Financial Crisis
September 27, 2008
Failures fascinate me, they always have. The current financial crisis is no exception. There is no shortage of opinion on the cause of this crisis. Housing, mortgages, financial institutes, and government regulation are all involved but I see little clarity or consensus on what caused the failure and what interventions might help alleviate the crisis.
I have wondered in the past what is different between the Canadian and U.S. systems. Recently a report claimed that Canada may be heading for an American-like meltdown. Although Canada’s economy is very much tied to the U.S. economy, the fundamental components of the meltdown are different, in my opinion.
I have heard the crisis referred to as a “perfect storm”. In my mind, the perfect storm analogy refers to a well understood system in which independent variables simultaneously reach a state that produce maximum nastiness. Watch the variables and you can predict when it is time to pray.
The U.S. financial crisis is not like a perfect storm. It is a classic nonlinear system in which we don’t understand the critical variables nor their expected behavior when these variables change. Here is my guess at what the critical variables are/were in this crisis:
- Government policy/agencies that promote home ownership
- Shift to mortgage-backed securities
- Foreign investors (e.g. sovereign wealth funds) looking for safe U.S. money market investments
- Lowest interest rate in history during 2001-2004
- An oversupply of housing
Compared to Canada, the U.S. has many more incentives for people to buy homes. Fannie Mae and Freddie Mac with an implied government insurance policy, tax deductible mortgage interest, and laws that required lending to traditionally high-risk individuals.
Mortgage-backed securities for years were hailed as a major innovation in the financial industry (Canada lagged in this department). Risk was measured by 3rd party rating agencies and shifted in bulk to all the owners of the securities. The incentives in this system encouraged deceit and sometimes fraud by both lenders and borrowers.
The incredible growth of China and other nations produced central banks and sovereign wealth funds that were flush with cash. There was a great deal of demand for safe money market financial instruments and mortgage-backed securities looked attractive compared to treasury bills at historic lows. Only the U.S. economy is large enough to meet the safety requirements these institutions demanded.
Some blame Alan Greenspan for this mess because he did not investigate the early signs of this crisis and because the historically low interest rate. This interest rate was set low to bolster the economy after 9/11 fueled the mortgage meltdown. Low interest rates together with government incentives for home ownership made buying a home seem “free”. Low interest rates made traditional money market products unattractive and a race was on to offer new alternatives (i.e. mortgage-backed securities).
Finally, an over-supply of housing made sure that the housing bubble would eventually pop rather than deflate.
Was there greed? Sure, pockets of it but it was not a key driver like it was for the Internet stock bubble. Fraud, again, pockets of it but certainly many orders of magnitude less than with Enron. Over enthusiastic investors? I find it hard to believe that anyone thought that mortgages were anything other than a safety play (but I certainly could be wrong). Regulators asleep at the wheel? Considering how complex this crisis is, I find it hard to believe that anyone could have prevented the crisis with prescient regulation. I doubt anyone can create new regulations now that would do less harm than good moving forward.
So will the 700 Billion plan fix things? I dunno. It makes for good theater though doesn’t it. Who says government doesn’t support the arts.
Landsburg Likes Huckabee’s FairTax
February 13, 2008
Economist Steven Landsburg thinks Huckabee’s FlatTax plan is brilliant.
Basically, Huckabee’s plan is to eliminate the income tax and replace it with a national sales tax. To a first approximation, that’s not such a radical change. As long as you spend what you earn, a sales tax feels just like an income tax. If you earn $1,000 a week and spend $1,000 a week, it doesn’t matter whether I take 20 percent of your income or 20 percent of your spending.
Bottom line for Landsburg is that the FairTax is a sneaky way of getting an unlimited IRA. He likes the idea of an unlimited IRA because it encourages savings.
I think the brilliance of the FairTax is that it makes a number of sneaky changes without really stating that its doing so. As far as I can tell it eliminates corporate taxes, payroll taxes (i.e. social insurance), and progressive tax rates down to two (no tax and normal tax).
All these types of changes are fine in my opinion but I’m not fond of the sneaky nature of the change. If you want to eliminate existing tax categories I think it is important to make your case for each elimination.
There is also a fundamental flaw in the FairTax. Any savings that a person accumulated in the old income-based system will now be double-taxed using the new sales-based system (if the person chooses to spend that money). There is no way around this as far as I can tell.
Punishing retired people is not usually a good political strategy… even if its endorsed by Chuck Norris.
U.S. Congress Bashes Bulbs
January 2, 2008
The Wall Street Journal reports that the energy bill passed by the U.S. Congress last month will effectively ban incandescent light bulbs by 2012.
Representatives of Philips and General Electric, two of the biggest lightbulb makers, say there’s nothing to be concerned about. And Larry Lauck of the American Lighting Association says, “I think everyone’s pretty happy” with the new law. But then, the lighting industry has no reason not to be: People will need light, whatever the law says–according to Randy Moorehead of Philips, there are four billion standard-size (or “medium base”) light sockets in America alone.
So if you’re GE or Philips or Sylvania, the demise of the plain vanilla lightbulb is less a threat than an opportunity–an opportunity, in particular, to replace a product that you can sell for 50 cents with one that sells for $3 or more.
Goofy if you ask me.
Fannie and Freddie vs. Canada
December 7, 2007
Clive Crook has an article in the Financial Times about the American institutions Fannie Mae and Freddie Mac.
Until recently it was possible to regard the US system of housing finance as one of the best – if not the best – in the world. Just as it was intended to, it has supported very high levels of home ownership, notably among the less prosperous. But the semi-public entities chiefly responsible for that success, and the financial technologies they devised and promoted, are deeply implicated in the housing market crash that now threatens the US and world economies. Will that turmoil lead to a scaling back of their role?
I find it curious that we have this natural social experiment, Canada vs. the United States, that is rarely used as a basis for comparing policy choices. As far as I can tell, Canadian culture and American culture are about as identical as any two countries in the world (though I’m guessing many/most Canadians will object to that characterization) yet the two countries have drastically different institutions. Except for goofy comparisons by Michael Moore, there is little discussion about the outcomes of the diverging policy choices in the two countries. Canada vs. the U.S. makes for a wonderful apples-to-apples comparison and it even has a handy built in 10x scaling factor for population.
I suspect that free market advocates would argue that Fannie and Freddie do nothing but subsidize bigger homes. The same argument holds for tax deductible mortgage interest (U.S. only). I think home ownership rates in the U.S. and Canada are approximately equal and this is NOT what you should expect given the very attractive incentives available in the U.S..
And the same holds true for public education. Whenever I hear an economist talk about school vouchers to fix the broken public school system in the U.S., I wonder if they think the public school system in Canada is also broken. I think public education works pretty well in Canada so why the difference?
The “Death Tax” (estate tax) only exists in the U.S. although the one big lump sum for capital gains can seem like a death tax in Canada.
Hand guns? Welfare? Minimum wage? Fuel taxes? Ethanol Fuel? Immigration? Why so few thoughtful comparisons?
The Tyranny of the Market
November 29, 2007
I finished reading The Tyranny of the Market by Joel Waldfogel last weekend. The subtitle of the book is “Why You Can’t Always Get What you Want”. The premise is that markets do not always fulfill the needs of consumers whose tastes are not shared by a majority of people. To support this claim Waldfogel describes black and Hispanic populations in urban markets being underserviced by radio, newspapers, and television options. Waldfogel says that two prerequisites are needed for this type of market failure. “First, preferences must differ across groups. And second, something — generally fixed costs — must limit the number of available options and prevent products from being provided to small groups of potential buyers.”
My answer to Waldfogel is <Mick Jagger singing> “If you try sometime, you just might find, you get what you need”. Sorry, couldn’t resist :-)
The mass media examples presented in the book remind one of Chris Anderson’s Long Tail theory. Anderson claims that finite shelf space is to blame for your inability to get Bollywood films at your local Blockbuster. The internet, on the other hand, has infinite shelf space and that fact coupled with technology to help customers find obscure titles allows “long tail” products to outsell blockbuster products in aggregate (or so the theory goes).
In my mind, Waldfogel only manages to demonstrate what seems obvious, products and their prices are beholden to the laws of physics and the availability of information. In the Long Tail theory, the physics of shelf space and population density determines how many titles are carried in a bricks-and-mortar store. iTunes and Netflicks did not change the laws of physics but they changed the way their products/services are delivered which changes the specific laws of physics that apply (or are most critical). Amazon.com biggest breakthrough involved information, that is, the way people discovered books. Sears built an empire around warehouses, the railway, and a large selection of products communicated through a catalogue.
I think free markets tend to find an equilibrium that balances price with product offerings. It takes shifts in information (i.e. innovation) to disrupt the system and a new equilibrium results. The fact that these equilibriums preclude certain offerings is not proof of a market failure that requires government intervention. Waldfogel’s book is well written and his argument is clearly presented but I’m left unconvinced.
Why Can’t We Grow New Energy?
November 27, 2007
I watched a TED Talk by Juan Enriquez titled Why Can’t We Grow New Energy? The general premise behind the talk is that new biological processes will make the extraction of energy from hydrocarbons much more efficient. He compared the efficiency gains to the Green Revolution that allowed food to be grown at cheaper and cheaper prices.
OK, I’m following but I’m confused because I’m expecting to hear how this technology will impact the carbon cycle and fix global warming (I guess I’m conditioned). Instead I hear about how efficiency gains in energy extraction/production will solve our future energy needs. Sounds great, I’m all for technical progress but doesn’t that just lower the price of energy and not really change the carbon footprint problem?
So as I’m busy scratching my head the talk ends with the following.
One of the things that we have to do is stabilize oil prices. This is what oil prices look like [shows oil price graph]. This is a very bad system because what happens is that your hurdle rates are set very low. People come up with these smart ideas about solar panels or for wind or something else and then, guess what, oil prices go through the floor and that companies go out of business and then you can bring the oil prices back up.
So if I have one closing and modest suggestion. Lets set stable oil prices in Europe and the United States. How do you do that? Well lets put a tax on oil that is non revenue tax that basically says for the next twenty years the price of oil will be whatever you want, 35 bucks or 40 bucks or whatever you want. If the OPEC prices falls below that we tax it, if it goes above that price that tax goes away. What does that do for entrepreneurs what does that do for companies? It tells people if you can produce energy for less than 35 bucks a barrel or less than 40 bucks a barrel or less than 50 bucks a barrel, lets debate it, then you will have a business. But lets not put people through a cycle where it doesn’t pay to research cause your company will go out of business as OPEC drives alternatives and prevents bioenergy from happening.
This is a “modest” suggestion? Fix a bottom price on oil to encourage entrepreneurs to do more energy oriented research.
Juan Enriquez sounds like a really bright guy and Wikipedia says that he “is recognized as one of the world’s leading authorities on the economic and political impacts of life sciences.”
So why such a disconnect with free market principles? Is it academia in general or perhaps seeing the world through the lens of research grant funded innovation that makes suggestions like this seem modest and reasonable? Am I out to lunch with my misguided faith in free market economics when this is clearly a case for government command and control? I’m confused…. really confused.
Repugnant Transplants
November 16, 2007
Alex Tabarrok at Marginal Revolution has an emotional post about Repugnant Repugnance.
Many people find the idea of selling human organs for transplant to be repugnant which is why Roth argues that we should focus more on improving efficiency through kidney swaps. I’m all in favor of swaps and have also suggested that one argument in favor of no-give, no-take rules is that they are ethically acceptable to more people than organ sales.
Nevertheless, I think Roth assumes too quickly that repugnance is a constraint to be respected rather than an outrage to be denounced and quashed. People’s repugnance at inter-racial dating or homosexual sex is no reason to prevent free exchange - the same is true for organ donations. Repugnance itself can be repugnant.
Is it not repugnant that some people are willing to let others die so that their stomachs won’t become queasy at the thought that someone, somewhere is selling a kidney?
I think Alex’s posts are some of my favorites as he is not shy about wearing his repugnance on his sleeve :-) Nonetheless, organ transplant policies and irrational biases (repugnance being one form) are complicated.
For a long summary of organ transplants (yet succinct given the complexity of the issue) see Tom Slee’s post Juicy Kidneys and his review of Kieran Healy book Last Best Gifts where he concludes:
Healy convinced me that the big issue is not the economists’ issue — of markets versus altruism — but is the sociologists’ issue of coping with complex incentives in large-scale industrial organizations, and that alone was worth the price of the book.
I agree with Tom on this one. Well not the “large-scale industrial organizations” part . Hopefully Tom doesn’t mind my mental paraphrase substituting “overcoming innate biases” for the Chomsky-esque stuff :-) I believe it is important to recognize our innate biases and sometimes in rare situations it is appropriate to create incentive systems to overcome these biases.
As another altruistic health example consider the practice of fecal transplants as a superbug treatment. I think its hard to argue that the repugnance in this case is an “outrage to be denounced and quashed” especially since I’m positive that some (most?) of the repugnance comes from the recipients who benefit from the altruism. I’m guessing that a funny commercial or even mainstream media coverage like the CBC’s will do more to overcome the repugnance than heavy-handed approaches.
Loose Change
November 8, 2007
I wore my winter coat yesterday for the first time since I put it away sometime in the spring. To my surprise, I found $5.21 of loose change in my coat pocket. That is $5.21 Canadian. Six months ago when I put my coat away that $5.21 Canadian was worth $4.92 US. Today it is worth $5.70 US. Wowzee. 16% in six months.
Stress Free Pricing
November 8, 2007
One of Pogue’s Imponderables is the following question:
Why doesn’t someone start a cellphone company that bills you only for what you use? That model works O.K. for the electricity, gas and water companies —and people would beat a path to its door. [And I don’t mean prepaid phones, where once again you’re paying for calls you haven’t even made yet.]
Economist Tyler Cowen says the most likely answer combines price discrimination with consumer misjudgment.
I think the answer is that people try to maximize their preferences while minimizing the amount of stress induced by thinking about it. Stress free brain cycles is the goal. A fixed monthly plan that fits most of your calling needs reduces stress when the monthly fee does not impact your cash flow. If you have problems paying your monthly bill then prepaid cards will reduce your stress. The service provider also tries to minimize stress in their organization (meeting payroll and/or shareholder expectations).
People prefer stress free pricing.
Us vs. Them
October 17, 2007
Paul Krugman, op-ed columnist for the New York Times wishes he said that.
Ezra Klein on the McCain health care plan, which — like all the other health care plans being proposed on the Republican side — basically says that the problem is that people have too much insurance, so they get too much Lhealth care:
It’s like if I tried to make food cheaper by encouraging you to diet.
I’m not exaggerating. Here’s what Mitt Romney said about what ails American health care, in his slide show:
-The tax code creates an incentive for over-insurance and over-use of the health care system
-Individuals don’t get the value they would otherwise prefer
-Leads to excessive, unnecessary health care spending
Actually, it is more like making people more selective at a buffet by charging them for what they eat vs. charging them an all-you-can-eat price. I don’t think the principle is as far fetched as Krugman’s “I’m not exaggerating” comment might make you believe.
Regardless, this is not a post about U.S. health care reform. When an economist uses “Us vs. Them” arguments rather than rational discussion what hope is there for the rest of us? Where are all the on-the-other-hand economists that we hear the jokes about?
Chimps Play Raisin Ultimatum Game
October 10, 2007
Primate researchers at the Max Planck Institute report fascinating results for a chimpanzee friendly version of the ultimatum game.
In each version of this mini-ultimatum game, the proposer could pull one tray with 8 raisins for himself and 2 for the other (an unfair split that people routinely reject). However, the proposer would have a choice. In one game, he could choose between this unfair offer and a fair one (5 raisins each). In another, he could choose a hyper-fair option (2 for himself and 8 for the responder). In a third, he had no choice (the second tray also had 8 for himself and 2 for the other). In the fourth game, the proposer’s other choice was hyper-unfair (10 for himself, 0 for the responder).
Unlike humans faced with these games, chimpanzee responders accepted any nonzero offer, whether it was unfair or not. The only offer that was reliably rejected was the 10/0 option (responder gets nothing). The researchers conclude that chimpanzees do not show a willingness to make fair offers and reject unfair ones. In this way, they behave like selfish economists rather than as social reciprocators.
Assuming that the experiment accurately mimics the human ultimatum game, this is a major finding (in my mind anyway). Humans tend to punish the proposer for deviating from an equal split while chimps will take any non-zero amount. How cool is that?
I hope someone tries this experiment with bonobos too. And children (against other children with raisins, not child vs. bonobo).
Minimum Schminimum
August 24, 2007
The Globe and Mail has an article by Reginald Stackhouse making a case for indexing the minimum wage to help the “working poor”.
What we need is the same remedy used to maintain retirement incomes at the level of inflation. We index the Old Age Security Pension and the Canada Pension. Why not index the minimum wage, too? Take it out of the arena of political debate and partisan competition. Periodically adjust it to the cost of living so that the working poor aren’t made poorer by inflation.
When I suggested this in Parliament 20 years ago, I was greeted by the Milton Friedman kind of argument that a minimum wage does not belong to a free-market economy. But that is irrelevant. My point is that if we are going to have a minimum, it should be at least on a par with the cost of living in the face of irresistible inflation. Indexing is the way to do it.
The Milton Friedman argument is only irrelevant if you don’t care about the ultimate outcomes. Increasing the minimum wage, through indexing or other means, will increase unemployment for the “working poor” and decrease the group’s spending power. This economic fact is counter-intuitive but it is important to rely on more than intuition when making proposals that will impact the lives of others.
Reggie Stackhouse…. what a great basketball name though.
Economics of Science Funding
July 24, 2007
As I continue to read Storm World and Evolution for Everyone one theme keeps popping up: science funding. In Storm World there is bickering between the warring science factions and funding, or lack thereof, is used as a sign of political interference. In Evolution for Everyone, the question of funding comes up in the chapter about Tame Fox Research in Russia.
Is science best when funded publicly or privately? Do we think of science research as a public good, infrastructure for human capital, or maybe semi-open sourced intellectual property?
