Category: Economics

I am puzzled by the resurgence of Austrian Business Cycle theory among Sachs, Krugman, Baker and many others who you would not ordinarily associate with the theory.  Sachs, for example, writes:

…the US crisis was actually made by the Fed… the Fed turned on the monetary spigots to try to combat an economic
slowdown. The Fed pumped money into the US economy and slashed its main
interest rate…the Fed held this rate too low for too long.

Monetary expansion generally makes it easier to borrow, and lowers
the costs of doing so, throughout the economy. It also tends to weaken
the currency and increase inflation. All of this began to happen in the
US.

What was distinctive this time was that the new borrowing was concentrated in housing….the Fed, under Greenspan’s leadership, stood by as the credit boom gathered steam, barreling toward a subsequent crash.

What is puzzling about this is two-fold.  First, there is no standard model that I know of (say of the kind normally taught in graduate school) with these kinds of results.  Second and even more puzzling is that the foul-weather Austrians don’t seem to draw the natural conclusion from their own analysis.

If the Federal Reserve is responsible for what may be a trillion dollar crash surely we should think about getting rid of the Fed?  (n.b. I do not take this position.)  The true Austrians, like my colleague Alvaro Vargas Llosa, have long taken exactly this position.  So why aren’t Sachs, Krugman et al. calling for the gold standard, a strict monetary rule, 100% reserve banking, free banking or some other monetary arrangement?  Each of these institutions, of course, has its problems but surely after a trillion dollar loss they are worthy of serious consideration.

Nevertheless, I haven’t heard any ideas, from those blaming the crash on the Fed and Alan Greenspan, about fundamental monetary reform.  (Can Sachs, Krugman et al. really believe that it was Greenspan the man and not the institution that is to blame?  That seems naive.)

Instead, the foul weather Austrians seem at most to call for regulatory reform.  But that too is peculiar.  Put aside the fact that banking is already heavily regulated, have these economists not absorbed the Lucas critique?  In short, suppose that whatever regulation these economist want had been put in place in earlier years.  Would the crash have been avoided or would the Fed have simply pushed harder to lower interest rates?  After all, the Fed lowered rates for a reason and if the regulation reduced the effectiveness of monetary policy in creating a boom well then that just calls for more money.

In November, the duo created Friends for
Sale, now one of Facebook’s most popular games with nearly 700,000
daily players. Users buy, sell and own their friends, as though their
friends were pets or stocks. Owners can control their acquisitions,
forcing them to do or say things, as well as sell them and turn a
profit. Those being bought and sold are also part of the game, going up
and down in value.

The game has become especially popular among Facebook’s crowd of users in their 20s.

Here is much more, for the pointer thanks to Marko Siladin and also Curt Gardner.  I have to admit I don’t really understand how this works, but it sure sounds like a "Markets in Everything" entry.

A few points on the new plan:

1. The Fed is smarter than other regulators, the Fed can pay higher salaries, and the Fed has more independence.

2. Ceteris paribus, the Fed usually can do a better job than other potential regulators.  If someone is going to oversee hedge funds and other non-bank financial institutions, why not the Fed?

3. An independent central bank is, all things considered, a good idea for reasons of monetary policy.

4. The Fed, as regulator of financial markets, has an incentive to keep economic growth high and this also militates in favor of the Fed as regulator.  A new prudential regulatory agency for capital markets would not be responsible for the overall macroeconomy and would not necessarily have that same pro-growth incentive. 

5. A regulator must, one way or another, be accountable to Congress and the President.  The more that the Fed is accountable to the other branches of government on regulatory issues, the more it is accountable to them period.  That would be true even if monetary policy and regulatory decisions were not converging in practice, as they have been in recent months.

6. In essence we are on the verge of "spending" some of the Fed’s monetary policy independence in return for superior regulation.  That choice makes me nervous.  Indeed, arguably we have already made that "expenditure."

7. The new plan, oddly enough, takes away the Fed’s power to oversee banks on a daily basis.

8. One important question is what kind of relationship would develop between the Fed and a new, unified office of prudential regulation.  See #7.  Even if there is consolidation of all the loose regulatory spokes (should credit unions really get a separate regulator?) into an oversight agency, we should somehow keep the Fed’s special access to bank balance sheets.  I’m not sure how the Paulson plan fares on that score.

Note also that the Fed is deliberately non-transparent.  Is that, when all is said and done, one reason why we are looking to it to enforce more transparency in other institutions?

That’s part of the latest Treasury plan. 

The potential gain is that a single agency would be accountable
for all the in-between derivative products which are currently overseen
by no one.  Even if you’re a libertarian who hates regulation, a lot of the subsequent oversight (but not all of it) would be enforcement of laws against fraud and false dealing.  Some of it would be preventing excess leverage to take advantage of the Fed safety net.

At current margins the gains from regulatory competition are less than before.  Arguably the CFTC applies a lower regulatory tax to keep economic activity in one of the sectors it oversees, most notably financial futures, and thus to keep itself in business.  This in turn forces the SEC not to regulate stock trading too heavily, otherwise volume will jump into the futures market.  All true, but that argument made more sense in the mid-1980s (post Shad-Johnson), when stock index futures were still a novelty with an uncertain future.  Furthermore international competition constrains the regulators more today than it did twenty years ago (London would gladly pick up business from the Merc), so that means less need for regulatory competition within the USA.

Ideally a regulatory marriage should focus the resulting agency on its most important roles, namely discovering and penalizing outright fraud and preventing catastrophic meltdowns.  Of course that wish might be dreaming.  After all, if investors are tricked why will underpaid lawyers see through the underlying problems in the market? 

Note also that few regulatory consolidations have gone well, at least not in their first few years.  Imagine actually forging the SEC and CFTC into a single culture with a single set of norms and regular communication patterns and employment practices.  I’d be surprised if it could be done in less than four years’ time and that is usually with some big bumps along the way, all in the service of learning of course.  (Google "Homeland Security.") 

So ideally the time to consolidate the SEC and CFTC is when the crisis is truly passed, not today.  In the meantime we should recognize that the case for separate agencies isn’t as strong as it used to be.  But given that the SEC already has its hands full (did they catch the Bear Stearns problems? No), do you want to divert its talent to managing the merger?  I’m not ready to press the "yes" button on this one, even though the final outcome is probably a better place to be.  A simpler alternative is to give the SEC authority over the derivatives and fold in the CFTC five years from now.

Chris Blattman, development economist extraordinaire , posts from Liberia.

Today we sat down with an inter-faith network of Liberian religious
leaders to talk about their peace building plans. They are a truly
inspiring organization, building local capacity to resolve conflicts,
and training mediators to resolve disputes in the community. The
countryside is, to some extent, a powder keg, and they are building
local early warning systems and rapid response capability to
potentially serious conflicts.

Moreover, to reduce tensions in
conflict-prone places, these religious leaders–principally Muslims and
Christians–do not just aspire to a new social contract, they sit down
with ethnic and religious leaders in each village and coax them to
actually write one, specifying norms and sanctions.

And they want to know if it’s working.

I
hum and haw about comparison groups, going through my impact evaluation
101 schpiel. I have serious concerns that one would or could develop a
control group, let alone randomize, for such a program. So I dance
delicately around the subject.

"Wait a minute," interrupts the Imam, "Are you talking about a randomized control trial?"

I gape.

"Oh I see!" says one Reverend Minister, "We need a control group! This is a good idea."

It
turns out his holiness was once an agronomist. "This is just like our
control plots for fertilizer. But how are we going to control for
spillover effects?"

An older Methodist leader frowns sitting in the corner glowers. "Please, a moment," he says. "I see a real problem here."

Here
it comes. Here is the doubt and questioning I expected. We’re talking
about a peace building exercise, not fertilizer on a farm plot. Even I
have my reservations. This man, of an older generation, clearly has
other priorities.

"How," he asks "are we going to select a proper sample?"

Hat tip to Dani Rodrik.

What’s really going on? What’s going on is that perhaps $6T of
mortgages with a duration of a decade that had been priced at a 1% per
year chance of default (with a 1/3 value haircut in the event of
default) are now being priced at a 4% per year chance of default.
That’s a loss of $600B in market value–and if your share of that $600B
is greater than your capital, or is thought to be greater than your
capital and so impedes your operations, you are gone.

But truth be told it is a zero-sum game–not a real destruction of
wealth. The real rates at which cash flows of constant risk are being
discounted haven’t changed much: there hasn’t been a big redistribution
of wealth between the present and the future. What has happened was
that a bunch of people believed that the default risk was 1% when it
was actually 2% and reported gains of $200B (of which they took
2-and-20 on the hedge fund slice, perhaps $20B, for themselves), and
that now a bunch of people believe that the default risk is 4% when it
is actually still 2% (unless, of course, the assembled central banks of
the world fail and unemployment heads rapidly upward). So in aggregate
hedge fund partners have gained $20B, hedge fund investors have
paid$20B to their money managers for the privilege of losing another
$200B that they never had, and there are $400B of transitory paper
losses that will turn into real losses for those overleveraged and
caught by the credit crunch and so forced into fire sales, and into
real gains for those with steel nerves and liquidity.

Unless, of course, Ben Bernanke and company fail to contain the
crisis, and we wind up in a severe depression. But then we would have
much, much bigger things to worry about than $600B of missing paper
mortgage value. 4 years x 3 percent excess unemployment x Okun’s Law
coefficient of 2 x $13T economy means a $3.1T cumulative Okun gap in
lost real wages, salaries, and profits. That’s the thing to worry about.

That’s Brad DeLong, here is the link.

Eamon McGinn, a loyal MR reader, asks:

I was wondering if you were willing to share your ideas for picking a mechanic. I had a look through the archives and couldn’t find anything.

Considering a choice between a garage run by an individual mechanic and one run by a nationwide company:

The individual run garage stands to lose more if too many repairs are done (causing me not to return in the future) but he has a temptation to increase the amount of repairs as he gets most of the profits (as opposed to the mechanic working at a company run garage who, ipresume, gets a wage). I feel the latter effect will dominate as I can’t really tell if too many repairs are done.

This would indicate that the company run garage is the one to go for. However the lack of incentive to over-charge also implies a lack of incentive to do a good job.

This is a tough dilemma, though I am not sure if individual vs. company is the trade-off I am worried about.  I would expect individual mechanics in large repair companies to have plenty of incentives to overcharge you (does anyone know how these people are compensated?)

I am pleased that, at 46 years old, I’ve never had to use a mechanic in the traditional sense.  I’ve never needed anything other than standard maintenance.  So my first piece of advice is to always buy a Toyota or Honda.  My second piece of advice is to support free trade and, if I dare say so, to support a reasonable level of immigration.  I suspect that a mechanic who is an immigrant, indeed an illegal one, is less likely to rip you off.  No proof, that’s just my best educated guess, based on the idea that people who are afraid of losing a big surplus are less likely to invite scrutiny and the irritation of others. 

As for the question itself, lack of experience, in this case, also implies lack of expertise.  Readers, do you have good suggestions for Eamon?

Here is one lesson, involving Venezuela and Curacao, via William Griffiths. 

The "card thing" is an intricate scheme involving local merchants, Socialist bureaucrats, Venezuelan travelers and middlemen.

Trying to slow capital flight, Venezuela limits its citizens to
$5,000 in annual credit card purchases abroad. That is 10,750 bolivars,
at the official exchange rate of 2.15 to the dollar. But at the
prevailing black-market rate of 4.5 to the dollar, the amount more than
doubles to 22,500 bolivars.

Seizing on that gap, some Venezuelans began coming to Curaçao’s
casinos last year and using their credit cards to buy chips. They then
played a few hands and cashed in the chips for dollars, which circulate
here along with guilders.

Dummy receipts are available too.  So, I am puzzled by the generality of Dani Rodrik’s defense of capital controls.  Internet commerce alone should mean that most capital controls aren’t easily enforced.  True, not everyone has access to large-scale transactions on the internet, or some companies may be too big and respectable to try to sneak money out of the country this way.  But if the enforceability of capital controls is relying on such imperfections in individual optimization, I would suggest that the idea, if it ever made sense in the first place, doesn’t have much of a future.

If backward time travel is also somehow possible, maybe firms in the
future will choose to outsource some of their operations to the past,
locating their manufacturing and other services in lower-wage time
periods. This opens the possibility of transtemporal gains from
trade… assuming, of course, that governments don’t implement
effective trade barriers.

That is Glen Whitman, here is more, interesting throughout.  By the way, Stephen King was right: the movie Jumper is quite good, albeit it requires a taste for conceptual science fiction counterfactuals.  It’s the best treatment of teleportation I know, with of course references to Plato’s Ring of Gyges.  Catch it on video if you can.

Great insights from two legendary entrepreneurs – that’s what Marc Andreessen is offering up in a series of posts on Charlie Munger’s The Psychology of Human Misjudgment.  Munger is Warren Buffet’s long-time partner and vice-Chairman at Berkshire Hathaway.   Andreessen writes:

Mr. Munger’s magnum opus speech, included in the book, is The Psychology of Human Misjudgment
— an exposition of 25 key forms of human behavior that lead to
misjudgment and error, derived from Mr. Munger’s 60 years of business
experience. Think of it as a practitioner’s summary of human psychology
and behavioral economics as observed in the real world.

Here’s a taste of Munger:

…almost everyone
thinks he fully recognizes how important incentives and disincentives
are in changing cognition and behavior. But this is not often so. For
instance, I think I’ve been in the top five percent of my age cohort
almost all my adult life in understanding the power of incentives, and
yet I’ve always underestimated that power. Never a year passes but I
get some surprise that pushes a little further my appreciation of
incentive superpower.

…We [should] heed the general lesson implicit in the injunction of Ben Franklin in Poor Richard’s Almanack:
"If you would persuade, appeal to interest and not to reason." This
maxim is a wise guide to a great and simple precaution in life: Never,
ever, think about something else when you should be thinking about the
power of incentives…

Andreessen is going through the speech and offering comment from his own experiences.  Here’s Andreessen with an important example:

…the result of shifting from stock options to restricted stock should be obvious: current employees will be incented to preserve value instead of creating
value. And new hires will by definition be people who are conservative
and change-averse, as the people who want to swing for the fences and
get rewarded for creating something new will go somewhere else, where
they will receive stock options — in typically greater volume than
anyone will ever grant restricted stock — and have greater upside.

Read the whole thing, it’s the first post in a series I’m very much looking forward to reading.

The new issue of Democracy: A Journal of Ideas (registration, but easy and free) is very interesting.  Here is one proposal, from Jason Bordoff:

Drivers who are
similar in all respects–age, gender, driving record–pay roughly the
same premiums whether they drive 5,000 or 50,000 miles per year, even
though the likelihood of a collision increases with each mile. This
“all-you-can-drive” pricing scheme imposes significant costs on
society: more traffic accidents, congestion, air pollution, greenhouse
gas emissions, and dependence on oil.

…the effect of PAYD on miles traveled and gasoline
consumption would be significant: a 6.5 percent reduction under
conservative estimates, and others suggest the reduction could be as
high as 10 percent. To put that in perspective, it would take an
81-cent-per-gallon increase in the gas tax to achieve a 6.5 percent
reduction in miles driven.

Monitoring costs seem workable, at least in principle with computerized odometers, so why don’t companies do this? 

Earlier this week Tyler wrote:

I was thinking of writing a science fiction story.  In this world human
capital is incredibly valuable.  Even if you lose all your wealth you
can earn back lots very quickly, at least if you are talented and
well-educated….The level of risk-taking is very high and capitalist enterprise starts to collapse…Production resumes only when a) managers precommit to costly drug addictions, so that they again fear pecuniary losses and b) shareholders find altruistic managers and also initiate
charitable contributions to India.  They threaten to cut off those
contributions if managers perform poorly.

Some of you were perhaps wondering what on earth this means.  (Recall my post on Tyler v. Alex.)  Perhaps I can help.  Here is a recent item from the NYTimes.

BlackRock, the publicly traded asset manager, and a hedge fund firm, Highfields Capital Management, are backing a new company seeking to raise $2 billion to buy delinquent residential mortgages.

Private National Mortgage Acceptance will be run by Stanford L. Kurland, former president of Countrywide Financial Corporation, the largest American home-loan provider, the companies said Monday in a statement.

Chapter five of Common Wealth is called "Securing Our Water Needs," an important topic but one neglected by most economists.  One lesson is that climate change will put a big stress on water supplies.  So far, so good, but the recommendations start with greater international cooperation:

A first step, at least, would be to focus on the hardest-hit lands, specifically the world’s drylands.  Fortunately, these are covered by the UN Convention to Combat Desertification, which has 191 member governments as signatories.  Unfortunately, the treaty as it now stands is little known and has little clout and financial backing.  Rather than reinvent the treaty, however, it would be better to reinvigorate it.

I would say it needs invigoration, not reinvigoration.  It is no accident that the Convention has little clout and little financial backing.  Many such Conventions are toothless objects, designed to appeal to a least common denominator within the process of the Convention itself (recall, it has 191 signatories).  No one is opposed to "international cooperation" but it is no accident that truly international bodies have to either find a way to make profit (e.g., the World Bank lends to China) or they are usually very strapped for funds.  That’s just not where the political rents are and that isn’t going to change.

Since Sachs calls this a "first step," his position is in some sense invulnerable.  Whatever you really think should be done can be called the next step.  Sachs writes, however, that the next step is more finance if I understand him correctly he wants to increase funding by more than a factor of 100).  I would prefer finance from national governments, or even from the states or provinces, than finance at the level of international organizations.  Most of the 191 signatories just aren’t that good at R&D, funds accountability, or even technology adoption.

I might add that national governments are the ones that subsidize the price of water to ridiculously low levels, most of all for agriculture.  My first step is to remove all these water subsidies, allow water prices to rise, institute more water trading, and then see which innovations the private sector decides to finance (hmm…those are my first four steps).  One role for government would be to ensure that patent law does not hinder international transfer of worthwhile innovations, a point which Sachs makes in other contexts.  That sounds less glamorous than a big international plan, but I think it has a better chance of succeeding.

America’s inequality problem — and I mean the stagnation at the lower end, not the hedge funds guys at the top — does indeed seem to stem from dysfunctional families and bad education:

We examine changes in the characteristics of American youth between the
late 1970s and the late 1990s, with a focus on characteristics that
matter for labor market success. We reweight the NLSY79 to look like
the NLSY97 along a number of dimensions that are related to labor
market success, including race, gender, parental background, education,
test scores, and variables that capture whether individuals transition
smoothly from school to work. We then use the re-weighted sample to
examine how changes in the distribution of observable skills affect
employment and wages. We also use more standard regression methods to
assess the labor market consequences of differences between the two
cohorts. Overall, we find that the current generation is more skilled
than the previous one. Blacks and Hispanics have gained relative to
whites and women have gained relative to men. However, skill
differences within groups have increased considerably and in aggregate
the skill distribution has widened. Changes in parental education seem
to generate many of the observed changes.

Here is the paper., ungated version here.  The authors use a different method but their results suggest that the earlier Goldin and Katz paper, which focuses on the connection between inequality and the inability to spring into higher levels of education, is essentially correct.  The problems with lower income stagnation do not stem fundamentally from trade, weak labor unions, or for that matter technical change.  I won’t call this question settled, but the Goldin and Katz result is looking increasingly strong.  I would also say that we, for better or worse, have more separating equilibria in today’s world.

Here’s an intuitive way to grasp the hypothesis  Let’s say that today you are a young Korean-American, perhaps even a Korean-American from a non-wealthy family.  Are your future income prospects good or bad?  Is upward mobility still there for you, if you want it?  Most people don’t even have to go to the numbers to answer these questions.

Here is a not unrelated article about the prospects for affirmative action.  And, if you’re more worried about the growth in income inequality that comes from gains at the top, well, the last few months have remedied that just a bit.