Correlation-Seeking

by  Alex Tabarrok in

Richard Squire has an important new paper in the Harvard Law Review:

…This Article identifies a pervasive opportunism hazard created by
contingent debt that lawmakers and scholars have overlooked. If liability on a firm’s
contingent debt is especially likely to be triggered when the firm is insolvent, the
contract that creates the debt transfers wealth from the firm’s creditors to its
shareholders. A firm therefore has incentive to engage in correlation-seeking – that is,
to incur contingent debts that correlate, or that through asset purchases can be made to
correlate, with the firm’s insolvency risk. The consequence is an overuse of contingent
debt that destroys social wealth through overinvestment, higher borrowing costs,
financial distress, and potential systemic risk. Correlation-seeking is especially
pernicious because, unlike other forms of shareholder opportunism such as asset
substitution, it can reduce risk to shareholders even as it increases shareholder returns.

It's long been known that a firm close to bankruptcy has an
incentive to gamble because if the gamble pays off the
shareholders prosper and if the gamble fails then the shareholders are no worse off (since the firm was already close to bankruptcy). 
But gambles like this
add to shareholder value primarily by transferring wealth from
the creditors who bear the downside risk without any hope of upside gain.

Squire shows how this idea is magnified when we add
contingent debt and correlated asset returns.  A contingent debt is one that must
be paid only in certain states.  If the shareholders take on
contingent debt and at the same time buy assets with low or negative
payoffs in the same set of states then the shareholders can focus the downside risk into the states in which they are bankrupt anyway – thus focusing the downside risk onto unsecured creditors. 

Correlation seeking of this kind becomes easier with contingent
securities and more difficult to monitor.  As Squire points out even as AIG was writing credit default
swaps (a type of contingent debt) on MBS it was buying MBS for its own portfolio and of course the ultimate unsecured creditors, the taxpayers, paid the price. 

*Europe, Europe: Forays into a Continent*

by  Tyler Cowen in

I very much enjoyed reading this now-dated (1989) but still insightful volume of country-specific essays by Hans Magnus Enzensberger, one of Germany's leading public intellectuals.  The chapter on Sweden was my favorite.  Here is one good bit:

The "motley feudal ties" to which Marx alludes in the Communist Manifesto were torn asunder here earlier than anywhere else, to be replaced by a strictly organized centralized state.  Oxenstierna, an administrative genius, invented the prefectorial system two hundred years before Napoleon.  He sent governors armed with executive powers into all the regions of the kingdom.  They even had military means at their disposal to enforce the king's policies against the interests of the provinces.  He created the first national atlas and the first central bank in the world.  And so on.  Does all this have no implications for the present condition of the country and for the problems of its institutions?

Enzensberger also refers to Sweden as a country which has liquidated its own history in a bout of extreme forgetfulness.  I also liked this bit on Italy:

The great strength of this system is that it works not only from the top down but also from the bottom up — because even the poor, the "underprivileged," have their privileges, their consolations, and prerogatives.  The concierge apportions his favors and his punishments as he pleases, and the doorkeeper enjoys a mysterious power, of which his boss, the minister, is quite ignorant.

You can buy the book here.

Colombia the economic turtle?

by  Tyler Cowen in

…because trade accounts for only a third of the economy, compared with a Latin American average of about half, Colombia has been sheltered from the worst of the global slowdown. The country also lacks the debt hangover of its western peers; credit is only a third of GDP, despite a mini credit-boom in mid-2007, when consumer lending grew more than 30 per cent.

As well as the peace dividend following the end of hostilities with insurgents, a burst of government spending in 2009, combined with swift interest rate cuts, helped keep the economy afloat. Colombia probably had Latin America's best economic performance last year.

But just as its slump was shallow, so may be the bounce-back. Fedesarollo, a think-tank, forecasts 2 per cent growth for 2010, versus a 3 per cent regional average. The new government faces a fiscal gap equivalent to 4 per cent of GDP. Furthermore, reinserting disbanded fighters into civilian life, plus reparations, could turn the peace dividend into a peace cost.

Colombia's so-called "doggie-paddle economy" – the stroke may be slow and inelegant but it is steady – has overcome far worse. Over the past century, the economy has only shrunk twice.

The link is here.

Colombia (China) estimate of the day

by  Tyler Cowen in

"It costs me as much to ship goods from China to Colombia's main Pacific port, as it does from the Pacific coast up to Bogotá," says one businessman.

The article is interesting throughout, for instance:

Until five years ago, only 15 per cent of Colombia's roads were paved, most of them single lane. In a country where some 70 per cent of cargo is hauled by truck, that made high transport costs a regular burden.

Extreme Foreclosure

by  Alex Tabarrok in

The house at 10512 Baldy Mountain Rd. in Sandpoint, Idaho, looks like just another vacant foreclosed home. Some appliances, a bathroom mirror and even the hot tub are missing. The dining room of the three-bedroom house has water damage.

But this isn't your run-of-the-mill problem house. Call it an Extreme Foreclosure. The 3,678-square-foot McMansion is a product of the popular "Extreme Makeover: Home Edition" reality television show. It isn't the only "Extreme" home to fall on hard times.

From the WSJ.

A revisionist perspective on ADHD

by  Tyler Cowen in

This article is not perfect, but it is much better than most MSM coverage of its topic.  Here is one good paragraph:

That said, some adults with ADHD are highly intelligent, energetic, charismatic and creative, and are able to focus intently on a narrow range of topics that interest them. David Neeleman, the founder of JetBlue Airways, and Paul Orfalea, founder of Kinko's, have spoken out about how the disorder helped them come up with innovative ideas for their corporations, despite their having done poorly in school.

I have tried to track this point through the research literature, but it still seems to me that the way in which ADHD brings a high variance of attention — rather than just jumpy, scatterbrained behavior — is poorly understood.  There is, by the way, some preliminary evidence that ADHD is overrepresented in entrepreneurs.

Financial reform and why it is hard to blog

by  Tyler Cowen in

Paul Krugman writes an Op-Ed on where the political debate is at and I agree with most of his points.  Of particular importance is this one:

So what the legislation needs are explicit rules, rules that would force action even by regulators who don’t especially want to do their jobs. There should, for example, be a preset maximum level of allowable leverage – the financial reform that has already passed the House sets this at 15 to 1, and the Senate should follow suit.

I favor this but I nonetheless think it remains problematic.  The more binding the leverage restrictions, the more banks and other intermediaries may try to recreate implicit leverage off the balance sheet.  (This is one reason to push for decentralized market monitoring, though I am not suggesting exclusive reliance on that.)  It's fine to call for maximum transparency, but mostly that's just wishing for a different world.  Activities off the balance sheet are off the balance sheet for a reason and it is hard to squeeze many of them into traditional accounting conventions.  Nor should we try to ban off-balance sheet banking, as it would happen somewhere — both geographically and in some corner of the financial sector – and indeed many of these transactions limit rather than raise risk.

The upshot is that managing off-balance sheet risk requires an ongoing, hammer and tongs approach.  There isn't any "once and for all" solution to banking regulation and the harder we try to find one probably the more we will end up relying on regulator discretion and judgment.

Bank regulation is a tough slog, it depends on the quality of the bureaucracy and the periodic attention of a somewhat responsible legislature, "toughness" can be counterproductive, the historic periodic of regulatory "easiness" relied on cartelization and near-automatic profits, and it is like a chess game whereby the private sector eventually finds a way around most of the binding regulations.

And now we can return to why financial reform is hard to blog.  There's always a new proposal and a big tizzy over the particular contents of that reform.  Whatever one thinks of the specific suggestions, I keep returning to the notion that the quality of the regulators — most of all Congress — truly matters.

How many times can one say that?  How many times can one think that and run away in fear?

Arnold Kling has good remarks on transparency.

Do daughters make you more conservative?

by  Tyler Cowen in

Dalton Conley and Emily Rauscher report:

Washington (2008) finds that, controlling for total number of children, each additional daughter makes a member of Congress more likely to vote liberally and attributes this finding to socialization. However, daughters’ influence could manifest differently for elite politicians and the general citizenry, thanks to the selection gradient particular to the political process. This study asks whether the proportion of female biological offspring affects political party identification. Using nationally-representative data from the General Social Survey, we find that female offspring induce more conservative political identification. We hypothesize that this results from the change in reproductive fitness strategy that daughters may evince.

I don't yet see an ungated copy, do you?  By the way, I applaud the authors for their "stones" in writing the last paragraph of the paper, such as:

The conservative emphasis on family, traditional values and gender roles, and prolife anti-abortion sentiments all stress investment in children – for both men and women. Conservative policies mirror the genetic interests of women, writ large. They attempt to promote paternal investment in offspring. Further, they stress investment in conceived offspring – “a bird in the hand is worth two in the bush.” In short, Conservative policies support the genetic fitness of women by capitalizing on each pregnancy, reducing male promiscuity, and increasing paternal investment in children. Such policies may impinge on the freedom of parents’ immediate offspring, but they increase the expected number of grandchildren via daughters.

I'm not sure that's true as stated, but it does deserve further debate.

Assorted links

by  Tyler Cowen in

1. Update on gaming the Massachusetts mandate, and more here.

2. When professors get their politics: early.

3. Steve Landsburg's influential books list; he mentions that Parfit is the book most frequently cited by others.

4. Labor hoarding is in decline.

5. China blocks Bob Dylan tour.

6. Literature on analytical anarchism.

7. The obesity epidemic began earlier than we used to think.

8. Bloggingheads TV: Glenn Loury and Ross Levine.

Favorite songs about technology

by  Tyler Cowen in

Michael Weintraub asks:

What are your favorite songs about technology? In my own thinking I have limited the universe of cases to those whose lyrics deal explicitly with technological innovations and their cultural effects, along the lines of Paul Simon's "Boy in the Bubble" or the Talking Heads' "(Nothing But) Flowers."

Those are good picks.  For me, what comes to mind immediately is XTC's "Factory Brides," "Roads Girdle the Globe" (there should be more songs about infrastructure, no?), Kraftwerk's "Computer World" (and many others), and a number of Byrds songs, including "CTA-102" and "Space Odyssey."  What do you choose?

Does incarceration make people black?

by  Alex Tabarrok in

In a paper in Social Problems, Saperstein and Penner find that there is a surprising amount of variability in racial identification in the NLSY.  Some of this variation is due to error or other random factors but some of it also appears to be systematic.  In particular, the authors find that if someone has been incarcerated they are more likely to self-identify as black as well as to be independently identified as black.  As the authors put it

Results show that respondents who have been incarcerated are more
likely to identify and be seen as black, and less likely to identify
and be seen as white, regardless of how they were perceived or
identified previously. This suggests that race is not a fixed
characteristic of individuals but is flexible and continually negotiated
in everyday interactions.

Here is a key table.  In the first column is the respondent's self-identification, European or Black, in 1979.  Thus 95% of the people who identified as European in 1979 and who were not incarcerated between 1979 and 2002 identified themselves as White in 2002.  In other words, racial identification for the non-incarcerated was quite stable.  But only 80% of the people who identified as European in 1979 and who were incarcerated between 1979 and 2002 identified themselves as White in 2002.  Thus incarceration appears to affect how people identify themselves.

The result is surprising at first but makes sense once one sees it as a natural extension of Akerlof and Kranton's work on identity.

RaceID

Note that there are some issues with the data since the precise
questions asked and options given changed over time (hence the change
from "European descent" to "White")–nevertheless, the differences
conditioning on incarceration appear to be robust–but see the paper
for more.

Hat tip Gabriel Rossman.

What I’ve been reading

by  Tyler Cowen in

1. King Kong Theory, by Virginie Despentes.  An excellent short book on feminism, rape, and prostitution.  Given how much ink has been spilt on these issues, it's more vital than you would expect; "full of energy," as they say.

2. Solar, by Ian McEwan.  Maybe this is still better than most people's stuff, but I didn't finish it.  He's lost his intellectual edge.

3. Wolf Hall: A Novel , by Hilary Mantel.  Usually I'm willing to blame myself when I don't like "classics," but on this one I'll push back.  I started thinking "magisterial" (itself a mixed blessing) and then found myself slipping to "dutiful."  It's good — not great — and it doesn't beat reading non-fiction about British history.  The second Amazon review hits the mark.

4. The Cost of Living in America: A Political History of Economic Statistics, 1880-2000, by Thomas A. Stapleford.  No, I'm not actually reading this one, but I should be.

5. Underground: The Tokyo Gas Attack and the Japanese Psyche, by Haruki Murakami.  This remains one of the classic studies of collective action, although it is hardly ever recognized as such.