires for profit, risk, and liquidity. And if all that complicated mechanism goes away, lenders and borrowers will have a hard time pairing up to do deals.

But they'll still want to do deals. About as much as ever. Surely they will be able to figure something out? Free markets have proven time and again that they can adapt extremely fast to changing conditions. With our current technology---computers and the internet---it seems likely that the credit markets could rebuild themselves very quickly. Can't borrowers and lenders meet on Craigslist? If eHarmony can find your perfect mate, how hard would it be for them to find your perfect investment opportunity?

At the top of this post, I said that economics was about allocating resources. But in order to channel resources to useful enterprises, the allocation process necessarily has to take resources away from the failures.

If the convenience store on the corner isn't making money, the owner won't be able to pay his rent or meet his payroll or pay his suppliers. He'll go out of business, and his landlord will rent to a different business, his employees will go work for someone else, and the supplies he would have purchased will be bought by someone else.

Every time a firm shrinks or goes bankrupt, the economy is taking resources from one activity so they can be given to a better one. All these financial firms going bust? That's the invisible hand of the market signalling us that these firms are no longer efficient enough.

Now their analysts are on the street, and their computer software is on sale to the highest bidder. Their cubicles are stuffed into some warehouse, their computers are on Ebay, and their offices are up for rent. Cheap. These are the raw materials from which the next generation of financial institutions will be built.

The trick is to let it happen. So, for example, if Ebay figures out a way to handle commercial loans through their website, we can't afford to have the SEC tie them up in regulations for three years.

Equally important, we need to let poorly-performing enterprises crumble in order to reduce their resource usage. There is already evidence that financial companies are holding onto troubled mortgage-based securities because they are hoping to get more for them in the bailout than they can on the free market.

(The worst case---which is not at all unheard of in the history of business regulation---is that stuggling financial corporations will convince legislators and regulators to clamp down on newer and more innovative business models in the name of protecting the old businesses.)

It's my belief that if we don't have this giant bailout, we can let the worst players in the current system collapse, and we'll still get by, as long as we don't keep trying to preserve the old system, and if we resist burdening the new system with harsh regulations.

So, the bailout bill has failed.

Cool. Scary too, but cool. I hope it stays this way.

As word got out that the bill was failing, the market fell. It fell a lot. It fell more than ever before, even more than it fell on 9/11.

Of course, when I say "the market," I'm talking about the Dow Jones Industrial Average, which isn't really the market, it's just an indicator of the market. And the market isn't our economy, it's just an indicator of our economy.

Look at it this way. The Dow was down to somewhere around 10,600 a couple of weeks ago. Then, as the bailout bill started working its way through congress, it went higher for a while, as everyone in the financial sector thought they were going to get a few hundred billion dollars without having to work for it. Now that they're not getting the money, the Dow is back down to around 10,400. Which is probably where it belongs.

The point is, the Dow wouldn't be jinking around like this if the politicians weren't screwing around with this bailout. Instead of trying to judge the market and handle their money wisely, everyone is busy trying to guess what congress will do. Or worse, trying to change what congress does.

For example, if you're running a financial institution, and you've got a lot of "toxic" securities, you might have been thinking of accepting another institution's offer to take them off your hands for, say, 30 cents on the dollar. It would be a loss, but you'd receive liquidity in return. However, as long as Treasury Secretary Paulson just might get a $700 billion authorization next week to buy them from you at a higher-than-market price, you're going to sit tight and see what happens, aren't you?

I think a lot of this market volatility is really just an effect of congressional volatility.

I hope.

The bailout plan has apparently hit a snag after a meeting of congressional leaders at the White House broke down into a "contentious shouting match." Add to that the failure of WaMu last night and I think the folks on Wall Street are going to go apeshit react strongly.

Then again, if I could really predict what happens on Wall Street, I'd be an advisor to a large investment fund, and they would treat me as a god.

Update: As Tim Cavanaugh reminds us, my inability to predict the market is rivaled by that of Treasury Secretary Henry Paulson, who's been seeing doom in every down-tick for a year now.

Update: Actually, people who pay more attention than I do probably weren't surprised by the WaMu failure. Shares declined from $35 a year ago to $1.69 yesterday, so I'm guessing the market isn't really going to be all that shocked this morning.

Update: Eh, the market open wasn't so bad.

This is probably wrong in so many ways, but why are we helping the bad financial institutions? Wouldn't it make more sense to help out the good ones?

I think, first of all, that the plan is not to simply give away the $700 billion. Instead, the U.S. Treasury will take over bad mortgage investments. I think the way this works is that if the government buys $100 million in bad mortgage investments and, say, only gets back 75 cents on the dollar, the government will have spent $25 billion to add $100 billion in liquidity to the economy. At that rate, spending the full $700 billion will free up $2.8 trillion from bad investments. (I have no real idea if these figures make sense.)

Second, as I understand it, the big fear in this crisis is that a series of institutional failures will cause a credit crunch that makes it hard for companies to operate from day to day and impossible for them to expand. This could cripple production and produce a huge involuntary contraction in our economy. Preventing this credit crunch is why we want to add liquidity by pouring in cash.

But why do we have to pour cash into the bad banks? Wouldn't it add just as much money to the credit markets if we poured the money into the successful banks?

As for the bad banks, we just let them bleed to death in the street. The remaining banks, now flush with U.S. Treasury cash, will fill in the gaps and prevent a credit crunch.

This solves the credit crisis, avoids rewarding financial institutions for their failure, and because we're lending the money to financial institutions that have not driven themselves into the ground, probably costs less.

One of the creeds of the economist is that there's no such thing is a free lunch, and this sounds like a free lunch to me. That means I'm probably misunderstanding something important about financial markets, and my plan is hugely flawed.

But I'll bet it's not the craziest plan you'll hear before this is all over.

As an economics blogger, I feel I should say something about the current economic crisis hitting our financial institutions. However, my libertarian philosophy isn't helping me as much as I'd like when it comes to the current financial crisis. It's not that pure free-market economics doesn't provide an answer. It does. I'm just not confident it's a good answer.

The straightforward libertarian response to the plunging prosperity of these giant financial institutions is simple: Let them splatter on the pavement, then let the remaining financial firms pick at the remains like vultures gobbling up the juicy bits.

(It's possible I'm more angry about this than I realized.)

This plan is the classical microeconomic prescription for all failing enterprises: Let them fail so their resources can be put to more productive use. This approach has the advantage of requiring no legislation or government funds. It also serves as a lesson to other financial institutions that they should be more careful because they're not going to get a bailout.

The problem with the let-em-bleed approach is that such massive disruptions of the financial markets might end up affecting the real economy, slowing the production of goods and causing massive unemployment. Don't ask me how. I don't understand financial markets well enough to explain it. But enough people are worried about it that I'm willing to believe it's possible.

Preventing that won't be easy, even with careful thought, and we aren't going to get careful thought:

Because the markets are eager for a final deal and because Congress is trying to adjourn for the fall elections, lawmakers are bypassing the normal committee process and working toward an agreement in hopes of votes in both chambers within days.

Part of what makes this so difficult is the need to prevent macroeconomic disruptions without rewarding financial institutions for taking on too much risk, and thus creating a massive incentive for them to keep on making the same mistakes.

One approach would be a policy that before we bail out a financial institution, we first shoot the executives. A slightly less extreme solution currently under consideration is to add a provision to the bailout bill requiring limits on executive compensation for firms that seek help. (I think much support for this provision stems from the obssessive hatred some people have for highly-paid executives, but it may make sense from a viewpoint of discouraging bailout-seeking behavior.) On the other hand, since we're offering bailouts for the good of the economy, we want institutions to use them, so maybe it's a bad idea to give the people who make the decisions a hard time.

Then there's the push to do something to save homeowners facing foreclosure. We got into this mess by encouraging way too many people to buy homes, so I'm not sure we can stay on that path without running into even more trouble.

There's also the problem of foreign banks. They want in on the bailout too. Ideally, there's nothing wrong with that: The purpose of the bailout is not to save banks, but to prevent damage to our economy. If a foreign-owned bank is a large enough participant in our financial markets that its bankruptcy would cause us problems, then it makes just as much sense to bail them out as to bail out our own banks.

The problem with that line of thinking is that even though we're only supposed to be doing the bailouts for the good of the economy, the recipients of the $700 billion in loans (or loan guarantees or whatever) will almost certainly benefit greatly, so we might want to try to keep it in the family.

My understanding is that large-scale liquidity problems produce externalities, which may make it good policy to use public funds to increase liquidity. However, the mere insolvency of a financial institution---no matter how large---is not a public problem. We want to help the economy, not the financial institutions. Unfortunately, the problems of illiquidity and insolvency are inextricably entangled, making it impossible to affect one without affecting the other.

I'll even go so far as to say that no matter how much we try to make the bailout program about the economy, once it gets going and people stop paying attention it will eventually turn into a giant corporate welfare operation.

The foreign bankers clearly realize this. Just look at what they have to say:

Gaining access to the relief was a top priority for European foreign financial institutions with banking operations in the United States, according to officials in industry and government.

They argued that the reputation of Wall Street and the United States government would suffer immensely if properly licensed foreign banks in the United States were shut out of the system.

"Who would open a bank again in the United States?" asked one executive of a major European bank who has been following the discussions.

Who would care if they didn't? If you don't think you can operate a bank profitably in this country unless you are promised a massive bailout, we don't want you to try. This is precisely the kind of bailout-seeking behavior we want to prevent.

Finally, what are we to make of this gem found in one draft of the bailout bill?

Sec. 8. Review.

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

Because everyone knows that boundless executive power is the key to national success.

Dear Federal Government,

Please buy my Nikon 35mm f/2 lens.

I bought it in 2006 for $300. My thinking was that a lens at that focal length with that aperture---a fast normal prime, in photographer lingo---would allow me to take medium shots of people in low light. I thought I would get a lot of good pictures that way, but it's not working out. I'm just not getting as many usable pictures with that lens as I expected.

Normally, I wouldn't ask because I know you folks in the government are buying lots of important stuff for important government-oriented purposes, such as tanks, airplanes, and Alaskan public works projects.

However, I hear you folks are working the weekend to put together a plan to spend $700 billion dollars to buy up bad investments. For example, if a bank gives someone $200,000 on a home mortgage, expecting to get a sequence of small payments in return, but the payments aren't coming, you'd buy the loan from them in the hope of selling it to someone else later.

That sounds like my situation. I gave a camera store $300 for a lens, expecting to get a sequence of nice photographs in return, but that's not working out. I figure you can buy it off of me and maybe you'll find someone who will have better luck with it.

Sincerely,

Mark Draughn

P.S. I promise to go shopping with the money. Thanks.

The U.S. Department of Agriculture and the meatpacking industry agree: The American beef supply is safe from bovine spongiform encephalopathy (BSE), a.k.a. "mad cow" disease. They know this because the USDA has been spot-testing slaughtered cattle for years.

That works for me, but maybe it's not good enough for you. Maybe you don't trust the statistical sampling process. Maybe the next time you bite into a juicy sirloin steak you'd like to know that the actual cow you're eating was tested and found free of BSE.

You're probably not the only one. Fortunately, there's Creekstone Farms Premium Beef, which in 2004 began plans to test every cow for BSE.

Unfortunately, there's also the U.S. Department of Agriculture and the meatpacking industry, which have made every effort to stop the testing.

Larger meat companies feared that move because, if Creekstone should test its meat and advertised it as safe, they might have to perform the expensive tests on their larger herds as well.

As I explained in my earlier post, this is seen as a bad thing in the communist-style command economy that serves as our agricultural policy, and the Department of Agriculture likes to protect our agricultural industry, even at the expense of consumers.

The USDA lost their court case in 2007, but they appealed the decision, and last week the Department of Agriculture won the appeal when the D.C. Court of Appeals rolled over and played dead for the USDA:

Last year a federal judge ruled that Creekstone must be allowed to conduct the test because U.S.D.A. can only regulate disease "treatment." Since there is no cure for B.S.E. and the test is performed on dead animals, the judge ruled, the test is not a treatment.

The U.S. Court of Appeals for the District of Columbia Circuit overturned that ruling, saying diagnosis can be considered part of treatment. "And we owe U.S.D.A. a considerable degree of deference in its interpretation of the term," wrote Judge Karen LeCraft Henderson.

I suppose you could reasonably argue that, in general, diagnosis is part of the treatment process, but I do wonder what treatment Judge LeCraft has in mind for curing a dead cow.

Kip Esquire points us to an AP wire story that has some shameful news (emphasis mine):

WASHINGTON - Two-thirds of U.S. corporations paid no federal income taxes between 1998 and 2005, according to a new report from Congress.

...

Collectively, the companies reported trillions of dollars in sales, according to GAO's estimate.

"It's shameful that so many corporations make big profits and pay nothing to support our country," said Sen. Byron Dorgan, D-N.D., who asked for the GAO study with Sen. Carl Levin, D-Mich.

Isn't that terrible? North Dakota Senator Byron Dorgon can't read. Either that, or he doesn't know the difference between sales and profits. He has an MBA degree, so I guess either is possible.

As the proud owner of a small software consulting corporation, I can assure you that I pay taxes. Lots of taxes. The company itself doesn't pay federal income taxes, but I pay personal income taxes on every dollar I receive from the company and every dollar of company profit.

If I hadn't incorporated, I'd receive fees from my clients and deposit them in my personal bank account. I'd deduct my expenses, and then make estimated self-employment tax payments during the year. Then at the end of the year I'd do a final accounting and settle up with the IRS.

Instead, my corporation receives the clients' fees, which are deposited in the corporate bank account. As the only employee, I pay myself a salary, which is then deposited into my personal bank account. Just like every other employer, I withhold federal income taxes and deduct Medicare and Social Security from my paycheck and send that money to the government right away. Then at the end of the year, I do a final accounting in which I deduct corporate expenses from revenue to calculate profit and report that to the IRS as income for myself as the owner of the corporation. Then I do a final accounting of my personal taxes and settle up with the IRS.

Either way---whether I receive the money directly or pass it through the corporation---I pay roughly the same amount of taxes. Only the paperwork is different.

(For various reasons, I'm probably paying a bit more as a corporation than I would as a self-employed consultant.)

When the corporations are giants like Microsoft and Exxon, the numbers are a lot larger, but the principle is the same: Even if the corporation doesn't pay income taxes, every employee and every stockholder does. And the amount they pay will be roughly comparable to what would have paid if they had received the corporation's revenue (and paid the corporation's expenses) directly.

Don't forget, too, that one-third of U.S. corporations do pay income taxes. That's in addition to the income taxes paid by their employees and stockholders.

(Note: Of course, some corporations do manage to get some sweet deals written into the tax code. For example, the mortgage bailout bill includes an awesome tax cut for Chrysler. But most corporate income is taxed before any fat cats can spend it.)

Moby Kip posts about the many, many problems with the home mortgage bailout bill, which seems to be designed to lure still more financially marginal families into home ownership.

And for some reason it even includes a tax handout to a giant company that has nothing to do with the real estate business.

John McCain has famously said he doesn't know much about economics. A recent AP wire story by Glen Johnson illustrates as much:

The presumed Republican nominee on Monday proposed a $300 million government prize to whoever can develop an automobile battery that far surpasses existing technology. The bounty would equate to $1 for every man, woman and child in the country, "a small price to pay for helping to break the back of our oil dependency,"

The battery industry has been going through a grueling competition to improve capacity, usable life, size, weight, reliability, and cost for almost three decades, driven by the unlimited needs of laptop computers and mobile phones. Some of that technology has already helped make hybrid cars feasible.

With the hybrid industry heating up due to high gas prices, we can expect hybrid storage batteries to improve a lot as manufacturers compete to provide the best products to consumers. There's already plenty of money to be made in this business, we don't need government grants.

If the government actually held such a competition, I expect that most of the manufacturers would not pour their efforts into better technology but into lobbying congress to change the definition of the contest to favor their existing technology. We're better off leaving it to the free market, which would pay engineers, not lobbyists.

The Arizona senator also proposed stiffer fines for automakers who skirt existing fuel-efficiency standards, as well as incentives to increase use of domestic and foreign alcohol-based fuels such as ethanol.

The market has already punished the automakers for building inefficient vehicles. Industry pundits are predicting the "end of the SUV" because fewer and fewer people are buying them due to high gas prices. With entire vehicle lines going out of business, does McCain really think that automakers need any more incentive to build fuel-efficient vehicles?

And the ethanol thing is just the usual tribute that all politicians pay to the farm lobby.

In addition, a so-called Clean Car Challenge would encourage U.S. automakers to develop zero-emission vehicles by offering consumers the incentive of a $5,000 tax credit when they purchase one.

By comparison, that's a much better idea. Clean air is a legitimate public good, so government intervention in the market is more justifiable. But, as always, the devil's in the details.

Of course, McCain is not alone in his ineconomeracy*:

On Sunday, Obama told a Washington audience he would strengthen government oversight of energy traders whose futures speculation he blames in large part for the skyrocketing price of oil.

McCain told a town-hall questioner on Monday that he was unsure of the extent of any oil speculation, but if it has boosted the price of a barrel by 50 percent -- as he has heard from some analysts -- or just 1 percent, "then it seems to me there should be a thorough and complete investigation."

If speculators think the price of oil will go up in the future, they will invest in oil now (or in various oil derivatives). This will drive the price of oil up a bit right now. Then, when oil prices go up in the future, speculators will sell their oil stockpiles to make a profit. The extra oil they pump into the market will reduce oil prices.

In other words, speculators will raise the price of oil when it's low and reduce the price of oil when it's high. The net effect is to smooth out the highs and lows in oil prices. Both oil producers and oil consumers can operate their businesses better when prices are smooth, so speculators are providing a service. Like everyone else, they make money for their services.

Let's suppose that McCain and Obama are right, and that speculators have dramatically overestimated the future prices of oil. That would mean that current high prices are due to speculation, not a fundamental increase in the cost of producing oil.

Now consider what happens next: If oil prices aren't really going up, then speculators won't be able to sell their oil at a profit. Eventually, they'll realize this, at which point they will stop buying oil and start selling it to reduce their losses. The sudden glut of oil will depress prices even further.

This rollercoaster ride in oil prices will have been hard on consumers and oil companies alike, but the speculators will really take it in the neck. Their increasing losses will induce the sale of even more oil, which will further depress oil prices. The oil market will go into a death spiral. The oil price bubble will have burst, and all the speculators who bought oil at inflated prices will lose their shirts.

I'm not trying to say that speculators havn't driven up oil prices---I haven't a clue---but if they have, they certainly haven't done it intentionally. And they will pay dearly for their error. No government intervention required.

*Note: I'm trying to come up with a coinage for economic ignorance, like illiteracy or innumeracy.

Kip is making fun of an op-ed by Robert Crandall in the New York Times, and rightly so. Consider the first paragraphs of Crandall's missive:

Thirty years ago this fall, Congress passed the Airline Deregulation Act of 1978. Since then, America’s airline system has greatly deteriorated.

I suppose that's one way of looking at it. Another way to look at it is that air travel has become much less expensive than it used to be. Airlines have learned to produce a low-cost product. Naturally, there are some compromises which result in poor service, but that seems to be a trade-off people are willing to make.

The second paragraph elaborates on the claims of the first paragraph.

Our airlines, once world leaders, are now laggards in every category, including fleet age, service quality and international reputation. Fewer and fewer flights are on time.

Translation: Air travel has become a price-competitive business. It used to be the Ritz, now it's Motel 6.

Airport congestion has become a staple of late-night comedy shows. An ever higher percentage of bags are lost or sent to the wrong airports.

Translation: The airports---which have not been deregulated---aren't run very well.

Last-minute seats are harder and harder to find.

Translation: Airlines are making more efficient use of their passenger-carrying capacity, leaving fewer empty seats, thus reducing prices.

Passenger complaints have skyrocketed. Airline service, by any standard, has become unacceptable.

No, not by any standard, just by the standards of guys like Crandall. Passengers may not be thrilled by airline service, but they certainly find it acceptable by the standard that matters most: People are flying a lot. In 1975, commercial air travel amounted to 136 billion passenger-miles. Thirty years later, in 2005, commercial air travel had more than quadrupled to 584 billion passenger-miles (far outracing population growth).

Airline service may not be the high-quality product it used to be, but it's certainly the low-cost product everybody seems to want.

Kip goes on to point out a strange internal conflict in Crandall's piece. At one point, Crandall writes this:

Although the system could conceivably be operated by a single efficient carrier, consumers clearly benefit from the existence of multiple airlines. The absence of competition never fosters better customer service.

But the very next sentence says something else:

Market-based approaches alone have not and will not produce the aviation system our country needs.

Kip's response is apparently genuine befuddlement:

So "competition" is good, but "the market" is bad? Don't worry -- I don't understand it either.

Oddly, I do understand it, so let me see if I can help out poor Kip.

Competition among suppliers is a state of the market in which sellers face constant pressure to make their product more attractive to customers out of fear of losing sales to other suppliers. They can try to attract customers by making their products better, or they can try to make their products cheaper. Airlines seem to have chosen the latter course. In either case, the essence of the definition is that suppliers are trying to win customers.

Crandall, however is using a different definition of competition, one that puts the emphasis not on the actual competition, but on the presence of competitors. He believes---or hopes to convince us to believe---that a good competitive market requires vigorous competitors.

This view---also popular among regulatory agencies---turns competition on its head. Instead of focusing on the benefits to consumers, Crandall and the regulator agencies want to focus on the financial health of suppliers. The result is a hodge-podge of recommendations that help the airlines stay in business, usually at the expense of their customers.

Consider this recommendation by Crandall:

The financial standards for new airlines also need to be made more stringent. In the years since deregulation, nearly 200 airlines have come and gone. These inadequately financed carriers — whose principal goal has often seemed to be merely to exist long enough to reap the rewards of an initial public offering — have consistently cut prices to attract passengers. This downward pressure on prices has hurt airlines that seek long-term success.

Here, Crandall is blatantly abandoning clear competition---cutting prices to attract passengers---to keep airlines in business. By his definition of competition---the presence of healthy competitors---that makes complete sense. Of course, that's not what competition really is. That's not what capitalism is.

At the end of his op-ed, Crandall makes this disingenuous declaration:

We need to be realistic: whether there are mergers or not, airline fares are going to increase. Every business must charge enough to cover its operating and capital costs. Regulatory and oversight changes intended to make our carriers more successful may well force prices up faster than would otherwise be the case. But we will be better off with higher fares and more competitors than with higher fares and fewer competitors.

Notice how he concedes that regulations will increase prices, but then goes on to effectively equate both possibilities by referring only to "higher fares."  Let me try to recast that last sentence in a more honest way:

But we will be better off with much higher fares and more competitors than with slightly higher fares and fewer competitors.

Personally, I'd prefer the slight fare increase. I'd prefer to receive the benefits of competition rather than spending my money to preserve Crandall's bogus definition of competition. Judging by the statistics on air travel, most passengers agree with me.

Finally, there's this sentence in the last paragraph:

The enormous economic importance of our once peerless aviation system is indisputable.

True enough. However, the benefit of an aviation system does not come merely from its existence, but from how we use it. Agriculture is important because it allows us to eat, the auto industry is important because it allows us to have cars, and the aviation industry is important because it allows us to fly.

Frederick W. Kagan has an article in National Review Online that attempts to refute some of the antiwar arguments about Iraq. I haven't read the whole thing---It's a huge piece that covers a lot of ground, and some of it may even be correct---but there's a pretty glaring example of the broken-windows fallacy in the first section:

The "$3 trillion war." Simplistic economic analysis declares that the war has cost the taxpayers $3 trillion since its inception, implying that this is a $3 trillion dead loss to the economy---a price too high to pay.

Modern economics has long understood that the notion of a one-for-one guns-versus-butter trade-off is simply wrong. A high proportion of money spent on defense goes back into the U.S. economy in the form of salaries paid to the more than 5 million Americans employed directly or indirectly by the Defense Department, and payments to the defense industry and the long and complex supply chains from which they draw their raw materials.

This might sound sensible---or even sophisticated and worldly---but it's nonsense, and it's been nonsense at least since Frédéric Bastiat pointed it out in 1850.

Of course the money spent on defense goes back into the U.S. economy---most of it is spent on salaries and merchandise bought here---but we never get back the labor purchased with those salaries, and we never get back materials expended in the war.

The cost of the war (or anything) is the lost opportunity to use the expended resources for something else.  If you pay a man to drive a truck for the army in Iraq, then both he and the truck are unavailable to private industry here at home. War is costly because it uses up people and things that could be used for something else.

It's a separate argument whether the war is worth the cost, but it's foolish to try to deny the cost in this way.

I've been trying to make sense of what the Federal Reserve has been doing with Bear Stearns. My usual source for smart thinking about financial issues, Kip Esquire, is so far silent, so I'm trying to figure this out myself. It's not going well.

The argument against government bailouts of private businesses is that it's a bad idea for the government (even in the form of the Federal Reserve) to rescue a corporation that's in trouble. It sets a bad precedent, creating what economists refer to as a moral hazard.

A lot of big financial institutions are thought to be "too big to fail," meaning that their failure would have such severe repercussions that the federal government would have to step in to save them. This insulates the institution's investors from the inherent risk of investing, encouraging them to invest more money in riskier ventures than would normally be wise. This leads to more failures and more government help.

My usual prescription for this problem is some tough love: The government and the Fed should let Bear Stearns bleed to death as a lesson for others. If this sets off the expected chain reaction of bank failures, it will be bad for the economy, but it might be worth it to discourage future risky behavior by investment banks.

As I learn more about the Bear Stearns bailout, however, I'm beginning to doubt my gut reaction because Bear Stearns isn't really being bailed out in the usual sense. Instead, it's being sold to J.P. Morgan Chase at a huge discount. It had a market value on Friday of $3.5 billion, but J.P. Morgan is only paying about $240 million. In other words, the owners of Bear Stearns lost 93% of their investment. (That's just the loss over the weekend. If you look back a couple of weeks, the loss rises to 99%.) That ought to be enough to discourage future investment in absurdly risky assets.

On the other hand, it looks like the Fed will be securing their loan to J.P. Morgan by essentially taking over some of Bear Stearns' portfolio. Since that porfolio consists of mortgage-backed securities, does this mean that the Fed will be holding the mortgages on people's homes? Does this mean that the Fed will be in a position to foreclose on people's homes? Do you think those people will be screaming to their congressmen about this?

I guess what it comes down to is that I'm suspicious of the Fed's involvement, but I don't quite know how to think about it. 

Over at Simple Justice, Gritsforbreakfast left this comment:

My college major was economics, and I was downright angry when, after learning all the theory, it became clear that nearly every "assumption" economists said make free markets "work" was actually, demonstrably false. E.g., people have perfect information, make rational choices that maximize their self-interest, etc.. For such an important topic, there's a lot of voodoo and crap in that discipline.

I'm only an amateur economist at best, but as someone who relies on economic arguments a lot, I felt compelled to explain myself. (I left a comment there, but I'm elaborating a bit here.)

Grits is right that the assumptions of economics are not literally true, but that's why they're assumptions. The real world is complicated and messy, so science and engineering disciplines use simplifying assumptions to make the problems easier to solve.

Sometimes this leads to grave errors which are often discovered only when disaster strikes. The builders of ancient churches had for centuries neglected the effects of mild winds to no ill effect. However, once they started to build really tall churches, the daily winds would push the brickwork back and forth, causing the mortar between the bricks to slowly grind away until the walls fell.  For this reason, the history of church architecture proceeds from short churches to tall churches that collapsed to churches with buttressed walls...and eventually to churches made of sterner stuff.

The trick is to recognize when the simplifying assumptions are no longer applicable.  If the assumptions are carefully chosen---and the conditions of their use are understood and respected---the results are often good enough. A structural engineer designing a building can simplify his calculations by assuming the Earth is flat, and he will have no cause for regret.

When it comes to the market economy, I think the theory of free markets is good enough in most cases. It's true that the market only produces perfect resource allocations under perfect conditions, but there is reason to believe that many small deviations from perfect conditions lead to only small deviations from perfect results. In addition, competition tends to correct long-term deviations.

Finally, When it come to free-market economics, I have to admit I'm emotionally attached to the assumption that people are rational utility maximizers.  That bit of jargon is an economist's way of saying that people know what makes them happy, and they will act intelligently to obtain that happiness, within the limits of their abilities and circumstances.

On an individual basis, this is obviously not true: We all screw up all the time and make ourselves miserable.  But there's some pretty good evidence that on average we do a pretty decent job.

More importantly, despite any mistakes you may make, when it comes to making decisions about your life, you have more information than anyone else, and you are more motivated to make the right decision than anyone else.

So while people make bad decisions about their lives from time to time, they are less likely to screw up than any one else making decisions for them, including legislators, government bureaucrats, and cops.

Contemporary economics therefore encourages a principle of public policy that is breathtakingly respectful towards ordinary people:  To the greatest extent possible, people should be allowed to control their own lives.

I like that a lot.

Chicago just got hit with some more snow, and I realized I need new wiper blades on my car. The ones I have now are not winter blades, so ice builds up in the wiper frame and prevents it from applying even pressure, allowing ice and sleet to remain on the window.

My Camry bit the dust with serious engine problems about a month ago (my mechanic says it's a "spun bearing," but that sounds like something he made up), so I'm driving an old T-bird that a friend is loaning me. According to the books, it takes 22-inch wiper blades on both sides.

I haven't been able to find the blades. I stopped at three different auto parts stores, and all of them were out of 22-inch winter wiper blades. They had other blades, but not the ones I needed.

How can that happen?

I mean, obviously, winter blades are in demand because it's winter, and I'm guessing that 22-inches is one of the most common blade sizes, so people have been buying a lot of them, and the stores have run out.

But shouldn't the buyers at the auto parts store have realized that 22-inch winter wiper blades would be in big demand in Chicago in January? Shouldn't wiper blade manufacturers know the ups and downs of their business and ship a few extras to stores?

I see similar economic mysteries all the time. Why is it that the ice cream section of the 7-Eleven always has plenty of Butter Pecan but consistently runs out of Dulce de Leche soon after each new delivery? Shouldn't some computer somewhere notice what's going on and start ordering more Dulce del Leche and less Butter Pecan?

The theory of efficient markets doesn't require that businesses never make mistakes, but the free market does tend to doom businesses that consistently fail to take advantages of chances to make money. So what's going on here? Is this some weird kind of market failure? Or does it somehow make good business sense to run out of Dulce de Leche ice cream and 22-inch wiper blades?

I speak, of course, of our Congress. They've actually gone and outlawed the light bulb. Thomas Edison's lightbulb.

I don't want to alarm you. They haven't gone and outlawed all illumination, they're only after your conventional incandescent light bulbs. They still want us to buy energy efficient compact flourescent bulbs. You know, to save energy.

I have no clue how bills like this get passed. This is none of the federal government's business. My first guess would be that a bunch of congressmen are sitting around when one of them says, "Hey, our term is half over and we haven't done anything nearly as stupid as outlawing high-volume flush toilets. How can we make our mark?"

Don't get me wrong, the bulbs themselves are a great idea. Compact flourescent bulbs cost more than regular bulbs, but they last longer (about a full year of continuous burning) and are about four times as efficie