On Floyd Norris' Book Selections

In the business section of the New York Times on Christmas Day, Floyd Norris offered a short list of the best books in 2009. The list contains six books:

--Liaquat Ahamed, Lords of Finance: The Bankers Who Broke the World.
--Robert J. Barbera, The Cost of Capitalism: Understanding Market Mayhem and Stabilizing our Economic Future.
--Johan Cassidy, How Markets Fail: The Logic of Economic Calamities
--Justin Fox, The Myth of the Rational Market: A History of Risk, Reward and Delusion on Wall Street.
--Frank Portnoy, The Match King: Ivan Krueger, The Financial Genius Behind a Century of Wall Street Scandals.
--T.J. Stiles, The First Tycoon: The Epic Life of Cornelius Vanderbilt.

(Note that all six titles of colons and subtitles.)

I have not read the last two books and am not interested in them as far as the recent recession and financial crisis is concerned. Ahamed's book is fascinating, describing the relationahsips among the key central bankers in the years leading up to the Great Depression. I recently finished reading The Myth of the Rational Market and am ready to read How Markets Fail. The book by Fox focuses on the idea of efficient markets in finance. It is good in that it describes the theory relatively well, and presents some interesting anecdotes about the famous economists and finance professors who developed and tested the theories. But, Fox rejects efficient markets, and is much more favorable to behavioral finance. For all the labors he goes through, his bottom line solution is, "It leaves us with a need to find ways to temper speculative excess while acknowledging that we won't necessariyl be able to distinguish speculative excess from an entirely sustainable boom." (p. 319). Very helpful. With that we should be able to have a bright and riskless future.

In skimming through the introduction to the book, How Markets Fail, the topic is broader than the stock market, but looks at people like Hayek, Friedman, and others who advocated free marekts as the best way to organize economic activity. Cassidy also discusses behavior economics, but seeks to offer a broader critique that he calls reality-based economics. He criticizes the Fed for not trying to pop bubbles earlier.

This last point is interesting because it is a topic the members of the Open Market Committee had discussed. It is also a topic in Lords of Finance. Benjamin Strong, who was President of the New York Federal Reserve Bank until is death shortly before the stock market crash, believed there was a bubble but that the means that would be used to pop it could cause a big crash and a depression. After his death, the key decision makers in the Fed tried to pop the bubble, and we had a big crash and a severe recession. No one knows what a concerted effort to pop the housing or stock market bubbles in 2005 or 2006 would have brought about. Perhaps a less severe recession, and perhaps just as severe a recession only sooner.

I also have not read The Cost of Capitalism, but Norris describes it as an attempt to exlain the importance of Hyman Minsky and to demolish neoclassical economics. I have recently read Minsky's, Stabilizing an Unstable Economy (no subtitle). I found Minsky to be difficult to read--not because the ideas or writing was difficult but because I found so much of it to be nonsense. He described the period from 1946 to 1966 as one in which the U.S. had a stable economic and financial system, and that it has become more unstable since then. The reason for the increasing instability is financial innovation. In the end, he calls for a much larger role for government to keep the system more stable. I suspect that Minsky would have argued that he paid more attention to historical realities than traditional economists. I am not sure that is true though.

Many people around my age (baby boomers) recall the time Minsky said was stable in nostagic terms. The U.S. economy was strong and American firms dominated the world's economy. This was the time period when things were normal. But this is false; it was a time of abnormality. World War II left Europe and Japan in shambles. It took time for these economies to recover and rebuild. It took time before they could compete with American business. The world economy became more normal in the sixties.

There is another historical dimension glossed over by Minsky--the actions the government was taking. Lyndon Johnson won the presidency with a huge mandate and a Democratic Congress. He pushed for more government involvement in the economy through things like Medicare and the war on poverty. Meanwhile, we also had an actual war in Vietnam than picked up steam. The resulting pressure on prices led to the Fed mostly accommodating the fiscal policy, but sometimes trying to reduce inflation. The end result was often a stop-start monetary policy that saw inflation and unemployment increasing. The continued conflicts in the Middle East and the new-found power of OPEC led to large increases in oil prices. U.S. labor markets experienced a huge influx of young workers as baby-boomers entered in large numbers, and as women began seeking long-term careers rather than jobs until marriage and children. Minsky makes no reference to any of these changes in the U.S. that surely had repurcussions on the stability of the economy.

So, I must disagree about the greatness of several of the books selected by Norris. (I'll offer my own list in a later post). But I would like to finish the lengthy post with one other observation. The Federal Reserve was created in 1914 after the turmoil of the Panic of 1907. The Fed was supposed to make such panics a thing of the past. Yet, twenty-five years later we were in the worst depression the country ever experienced. Many economists blame the Fed for the severity and length of the depression. If people followed the pattern of many books today--the recession we just had shows the bankruptcy of economics and of markets. One could have concluded with better justification for the argument in 1930 that the Fed failed so miserably that it should have been disbanded.

Bad News and More Bad News

The government announced that the GDP figures for the third quarter have been revised downward again. (See WSJ article on it here.) The original estimate that was released in mid-October was 3.5% annual growth rate. It was revised down to 2.8% in November and now revised again to 2.2%. That is a substantial change in the figures. One thing it shows is that we should be cautious in our declarations about the strength or lack of strength of the recovery based on preliminary figures. A country hungry for good news in October jumped on the robust estimate. It is still positive growth, but more in line with the concern felt by many that unemployment will take a long time to return to levels we observed earlier in the decade.

Yesterday's Wall Street Journal reported that the decade of the '00s has seen the worst performance by the U.S. stock market for any decade, even worse than the '30s.

Hopefully, there is no where to go but up.

Quo Vadis?

Two articles in yesterday's Wall Street Journal relate to concerns I have raised in this blog before. The first article talks about the federal government through the Department of Energy becoming the largest "venture capitalist" in the country. A small automotive firm, Fisker Automotice, Inc., ran into financing difficulties with plans to build a plant in Finland. With the help of the U.S. government, and Vice-President Biden, the company received funds and set up the plant in Delaware. (Evidently, VP Biden still is a senator from Delaware.) According to the article, the DOE will lend or give out more than $40 billion to businesses that work in "clean" technology.

The second article describes how Edward Montgomery, the auto-communities recovery czar, is able to cut through red tape to help auto firms redevelop abandoned auto sites. In particular, he has been able to get the EPA to expedite and alter its brownfied site-assessment program. Perhaps it is a coincidence, but the auto industry, in which the federal govenrment now has ownership stakes in two of the leading auto makers, is the main beneficiary of the czar's activities.

We are moving from an economic system that relied on private firms and initiatives to one that is becoming more dependent on government. Of course, we did not have a "free-enterprise economy" before January 2009--there has always been a lot of government involvement in the economy. But there still seems to be a difference now. I suspect government officials argue much of it is due to the recession. The same thing happened during the Great Depression, and much of the government involvement persists to today. Are we in for another ratcheting up of government guidance (control?) of the economy?

Tax Cuts versus Government Spending

Greg Mankiw's column in today's business section of the New York Times compares economic research on the stimulative impact of tax cuts relative to government spending. He cites research papers that find a larger impact for tax cuts, including work done by the President's advisor, Christina Romer. I know space is limited in a column, but I wish Mankiw had emphasized more the difference between temporary changes and permanent changes. As anyone who has had any microeconomics knows (or at least learned at one time) all elasticities are greater the longer the time period.

The stimulus offered while George W. Bush was still president was a tax cut, but a temporary tax cut. The effect was that most people used the tax cut to pay down debt or increase savings. I think these are good things, but they do not stimulate the economy. Similarly, increased spending that is know to be temporary in nature will not have as much effect as an increase in spending that should last a long time. If a firm wants to take advantage of a temporary increase in spending, it will not make long-term investments as part of the process. If the firm believed the spending might be available for many years, it would respond in a different manner. One of the reasons tax cuts provide more stimulus when the cuts are expected to be permanent, or as permanent as anything can be that involves the government, then there is both a spending effect and an incentive effect. The latter is not in place for temporary tax cuts or rebates. Probably the worst think Keynes ever said was, "In the long run, we are all dead." But time passes and constant focus on the short run leads to ad hoc measures that lead to more measures later on.

On Interest Rate Risk

The Sunday New York Times has an article about banks not refinancing mortgages much right now. In his speech on Saturday, the President blamed large financial institutions for the recession. Others in the article suggested that banks should be more willing to refinance mortgages, and many would want to because interest rates are low.

Financial institutions were at fault but so was the government. Government policy encourages homeownership in many ways, including pushing regulated banks to find creative ways to help poorer risk families obtain mortgage financing. Ultimately, banks and other financial institutions got on the bandwagon, ultimately paying very little attention to "due diligence."

Interest rates are low right now, but the article also points out that the low rates are due to government programs that probably will phase out soon. In other words, rates will be going up. A bank that refinances potentially locks in for 15 or 30 years at a low interest rate. If interest rates begin rising in a few years, the bank cannot force the borrower to accept a higher rate. That is, the banks bear the interest rate risk. Securitization has been one of the methods used to get rid of the interest rate risk. But securitization is part of the "risky loans and complex financial products," that the President complained about in his speech.

I had hoped that the current recession would lead to changes in behavior. There are signs that households are wising up and increasing their savings while reducing their debt. It is not clear that financial institutions have made changes other than ones necessary to comply with government concerns. And, it is not clear the government is making any lasting changes. There is still a push to encourage wider howeownership, the building of new homes despite the large inventory of unsold homes, and the ever-constant desire for low interest rates. We may have missed a depression in the economy, but I find the situation today depressing.

A Day of Infamy

The EPA announced that greenhouse gasses are a threat to public health, preparing the way for EPA regulation of the sources of greenhouse gasses. It is ironic that this announcement fell on December 7--the anniversary of the Japanese attack on Pearl Harbor and the day President Roosevelt called it a day which will live in infamy. EPA Administrato Lisa P. Jackson is quoted in the release, "These long-overdue findings cement 2009's place in hitory as the year when the Unted States Government began addressing the challenge of greenhouse-gas pollution and seizing the opportunity of clean-energy reform." As an editorial in the Wall Street Journal today notes, seizing is the correct verb. The EPA is seizing the political process and taking on the role of the legislative branch.

I am sure the EPA would dispute this claim, and would argue that their decision is legitimatized by past acts such as the Clean Air Act. But a policy as controversial as climate change policy has been should surely be handled through the legislative process. Instead, democratic principles are ignored in favor of administrative fiat. Perhaps Ms Jackson is so convinced in her rightness that grabbing power is justified in her mind. It may be the same attitude as displayed by the scientists whose e-mails have been released and indicated that they were trying to keep any dissenters to the climate change "consensus" from publication. They may be right, but in lands where the rule of law is supposed to apply and in which democratic procedures and institutions exist, the route taken is simply wrong.

Justice and Economic Growth

Michael Sandel is a professor of government at Harvard who teaches a popular course on justice. He now has published a book based on the course and it was reviewed in Sunday's New York Times. The reviewer, Jonathan Rauch, notes that many public policy disagreements are really differences about justice. I suspect he is correct, although Tom Sowell's book, A Conflict of Visions, remains a better discussion of his point. But Rauch begins his review by recalling a conversation with a prominent conservative commentator who railed against the Obama administration's handling of General Motors and Chrysler. Rauch states that he found the fury of the commentator puzzling. He asks, "Was it such a crime for the government to treat differently situated stakeholders differently, even if doing so was unorthodox?" Clearly, Rauch thinks the answer is no, but I must respectfully disagree.

When economists give advice about how a poor country can encourage economic growth a common part of the answer is the importance of the rule of law. When decisions about who owns productive resources are left to the whims of the reigning government, few people make long-term investments in the resources. A predictable constancy is necessary if investments are to be made. Or, as Mancur Olsen put it--the wealth of a society depends on its ability to make long-term investment commitments. Such investments will not be made when the fruit of the investments may be confiscated at a later date. To alter bankrutpcy proceedings for the sake of political expediency is to move away from the rule of law. Rauch is aware that the rule of law is involved, but dismisses it when he writes, "Is justice absolute and process-driven, so that we should stick to rules come what may? Or is it situational and outcome-aware, so that we should sometimes imporise to take account of special circumstances?" Rauch seems to favor the latter. I favor the former, along with Hayek, Sowell, and Milton Friedman (to name a few).

We may be moving into a period of slower growth rates for the country. The focus on the short term that exists in Washington, the alteration of rules due to the emergency of a recession, and probably health care reform will reduce somewhat incentives to invest. For the latter, David Brooks offered an interesting discussion of health care reform as a trade-off between vitality and security. The social safety net will be enhanced but marginal tax rates will increase. The latter will reduce growth rates in the future.

Living in a liberal democracy means that decisions about trade-offs like those just mentinoed are decided through political processes. If society prefers less growth but bigger safety nets, then who am I to say society is wrong? Most Europeans I have met prefer their society to ours. But I am not certain most Americans prefer European economic and social systems to ours. Time will tell.

China and the U.S.

Tyler Cowen's article in today's New York Times is worth reading. Cowen refers to the symbiotic relationship between the U.S. and the U.S., as noted also in Niall Ferguson's term, "Chimerica." At the heart of the problem is the exchange rate policy of China--pegging the dollar-yuan rate so that Chinese exports remain cheap in the U.S. China maintains the exchange rate by borrowing heavily in the U.S., which helps keep interest rates low in the U.S.

Since the financial crisis and the full-fledged recession began, I fear that the U.S.-Chinese relationship has not been getting enough attention. Part of the reason may be simple--what can the U.S. do about the relationship unilateraly? The U.S. cannot China to revalue its currency. But the bail-outs of Wall Street, the continued propping up of housing markets by the U.S. government, and the call for a "jobs bill" by many Democrats, along with the push for health-care reform, drops the China-U.S. relationship down on the Administration's to-do list. I hope Cowen's article can help raise concern over the China-U.S. relationship higher on the to-do list.

HUD Saved Us from a Depression

An article in today's New York Times concerns the Federal Housing Administration. FHA provides insurance for homebuyers who don't meet traditional criteria for conventional loans. In othe words, the FHA is part of the government support and encouragement of homeownership. During the subprime craze, many buyers bypassed the FHA, but in the last year or so the FHA has backed a lot of mortgages. Their reserves are low--0.53 percent of the total porfolio, and some think that the FHA will need a bailout before too long. Yet, they also had faced pressure from Congress to open their doors to a broader group of applicants, i.e., applicants with lower down payments and poorer credit ratings. Brian Montgomery, a former head of the FHA, said that even if a bailout is needed, people should still feel gratitude. The article ends with a quote form Mr. Montgomery, "They should be going over to the H.U.D. building and frankly thanking the career staff for saving them from a depression."

So, government subsidization and pressure on lenders to encourage broader homeownership led to the run up in housing prices. When the housing bubble burst, we entered a severe recession. The FHA has continued to prop up housing markets, evidently saving us from a depression. But the collapse in prices that followed the run-up in prices is due, to a considerable extent, to government policy. Does that make sense?

Are Football Hemets Risky?

An article in today's WSJ raises an interesting question about head safety. Concussions are common among pro football players, and retirees often experience head and brain issues later on in life. Would they be better off without helmets? Obviously, no helmets would change the game. When I was in graduate school, a classmate thought about doing his dissertation on whether safer football equipment actually reduced injuries. His expectation was no--as the equipment gets better, the behavior of the players changes. This fits into a well-known article written by Sam Peltzman concerning automobile safety mandates and whether they resulted in saved lives. Peltzman hypothesized that as people drove safer cars, their driving behavior would change. People would drive less defensively. The probability of dying in a car accident is the probability of being in an accident times the probablity of death given you were in an accident. Safer cars--mandatory seat belts, collapsable steering columns and so on, reduce the probability of death given an accident. But changed driving behavior may increase the probability of an accident. Peltzman's empirical analysis found that few drivers and passengers in cars died but more pedestrians and motorcycle riders died. This is consistent with the behavior change. (See Sam Peltzman, "The Effects of Automobile Safety Regulation," JOURNAL OF POLITICAL ECONOMY, 1975, 83 (4), pp. 677-726).

Government as Co-Conspirator

In my previous post I cited a WSJ op-ed piece, in which the author argued that the government has been a co-conspirator with many on Wall Street in running up debt that led to the financial and economic crises. I think the article still focuses too much on Wall Street and not enough on the government. It does note that the recent actions of the government, both the Fed and the Treasury, are similar to actions taken several times over the last thirty years. The most surprised and disappointed man in America had to be Dick Fuld, CEO of Lehman Brothers, when the government didn't resuce them the way it did so many others in the past. Given what happened afterwards, it is very doubtful the government will ever let any large financial institution go under again. So, the moral hazard issues continue. The short-term approach followed by the Fed and Treasury also continues.

Government as Co-Conspirator in Financial Meltdown

Interesting op-ed piece in today's WSJ. Am busy so no time to comment today but will do so soon.

More on "Jobs Saved"

Former colleague Victor Claar sent me a link to a news story about errors in the counting of saved jobs, including the treatment of raises as equivalent to saved jobs.

There is another dimension I had not considered as yet. There has been a disruptive construction project on an intersection in Holland through which I often drive. Signs indicated that funds came, at least in part, from the stimulus package. The firms that worked on the job then must estimate how many jobs the project saved or created. The project lasted three months. Will the companies report these jobs saved or created as if they were year-long jobs or will the length of the project be considered? In earlier blogs I wrote about how the methodology used by the government to estimate jobs created or saved focused on job-years. I believe the average citizen reading about jobs saved or created believes that the number of unemployed falls or at least doesn't increase by the number of jobs saved. But, that clearly is wrong, and there is really no way to tell by how much.

Things That Can Be Explained by the Bell Curve

My previous post on Ed Lazear brings to mind a lecture I often give in class on the Bell curve. The tails of the Bell curve never touch the axis. So, if intelligence is measured on the axis and a pretty intelligent person is two standard deviations above the mean, there are still some people farther out--three, four, five standard deviations. In percentage terms, the probability of someone being five standard deviations above the mean is small, but when you consider that we live in a country of 300 million people, there can be a number of people at that level of intelligence. No matter how smart I may think I am, there are lots of people a lot smarter.

What if we measure something like sexual deviency on the axis? In a country of 300 million people there may only be five or six people at five or more standard deviations away from the mean. But that is enough people to fill up an episode of Jerry Springer. And, they all want to be on TV. So, some of these TV shows don't prove that the country is going to pot; they just verify the Bell curve.

Are Economists Insensitive?

I posted yesterday about an op-ed piece by Ed Lazear. I met Lazear over twenty years ago at Lousiana State University. A colleague had visited at the University of Chicago and was able to bring a couple of economists from Chicago to LSU for a few days. Lazear came the day after he ran in the Chicago Marathon. He was hobbling around quite a bit. We took him to lunch at a restaurant in the student union, which was in the middle of campus. It was about a ten minute walk. The next day as we got ready to go to lunch, he asked if we could go somewhere by car. No one thought to take into consideration the obvious pain he was in when walking after the marathon. So my answer to the question in the title is, "Yes."

He presented a paper on "Sales". He began by talking about paying the bills and noticing that his wife's shoes were more expensive than his. She said that women's shoes tend to be more expensive. But why? he wondered. His shoes had more material in them, were more durable, and one would think would cost more. This is someting I had discussed with my wife on more than one occasion. Men's shoes should be more expensive but are not. What is going on? Lazear went on to develop a model to explain why, other things equal, women's clothes had higher prices than men's clothes. It made sense when he went through the model. It was published later in the American Economic Review. This anecdote illustrates one of many differences between economists who end up at the University of Chicago and economists who end up at places like LSU.

Salieri is my patron saint.

Jobs Again

There is an op-ed piece by Ed Lazear in today's Wall Street Journal. Lazear was chair of the Council of Economic Advisors under Bush. He writes that his final economic forecast while a part of the council predicted the economy would begin to recover in the third quarter, and this was without considering a stimulus plan. Of course, his forecast could have been overly optimistic, but it could also mean that the GDP growth in the third quarter was not due to the stimulus plan we have.

He also talks about the estimates of jobs created and the jobs retained as due to the stimulus. Recipients have to fill out a report providing the data. Lazear notes two problems with the reports. The first is reporting bias. A construction firm wanting additional funds may believe that it needs to err on the high side of estimates of jobs created or retained. Second, these programs are likely to count people who switch jobs as new hires.

I have written before on the methodology used by the government to estimate the jobs created and saved by the stimulus. It is a direct link to the spending, assuming so much money equates one job. It also measures job-years and not individuals. That is, a person who is hired as part of a two-year project would count as two jobs--one for each year. The Administration has been criticized for the way they are trying to estimate jobs created or saved, but they keep doing it. The process gives the illusion of precision that is only an illusion. The concept of a job saved is ok--grants sent to states that use the money as a stop-gap in cuts in schools will save some jobs of teachers. But to think we can measure these in a meaningful way is not legitimate.

Perhaps the members of the administration think that if you repeat something often enough, people will believe it must be true.

Is the Recession Over?

The Bureau of Economic Analysis issued a statement today reporting that GDP increased in the third quarter. Normally, that would mean the recession is over. Obviously, the pain is not over yet, and we are no where near a level of output that we had before the recession began. Another concern is that the third quarter may be something of an anomoly because auto sales surged with the "cash for clunkers" program. Real personal consumption expenditures rose 3.4 percent while durable goods increases 22.3 percent.

The figures are preliminary and may be adjusted when more data become available in late November.

Low Rating for U.S. in Health Care

A column in yesterday's Wall Street Journal discusses the often-used ranking of the U.S. health care system as 37th in the world. Experts know that the ranking system is seriously flawed, yet politicians keep citing it to demonstrate how bad the U.S. system is, and to justify the call for reform. A number of years ago, I organized a conference at Hope College on health care. In the research I did preparing for the conference, I learned that many European countries don't count the births of very premature babies as a live birth. The U.S. does. Since many of the very premature babies die shortly after birth, there will be a difference in the infant mortality rates from this difference. Now, it is unlikely that the difference in definition accounts for all the differences between the U.S. and Switzerland, but it accounts for some. There are numerous other differences in definitions, life-style choices, incidence of smoking, violent crime, and ethnic diversity across countries to make international comparisons difficult. Add to the fact that much of the rest of the world free rides on U.S. spending on research and development, and much of the differences across countries can be explained.

This is not to argue that changes in our system may not be advisable. It is meant to suggest that merely copying what some other countries are doing may not be optimal for the U.S.

Golf is a Bourgeoise Sport

Caesar Chavez of Venezuela has railed against golf as a capitalist and elitist sport, also calling it bourgeoise. I have to agree with Chavez that golf is bourgeoise. I will even add that golf is the quintessential capitalist sport. To me, these are good things though.

Golf is an individualist game. There is no team. There is no one to blame except oneself if one doesn't do well. It is the golfer and the course. True, golfers also compete against other golfers just as businesses compete with one another. The winner in the competition, be it golf or business, is the one who is better than the other.

A former colleague of mine when I was at LSU raised an interesting question about team sports. The comment is often made that sports builds character. He wondered whether that was true. In football, for example, coaches teach how to hold without being seen by the refs. Basketball players work on subtle ways to push off without being seen. Pitchers in baseball look for advantages such as vaseline on the ball. Former Cincinnat Reds manager said once that he collected baseballs discarded by the umps during games when Dodgers pitcher Don Sutton pitched to show the similarity in cuts on the balls. Anderson accused Sutton of using a belt buckle to cut the ball to increase the movement of the ball.

In golf, players penalize themselves when they break a rule, even when inadvertently they break a rule. Refs are not part of the game. Officials at tournaments are there to help clarify rules but not to catch cheating. When was the last time a baseball player told an umpire that he had missed the tag?

Deirdre McCloskey wrote an excellent book, The Bourgeoise Virtues: Ethics for an Age of Commerce. A commercial society may not produce works like The Iliad, but life for the majority of people is significantly better in a commercial society than in a warrior society.

Root Causes of the Economic Crisis Continued

In an earlier post (Oct. 1) I mentioned an article in the Journal of Accountancy that I thought was very good about the root causes of the economic and financial crises and the recession. I also noted that Marty LaBarge and I had written a comment on the article and sent it to the journal. The comment, divided up by questions supplied by editors, is part of an "Economic Discussion" on the original article. It is available, along with other comments on the original article, on-line here. My only complaint is that they left in our reference to a figure we supplied on US net exports but didn't publish the figure.

The Other Nobel

There is an interesting op-ed piece in the Wall Street Journal today about the Nobel Peace Prize. Bret Stephens argues that the committee often selects people who are "Goodists"--people who think all conflict stems from avoidable misunderstandings.

This reminds me of an interesting book by Thomas Sowell, A Conflict of Visions: Ideological Origins of Political Struggles. Sowell argues people tend to have one of two overriding visions about humanity. One he calls the unconstrained vision. He uses William Godwin's Enquiry Concerning Political Justice as a work that illustrates this approach. (Godwin was Mary Shelley's father, I believe.) To Godwin the essence of virtue is the intention to benefit others. With proper education and enlightenment, human beings could behave with the best interest of others and bring about social good. The second vision about humanity is the constrained vision. Examples would be Adam Smith and the authors of the Federalist Papers. Human beings have moral limitations and tend to be egocentric.

The two visions lead to different views about how to organize social and political life. For one thing, the unconstrained vision sees education as a way to move society forward and toward perfecting humanity. The constrained vision values education but does not see education as the key to making people better. The unconstrained vision does not look to incentives to affect behavior while the constrained vision does. The constrained vision also looks for ways to reduce the power one human being has over another. The constrained vision looks for political systems that includes ways to separate power and to slow down or limit government. The unconstrained vision usually leads to view that seeks a more active government.

The op-ed piece is worth a look. Even more, Sowell's book is a good read.

Nobel Prize 2009

The Nobel Prize in economics has been awarded to Elinor Ostrom and Oliver Williamson. The academy offers a statement for the public on the significance of the research, which can be found here, and a more detailed paper on the significance meant more for economists, which can be found here. Ostrom is the first woman to win the prize in economics. (I was surprised in the early years that Joan Robinson never won since she was a big name from the 1930s and 1940s. But, she died and the award is not made posthumously.)



The two economists are linked in that their work relates to property rights/transaction costs approaches to economic analysis. Williamson worked on the firm as an institution and Ostrom worked on open-access property and communal property-rights regimes. I am a little disappointed in Williamson. His work is in the same field as Ronald Coase, but I always felt Willamson's work was not at the same level as Coase's work. His focus on post-contractual opportunistic behavior strikes me as inadequate as a basis of firm governance. I saw Williamson present a paper once while I was at UCLA, and he used more "you knows" in his talk than I have ever heard from an educated person. But, I am in the minority among industrial organization economists in my regards of Williamson. Ostrom is a good choice. She has done important work on property rights, and helped change the landscape. When I first taught about property rights, I talked about three types of systems--private, public, and communal. Today I talk about four types--private, public, communal and open access. Hardin's "The Tragedy of the Commons" should be called "The Tragedy of the Open-Access Property Rights Regime." (I know it doesn't have the same ring to it.) But there are assets owned by communities that manage to limit access of one another and to prevent use by those outside the community. Open-access property is truly available to all and no one can be prohibited from using it. The problems associated with over use are greater for the latter. The supreme example today is global climate change.

Executive Pay

The Wall Street Journal reports that the government's pay czar is targeting salary cuts for firms that received aid from the government. This is not a surprise; government money usually implies government control or at least restrictions on behavior. An example is federal funds that go to universities or colleges comes tied with government regulations. A few colleges, perhaps Hinsdale College in Michigan is the best known, refuse to accept government funding.

There is also a question of the method used by the czar to limit pay. In particular, there will be a shift from salary to stock and requirements that the stocks should be held for a period of time. The goal is to reduce the incentive for taking large risks in hopes of short-term gains. But why don't the boards of directors of these firms establish such practices? They exist in many firms. Why is the government better able to sculpt the appropriate pay package than the boards? I doubt the government is better. But, we are also back in the "too-big-to-fail" problem. If a bank is too big to fail, people anticipate that there is always a government bail out in the background, and this lowers the cost of acquiring funds for the bank. It also increases the incentive to take on more risk. The optimal solution is to end too-big-to-fail, and let banks that suffer losses from taking on too much risk bear the consequences.

Finally, to learn more about executive compensation, go to the web site of the Center on Executive Compensation. They offer information and research about ways to arrange executive compensation so that it rewards longer-term profitability.

What Did People Expect?

The headline for an article in yesterday's Wall Street Journal is "Cruel September for Car Makers." Car sales fell 23% in September. But in the preceeding couple of months, the government's "Cash for Clunkers" program was in effect. The auto industry had used incentives in the past to boost sales, and usually found that the boost in sales came at the cost of sales in other months. The government's program was the same type of thing. The big question is whether it generated a net increase in car sales or merely changed the timing of the sales. Given it included a sizeable subsidy for new car buyers who had a "clunker" and bought a more fuel-efficient car, it is likely it stimulated demand from what it would have been rather than merely transfer sales from the end of the year to the late summer months. But it is hard to see a reason to expect improved sales for the rest of the year.

It is interesting to see that Ford continues to increase market share while GM and Chrysler are losing market share. Ford is the firm that did not get direct aid from the federal government and now faces competition from government-aided firms, yet is gaining market share at their expense. Apparently, producing cars people want matters more than government support.

Root Causes of the Economic Crisis

There is an interesting article on the root causes of the economic recovery in the October issue of the Journal of Accountancy. I think it is correct in its assessment of the crisis. My colleague, Marty LaBarge, and I have written a comment to it, in which we agree with the article but offer a little more information about the international dimension of the crisis. It can be found here.

Tracking Property Ownership

A column in Sunday's business section of the New York Times discusses the difficulty in sorting out claims on property after the big run up in prices and in the number of transactions. A private firm that tracked electronically mortgages called the Mortgage Electronic Registration System claimed to eliminate the need to record changes in property ownership in local land records. Gretchen Morgenson notes that there have been foreclosures that missed a possible lien holder on a home because the information was not in the land records. MERS has successfully proceeded in the courts to obtain funds for the claimant that used its serves. But, a recent Kansas Supreme Court ruling prevented a claimant from getting part of the proceeds of a foreclosure process because the information was not part of the official records. As Morgenson notes, the business model of MERS has been rejected by the Kansas Supreme Court.

A market system relies on well-defined property rights. Traditionally, we have put more effort into maintaining clear lines of ownership on real property--land and the buildings on land. Market systems also rely on bankruptcy laws that allow property to move to higher valued uses. The mortgage market in recent years may be bringing these two needs into conflict. It will be interesting to see how other state courts handle things. MERS did not cause the housing markets around the country to overheat, but it did facilitate the process.

Do We Get It?

An article in today's Wall Street Journal discusses actions of the Fed to encourage home buying. These include keeping interest rates low, buying up mortgage-backed securities, and exptening a mortgage-purchase program. The current crisis began when the bubble in housing prices burst. Some adjustments were needed in housing and mortgage markets. Is continuing to subsidize housing and increasing the extent of subsidization really in the best interests of generating a sustainable recovery? Will we revert to an over-reliance on debt?

Posner, the Keynesian

Richard Posner, one of the denizens of the law-and-economics movement, as well as a federal judge, wrote a book on the economic recession, A Failure of Capitalism. He also has a blog through the Atlantic magazine on the "depression," the term he prefers. Now he has an article in the New Republic on how he became a Keynesian. In addition, he weighs in on economists lack of understanding of the macroeconomy, although he is not as mean-spirited as Krugman. He said he was baffled by the economists' disarray and decided to read Keynes' General Theory himself. What he offers is a principles-level account of Keynes' ideas.
When Posner says that, "There is no professional consensus on the details of what should be done to arrest the downturn," he is correct. But he seems to imply there should be a consensus. But macroeconomics is complex because the macroeconomy is complex. Polls of economists have consistently found economists to be more of one mind on micro issues than macro issues. But, even in micro issues, there can be substantial disagreements. To take Posner's area, law and economics, there is not a consensus on whether capital punishment deters murder. There are philosophical differences, theoretical differences, and empirical differences among people who have examined the issue. This does not imply that we should give up on law and economics or that we should go back to economic analysis of law that predates Coase or Posner's early work.
If you check out his blog, you can see that Posner is also experiencing the rabid rage of Krugman and Brad DeLong because he criticized a speech Christina Romer gave. As a lawyer and judge, he seems thick-skinned enough to deal with the criticism.

The Chicken Tax

The Wall Street Journal today has an article about a tariff in the auto industry that dates back to the 60s. It goes back to a dispute with Europe when Europe imposed high tariffs on imported chicken. The U.S. retaliated with a tariff on foreign-made trucks and commercial vans. The tariffs are still in place. Delivery vans imported to the U.S. face a 25% tariff, while passenger vans face a tariff of 2.5 percent. So, Ford produces a van in Turkey, adds rear side windows and some rear seats and ships them to the U.S. Once here, the rear seats and rear side windows are removed. By doing this, they spend more money but save even more taxes.
George Stigler noted that economists don't have influence on politicians. As proof he offered tariffs. Almost all economists think tariffs are bad but tariffs are still ubiquitous. The chicken tax is a reminder that once a tax or tariff is imposed, it is difficult to get repealed.

New book by colleague

Congratulations to my colleague, Kim Hawtrey, whose book is soon to be released. A description of the book at Amazon can be found here.

Lehman Brothers Anniversary

It has been a year since Lehman Brothers went bankrupt after the government refused to bail them out as it had with Bear Stearns. There has been a spate of articles and essays on the events that have occurred in the last year. Several interesting columns appeared recently in the Financial Times. Niall Ferguson wrote on why a Lehman deal would not have prevented the financial crisis and the recession. In fact, he argues, it took the collapse of Lehman Brothers and the credit freeze to get Congress to act and pass a huge, across-the-board bail out. Martin Wolf wrote on the wrong lessons from Lehman's fall. Wolf argues that we cannot allow the too-big-to fail doctrine continue, and that an ambitious overhaul of the financial system is in order. John Kay writes that changes are needed in what assets are required to stand behind deposits at banks.

The essay I like best is buy William White, "Some Fires are Best Left to Burn Out." He raises the question of whether the constant effort at preventing any and all recessions from occurring or from continuing increases the ultimate cost of a later severe recession. He uses an analogy from fighting forest fires. Fires thin out undergrowth and rejuvenate the forest. If all forest fires are prevented or immediately put out, it leads to a larger more dangerous forest fire later. The focus tends to be on the short term and causes problems in the long term.

White's point is important. It is common to hear laments in the financial press about businesses being too concerned about the profits of the next quarter. This short-term emphasis comes at the expense of long-term planning and profitability. But the same tendency exists in the public sector. Every recession that has taken place since I have been a professional economist has been seen as requiring immediate action to stop and get the economy growing again. This has been true of recessions that turned out to be relatively short or mild. The Obama administration argued that the end was near and the stimulus package was needed to prevent a depression. Never mind the huge deficits; we have to fix things now! I am not arguing for or against the stimulus package at this point. I am just noting the similarity between the private and public sectors. But what if firms that focus on the next quarter end up reducing their long-term viability? And what if the government's efforts to forestall or prevent any economic downturn ensure that there will be eventually a severe downturn? White says, "Just as good forest management implies cutting away underbrush and selective tree-felling, we need to resist the credit-driven expansions that fuel asset bubbles and unsustainable spending patterns."

(Note: I did not link the opinion pieces from the Financial Times since a subscription is required to upload the articles.)

Letter on Krugman's Essay

The letter to the editor of the Sunday magazine of the New York Times that my colleague, Marty LaBarge, and I wrote in response to Paul Krugman's essay, "How Did Economists Get It So Wrong?" will be published in Sunday's magazine, and is available on-line here. A comparison with my earlier post below shows that the editors shortened it by a sentence.

More On Jobs Saved and Created

In an earlier post, I outlined how the government is counting the number of jobs created or saved by the American Recovery and Reinvestment Act, or the stimulus package passed by Congress in February. Since the government used a formula that related so much spending to a job, it ignored the fact that some of the spending would be replacing other spending. For example, spending on green technologies means less spending on "dirty" techonologies. A job created in one area offsets the loss of a job in another rather than creates a new job.
The Wall Street Journal now has an article on estimates the states are reporting to the federal government about the number of jobs created or saved. The figures are much less than the estimates of the federal government.

Baucus Health Care Plan

The New York Times reports (see here) that Sen. Baucus has issued a health care plan. It is cheaper than the other plans that have been proposed, and the Congressional Budget Office estimates even lower costs, although still over $700 billion. Republicans have blasted the plan over making so many cuts in Medicare to pay for the coverage of the uninsured and other increased or new benefits. Democrats claim that the reductions in the rate of growth of Medicare will be accomplished through greater efficiencies rather than reductions in benefits. I am sure there are inefficiencies in Medicare. But, if reductions in costs could be made through reducing inefficiences, what is stopping the government from doing so?

Odds and Ends

A couple of items to look at if the reader is interested. Sunday's NY Times business section had a number of good articles and columns about the year anniversary of the collapse of Lehman Brothers. Definately is worth a look.
On another topic, a blog that relates economics and theology that I find very good is Kruse Kronicle. He is providing a series of posts on key economic issues. The first dealt with scarcity, a concept accepted by economists but there are theologians who dispute that scarcity if a worthwhile starting point.

How Did Economists Get It So Wrong?

Paul Krugman had an essay in Sunday's New York Times magazine. He argued that modern macroeconomics was unable to see the crisis coming and that a new macroeconomics would have to start with Keynes. My colleague, Marty LaBarge, and I submitted the following letter to the editor of the magazine:

Paul Krugman offers a critique of modern macroeconomics in his essay, "How Did Economists Get It So Wrong?" He cites a concern for mathematical elegance over truth and reliance on efficient marekt theory as reasons for economists missing the instability in markets. But similar arguments could be made about the Keynesianism that Krugman advocates. In its heyday, Keynesianism included elegant mathematical models that demonstrated marekts are inherently unstable, and had its own version of an efficiency theory, only it was government that was efficient; a wise and good government could "fine-tune" the economy through appropriate fiscal policy, ignoring how real-world governments actually operated. While financial markets do fall short of perfection, the progression of the "perfect storm" of events that generated the worst recession since the Great Depression--the global saving glut, low interest rates, securitization, and government policy supporting homeownership--cannot be blamed on "extraordinary delusions and the madness of crowds."

Krugman pays no attention to the approximately twenty-year period of good macroeconomic performance known as the "Great Moderation." He also ignores "bubbles" that didn't lead to recessions. Something is at work besides irrational financial markets. The market system works well most of the time. Perhaps a key factor affecting whether a shock to the system or even 'irrational exuberance" leads to a serious recession is the level of buffer stocks held by households and firms. When savings exist and debt levels are not inordinately high, the economy adjusts to a shock. But when debt levels are high and savings low, the bursting of bubbles in houses and equities can turn into a severe recession. The crucial question now is whether taking on huge levels of government debt is the best way back to sustainable growth.

We don't know if the letter will be published or not.

Bailout Payback

Some of the banks that received bail-out money last year are paying funds back and the U.S. government is receiving a profit. (An article on this from the NYT is here.) At the time of the bailout, it was said the government could end up getting much of the money back. This is a good sign that the claim may be true. As the article notes, though, not all banks and other institutions may be able to repay the funds and the government could experience a loss overall.

So, does this indicate the bailout was successful? Unfortunately, we can never know what would have happened absent the government's actions. The return to the government is good, but less than private investors would have made because the government paid above market price for some of the assets. Of course, the purpose of the bail out was to help the balance sheets of banks look better. If the system would have gone under without the bailout, then any profit has to be a plus; if the system would not have gone under, then it should have been left to private investors. Again, a problem with economic as a science is that the controlled experiments rarely happen. We can bail out the banks and see what happens or we can not bail out the banks and see what happens, but we cannot do both.

Bernanke Chosen for Second Term as Fed Chairman

President Obama has nominated Ben Bernanke for another term as chair of the Fed. (For a news article on this, see here.) Bernanke likely will face some sharp questioning in his confirmation hearings because of his role in the financial bail outs. Likely, he will face criticism from both the left and the right. But I think he is a good choice for a couple of reasons. First, his knowledge of the Great Depression has proven valuable in the ways he handled the Fed's reaction this time. Second, his focus has been on the task at hand rather than his own ego. Third, he is respected by other central bankers and many within the Fed. Fourth, he has to better than Larry Summers, who apparently was on a short list for the job. (Janet Yellen would have been better, but Bernanke is better yet).
I have some reservations though. I fear that his actions may impinge long term on the Fed's independence. I also am leery of adding more regulatory power to the Fed because that may make it more difficult to remain independent.
Senators tend to be great Monday-morning quarterbacks, so I expect the fact that Bernanke made some mistakes will be emphasized in the hearings. Hopefully, it will just be a lot of huffing and puffing, and Bernanke will be confirmed.

In Fed We Trust

I read recently a new book on the Federal Reserve and its handling of the recent financial and economic crisis. The author, David Wessel, is economics editor of the Wall Street Journal. The book is In Fed We Trust: Ben Bernanke's War on the Great Panic. It is the best book I have read relating to the crisis. While it's focus is narrow, it is thorough and the economics in it are good. So many of the books that have come out focus on greed and are sensationalistic. This book is not sensationalistic, but is a sensational read. I highly recommend it.

Where's the construction?

This will be brief since I am on vacation. We drove roughly 1000 miles, mostly on interstates to get to our vacation destination. Road construction delays were virtually nonexistent. Where is the stimulus?

Is the "Recovery" Obama's 9-11?

Democrats often accused George W. Bush, with some justification, of using September 11 as a reason for any bill he wanted passed by Congress. September 11 was his trump card. It appears President Obama has his own trump card--the recovery. Any bill he wants passed is crucial for economic recovery. In today's papers there are articles about his push for passing health care legislation. (See here for an example.)

The current health care system in the country had nothing to do with the financial crisis that led to the recession. The health care plan may or may not be good for the country, but it has nothing to do with ending the recession. We had growth with the current system and can have growth again with it. It would be nice if policies were argued on their merits rather than by using fallacious arguments.

Three Cheers for the G-8

G-8 leaders reached an accord on climate change. They agreed to cut emissions of heat-trapping gasses by 80% by 2050. They did not agree on any specific cuts for an earlier date. I plan on cutting my carbon footprint by 100% by 2050. That is, as long as the casket I am in then is sealed properly.

Is Homer the Village Idiot?

Richard Thaler has a column in today's New York Times business section on "Mortgages Made Simpler."Thaler is co-author of a book, Nudge: Improving Decisions About Health, Wealth and Happiness. Thaler is a behavioral economist. In the article, he describes a traditional economist as someone who characterizes the economic agent as "Homo economicus" or "Econs". These are people who are self-interested, rational, forward looking and make decisions that are best for them given the constraints they face. Behavioral economists believe people are more like Homer Simpson--they fail to save for retirement, have troubel balancing their checkbook, and so on. So we have "Homer economicus" or "Humans." Thaler goes on to argue that regulations are needed to protect humans who do not engage in the careful rational calculations presumed by mainstream economics.

Both in the column and in his book, Thaler's examples tend to be mundane and not likely to cause a huge stir among people. However, I worry about the path it takes us down--a path towards increasing paternalism on the part of the government. While at LSU, I taught the economics of regulaton regularly. We would cover Consumer Product Safety Commission among other regulatory agencies. We also would examine some tort cases where sufficient warnings had not been provided about proper and improper use of a product. At one time, the law presumed a "reasonable man" approach--something had to be safe enough for a reasonable person to see the dangers of using the product wrongly. Later, according to one critic, things had to be made so the "village idiot" wouldn't get hurt. Is Thaler talking about a modification toward presuming most humans are actually village idiots? Are not regulators also human, subject to defects as any other human? Further, are not regulators often people who see themselves as superior to others, and knowing what is best for others?

Obama's Plans for Changing Financial Regulation

The Obama administration outlined its plans for regulatory reform of the financial and banking systems. The White Paper on the proposals is here. Today's Wall Street Journal has a lot of information about the proposals. For example, see here and here. I am currently on a short vacation, but will comment on the regulations next week.

The Great Depression Redux

There is an update of a column that appeared in April in Vox by two economic historians--Barry Eichengreen and Kevin O'Rourke. You can get it here. The date the start of the current recession later than the NBER did, and compare a number of variables with the same time period during the Great Depression. It is sobering.

Books on Panics and Depressions

I finished recently an interesting book--The Panic of 1907: Lessons Learned from the Market's Perfect Storm by Robert F. Bruner and Sean D. Carr. The panic was a catylist for the passage of the Federal Reserve Act in 1913. With no "lender of last resort," it took private individuals such as J.P. Morgan to arrange loans and guarantees to the banks and trusts that were facing bank runs due to the panic. People Morgan relied on included Benjamin Strong and George F. Baker. Strong plays a prominent role in another interesting book--Lords of Finance: The Bankers Who Broke the World by Liaquat Ahamed. The latter book concerns the four central bankers of the U.S., Great Britain, France and Germany, and mistakes made that led to the Great Depression. Strong was the President of the New York Federal Reserve Bank, which was the dominant bank at the time. Strong died in 1928--before the onset of the depression. Friedman and Schwartz, in their history of monetary policy, state that they think Strong may have helped prevent some of the worst decisions made during the depression.

Of interest to me also was the inclusion of George F. Baker. Hope College has a Baker Scholar's Program and I am one of the advisors to the group. Originally, it was formed through money from a trust left by George F. Baker for educational purposes. Later, the family pulled out of educational endeavors, but Hope was permitted to maintain the George F. Baker name. Baker was a banker and close associate of J.P. Morgan. He also gave money for the start of the Harvard Business School. In an appendix in The Panic of 1907, the authors state that Baker cofounded the First National Bank of New York in 1863 at the age of 23. He was a director in 22 corporations and also a philanthropist, providing gifts that founded the Harvard Business School and Baker Library at Dartmouth.

At Hope, the Bakers are juniors and seniors who were selected after interviews with local businesspeople. The emphasis is on student leadership. The group meets with businesspeople, both locally and on trips that usually include New York, Chicago and San Francisco. Over the last two years, visits have included Cisco, Google, JPMorgan Chase, ADP, and the Chinese Consulate in San Francisco. The current Bakers are a great group, and it is a pleasure to work with them. Their website can be found here.

Unemployment Rates by Metropolitan Area

The Wall Street Journal had an article in Wednesday's edition of unemployment rates by metropolitan area. (See here.) Cities in California dominate the high unemployment rates--El Centro tops the list at 26.9%. Iowa City has the lowest on the list at 3.2%. Other low cities include Ames, Iowa, Lincoln, Nebraska, Manhattan, Kansas, and Sioux Falls, SD.
I note that my area of Holland, Michigan is at 11.5% while Baton Rouge, Louisiana is at 5.2%. In 1992, when I moved from Baton Rouge to Holland, the unemployment rate in Holland was well below the national average while Baton Rouge was above the national average. Things have certainly changed.

Harm to Competitors or Harm to Competition

The Wall Street Journal has an interesting piece in its opinion section by George Priest, a Yale University Law School professor of antitrust law. He notes that the Justice Department issued a report in 2008 addressing appropriate antitrust approaches, and that Christine Varney, the new Assistant Attorney General for Antitrust has rejected it outright. According to Priest, the report was not a rehash of the Chicago-school antitrust approach (which is an approach I like), but an approach more moderate. Ms. Varney has denounced the report outright.

The issue seems to be an old one in antitrust. Should antitrust focus on harm to competitors or on harm to competition? That is, should the focus be on the fact that some firms lose in the competitive process, and if the winner is large or grows large, antitrust should step in and "correct" the situation? Or, should the focus be on harm to the competitive process? Collusion is an example of something that harms the competitive process. Predatory behavior can also harm the competitive process, but the existence of firms harmed by a competitor is not evidence of predation.

Priest notes that it appears Ms. Varney thinks US policy should emulate European policy. This is strange in a sense, since European policy came to emulate US policy in the post-war period. Even in the 1950s, cartels were legal in a number of European countries. But in recent years, the EU's antitrust focus has been on large firms in the IT area who have been successful. Microsoft and Intel are the two prime examples. (I wonder whether EU regulators would have decided differently if Microsoft and Intel were European firms.)

There was a time when American antitrust focused more on harm to competitors than harm to competition. In the last thirty years, it has been wiser and focused more on harm to competition. The return to harm to competitors does not bode well for the competitiveness of the American economy in coming years. It might pay to recall that in the 1960s there were many who thought General Motors should have been sued by the antitrust authorities because it had monopoly power and could harm its competitors. Does anyone think so today?

How Are 3.5 Million Jobs Calculated?

The American Recovery and Reinvestment Act of 2009 is supposed to create or save roughly 3.5 million jobs. How was this estimate determined? Two documents provide the information. The first was written by Christina Romer and Jared Bernstein in January, before Barack Obama was inaugurated. It is entitled, "The Job Impact of the American Recovery and Reinvestment Plan." The second is a report prepared by the Council of Economic Advisors, of which Christian Romer is the Chair, entitled, "Estimates of Job Creation from the American Recovery and Reinvestment Act of 2009." I will rely primarily on the second report, but it relies a lot on the first report.

Probably the average citizen hears that ARRA is supposed to save or create 3.5 million jobs thinks that this means that 3.5 million people will have jobs that would not have had jobs in the absence of the program. This is not correct though. The jobs are actually job-years. Suppose a project lasts two years and results in an extra 100 people being employed. The Council of Economic Advisors is calling these 200 job-years—the 100 people are employed for two years so each person is counted twice. In my previous post, I mentioned a project in Washington that involves $1,635,000,000 to be spent over several years. The estimate for that project listed on the website is 21,255 job-years. This does not translate into 21,255 people with jobs who would not have had jobs otherwise.

There is still the question of how the 21,255 figure was determined. For this, the report provided by the Council of Economic Advisors states that they estimated that a $100 billion of government spending creates 1,085,355 job-years (p. 5). That works out to $92,136 of government spending needed to create one job-year. To use an example in the report, an $11 billion program, “…will create about 120,000 job-years during the President’s first term.” (p. 5). That is, $11,000,000,000/92000 = 11,956 or approximately 12,000 job-years. In the example above, the $1,635,000,000 project will create 17,772 job-years, which is less than the 21,255 job-years listed on the website. I do not know the reason for the difference.

Keeping Track of the Stimulus Spending

The government has set up a website (www.recovery.gov) where the public can go and see how much has been spent and how it has been spent. A firm also has a site (www.recovery.org). The firm has a number of search engines that are used to find government Request for Proposals and other notices of bid taking for new projects. As of the date of this writing, the private web site has more information than the government web site. According to the private web site, the most expensive project authorized so far is in the state of Washington and involves demolishing nuclear facilities and remediating the waste sites. The price tag is $1,635,000,000. It is unclear when the money will start being spent since the usual government process involves a request for proposals, the collection of proposals and bids, and the awarding of bids. Once the bid is let, it takes time for the firm to begin work. However, this particular project is interesting in that part of the task is to, “Accelerate cleanup of facilities, waste sites, and groundwater along the Columbia River to support shrinking the active area of cleanup at the 586-square-mile Hanford Site to 75 square miles or less by 2015". That is, money for this project will still be paid out as late as 2015. Some critics of the American Recovery and Reinvestment Act point out that a lot of spending may be done after the recession is over and is no longer needed.

Obama, DIrigisme and Energy Policy

The new CAFE standards announced by President Obama have generated an interesting article in Financial Times by John Gapper. He notes that the CAFE standards killed large cars in America but helped create the SUV. Unintended consequences once again. He makes the case economists often make that a more efficient way to reduce oil consumption is to tax it--in this case, by a large, European-style gas tax. Gapper writes:

"Instead of the simplest, most obvious and least expensive way of achieving that end – raising the national excise tax on petrol – the president was again relying on a complex, dirigiste intervention."

It is likely, as Gapper notes, that Congress would never pass such a tax. It certainly wouldn't be popular among taxpayers and voters. But, given Obama's popularity, why not tackle something difficult instead of easy things like increased spending, something most politicians and voters like. I am getting the sense that the new administration prefers dirigistic approaches since such approaches rely on the wisdom of the regulators rather than relying on people responding to market forces.

Thoughts on the Economic Crisis, IV

In the previous three posts on this topic, I asked why don't we expect things to always be bad since we have a system in which no one is in charge of the economy. I then looked briefly at how markets work and at some sources of instability. I conclude in this post with a look at instability, rehashing some of what has been said before.
An important source of instability would be something that disrupts production of goods and services. Bad weather impacts agricultural production. A couple of years of drought can have severe effects on an economy, especially for a country that has a large agricultural sector. Several times over the last 35 years we have dealt with rapidly rising energy prices which disrupt production of energy-intensive products and of transportation. The large prices in oil that took place in 1973 and 1970 were followed by recessions.
These negative shocks tend to set in motion forces that correct the problem, but there may be a considerable lapse of time before normalcy returns. Higher energy prices encourage consumers to conserve and encourage producers to find new sources of energy or alternatives to specific forms of energy that have become more expensive. Higher food prices bought on by drought also encourage conservation, substitution to foods less dependent on large quantities of water, and the development of ways to tap into other sources of water, such as through canals, aqueducts, and wells.
On the positive side, innovations in the form of new products or improvements in production processes can spur economic growth and create a boom period. But this is still a source if instability. Innovations often generate new firms and industries while destroying other firms and industries. Joseph Schumpeter described this process in capitalistic economies as creative destruction.
Innovations are a catalyst to growth and change. Firms expand or new firms start up, increasing the demand for natural resources and labor and generating higher incomes and consumption of goods and services. If a particularly productive and fertile innovation has substantial impact on the economy there can be a fall back of growth if another equally-productive innovation does not come forth after the first innovation worked itself through the economy. What we have just described is a very simple version of what is known as real business cycle theory.
There are other problems that can develop in the real economy, but they do not tend to be systematic in nature. Mistakes on the part of firms in some industries can result in an excess supply or surplus of their good, forcing price down and perhaps forcing some firms out of business. But changing relative prices should correct things over time, and these issues should impact only some sectors at any time. We are interested in things that have economy-wide impact. While there are problem areas in the real economy, the problems should normally not be long term and rarely economy wide.
The production and consumption of durable goods are potential sources of instability. Durable goods, as opposed to nondurable goods or services, last and provide services to the user for several years or even a decade or more. Examples of durable goods include houses, autos, and regrigerators. (For record-keeping purposes, the government distinguishes a durable from a nondurable good by whether it is expected to remain in use more than three years or not. Some nondurable goods can last longer than three years—clothing for example—yet are treated in the data differently from refrigerators.) The purchase of durable goods can be postponed when the household is concerned about a recession.
Similar to consumer durables are capital goods purchased by business firms. . Capital goods are goods that are used to increase production in the future. Factories and much of the equipment in a factory are examples of capital goods. Capital goods also are durable goods. As durable goods, firms can delay purchasing capital goods when business is bad.
Capital goods and durable goods in general tend to be very pro-cyclical. That is, when the economy is booming, producers of durable goods and capital goods do very well; but, when the economy is in decline, producers of these goods see a sharp decline in their sales, revenues, and profits. Sales of durable goods are more volatile over time than sales of most nondurable goods or of services.
Real GDP has fallen about 2.5 percent since the official start of the recession. In contrast, the decline in investment spending by the private sector has been over 25 percent. Investment spending is more volatile, at least in part due to the durability of capital goods.
A market economy relies on money and financial instruments to operate smoothly. Studies have found that a developed set of financial markets enhances economic growth. But finance is also subject to wide fluctuations at times and can be a source of instability. We examine finance and money together because money can be viewed as a financial asset and because the Federal Reserve System’s operations, which controls the U.S. supply of money, affects interest rates and prices. Further, a link between finance and the real economy exists because capital goods purchases of firms and durable goods purchases of households usually are purchased by using financial and credit markets.
There is often a difference in timing of receipts and expenditures. People usually buy some durable goods, autos and houses to take two major examples, by borrowing funds and paying the loan off over time. Businesses build factories, malls, oil pipelines, and purchase other capital goods, often by means of borrowing or by raising funds through equity markets.
Finance is the mechanism through which the funds of those who want to save are provided to those who want to borrow. Some borrowing is done for consumption, but the largest use of borrowing is by businesses for investing. The investments enable firms to produce goods and services in the future. A decentralized market system cannot function without financial markets.
Many financial instruments are essentially IOUs. This is true of checking account deposits where the bank owes the depositor the funds, bonds where the seller of the bond owes the buyer funds to be delivered in the future, and loan instruments such as mortgages, car loans, and credit cards. Finance relies on promises and people keeping their promises. But, promises can be broken and both the borrower and the lender know that promises can be broken.
Promises can be broken because of malice on the part of the borrower, but promises can be broken out of circumstances as well. The future is uncertain. Expectations may not be met. A firm can invest in new production facilities for a new product with the expectation that they will be able to sell 10,000 units a month for $20 a unit. But when the product appears on the market at some later date, the firm can discover that people will not pay more than $12 a unit, and the firm cannot cover its costs. It goes out of business and defaults on its loan. If the future were certain, default would never take place.
Financial markets rely on trust. Lenders have to trust that the borrowers will be able to pay them back in the future, and that the borrowers will fulfill their promises. Due to the time dimension, the real economy also depends on trust. A parts manufacturer that supplies parts to automakers normally doesn’t expect payment for a few weeks. The parts manufacturer trusts that the automaker ultimately will make the payment. Recent events in the American automobile industry illustrate problems that can develop when trust no longer exists.
Risk is a part of financial markets also. Some financial assets have very low risk. Short-term government bonds are considered virtually riskless. Consequently, the return on short-term government bonds is very low. For other assets to sell in the market, they have to provide a greater expected return. People have to be compensated to take on additional risk. By taking on more risk, an investor can increase his or her expected return. But, the actual return could end up very large or could end up very small. Other things equal, the longer the time period the greater the risk.
Another way to increase return on an investment is to use leverage. Suppose someone buys 1000 shares of IBM at $100 a share. The investment is $100,000. If the price goes up 10 percent to $110, the value of the investment increases to $110,000 and the stockholder has earned a 10 percent rate of return. If the shareholder didn’t pay the full amount, but only paid 50 percent of the $100,000 and borrowed the other $50,000. Now, if the price goes up 10 percent and the value of the investment increases to $110,000, the shareholder has earned a 20 percent rate of return ($10,000, $50,000), If the shareholder only paid 10 percent and borrowed 90 percent, then the return would be 100 percent. Of course, stock prices can fall also. If that happens, the losses can multiply with leverage as the shareholder still has to repay the loan. The greater the leverage the greater the risk.
Moral hazard generates riskier behavior. Moral hazard is a term first used in insurance markets. It involves situations where the actions of the insured person affect the likelihood of the event that is insured against. By taking certain precautions, a homeowner can reduce the probability of a fire. If insured fully, the homeowner may not be as vigorous in taking the precautions as he or she would otherwise. The likelihood of a run on a bank is greatly reduced due to the presence of the Federal Deposit Insurance Corporation which insures deposits of most depositors. The bank has less incentive to be prudent and the depositor has less incentive to judge the riskiness of the bank. On a larger scale, if the people who run a bank believe they are too big to fail, that is the government will bail them out in the case of insolvency, the bankers have less incentive to behave prudently.
It should be obvious that there is greater potential for instability the greater the leverage is used in the buying of financial assets. Actually, this applies also to the buying of homes since the lower the down payment the greater the leverage and the greater the risk. When assets are purchased with a lot of borrowed money, they are riskier. If the asset prices fall, the owners face credit constraints that can lead to default. Default in some markets can spread to other financial markets, especially if financial institutions holding assets of other institutions whose assets are losing value.
As noted above, the Federal Reserve System (Fed) controls the money supply. It does so primarily through open market purchases and sales of government bonds. If the Fed is buying bonds, then the prices of bonds increase and the return on the bonds decreases. That is, the short-term interest rate falls. This action also increases the money supply by increasing reserves in the banking system, which allows commercial banks to make more loans. Economic activity increases as a result of the lower interest rate and increased quantity of money in the banking system. If the Fed sells bonds, the opposite happens—bond prices fall, interest rates increase, banks have less reserves and cannot extend more loans, and economic activity decreases.
One of the functions of the Fed is to maintain relative price stability. That is, it should prevent either inflation or deflation from occurring. In actual practice, the Fed is more concerned about deflation than inflation because deflation is often associated with severe economic downturns. The Fed seems to seek a relatively low and stable rate of increase in overall prices.
But the people who run the Fed are not omniscient and they make mistakes at times. When they do so, they may over stimulate the economy, leading to increased economic activity in the short run but higher prices in the long run. Inflation raises the cost of making informed decisions in the marketplace because people cannot be sure that changes in the price of a good are due to inflation or due to changes in the relative scarcity of the good. If fear of inflation is great enough, people end up spending real resources, including their time, trying to offset the effects of inflation rather than on economically productive activities. To reduce the inflation rate requires the Fed to restrict the rate of growth of the money supply, reduce economic activity, and often create a recession. The recessions in the early 1980s were created by the Fed in order to bring inflation under control.
Finally, two other areas can be mentioned briefly. The first is the international arena. International trade and finance provide many benefits but also can be sources of instability. Second, the government can be a source of instability. This can be through poor policy choices. It can also be due to time lags. In trying to prevent recessions the government, both the Fed through monetary policy and the federal government through fiscal policy, may alter policy. The government may increase spending or reduce taxes to stimulate economic activity. But, there are lags. There are lags in realizing there is a problem, lags in coming up with the appropriate policy, lags in implementing the policy and lags in the policy becoming effective. There have been times when the stimulus hit after the economy had already recovered, and ended up over stimulating the economy and generating inflation. As noted above, the Fed also can make policy errors.
The government can also fail to provide a stable environment. If the government changes the rules-of-the-game for the sake of expediency, or flip-flops in its regulations and enforcements, or over regulation, or shows favoritism to some groups but not others, the economy will not function as well.

Regulation Z

The Fed recently announced new regulations relating to truth in lending. The posting by the Fed is here.

Regulation is Coming

Article in the New York Times discusses planned regulations of financial markets by the Obama Administration. Link is here.

Retail Sales Fall

Retail sales fell in April 0.4%. The decline in sales was worse than what had been anticipated. See an article on this here.

Increasing Regulation--Antitrust

We can expect the Obama Administration to increase regulation of the financial sector because they believe that deregulation played a role in the financial crisis. They are not alone. Judge Richard Posner's new book, A Failure of Capitalism: The Crisis of '08 and the Descent into Depression, also blames deregulation of finance as a cause of the recession. (He says we are in a depression.) But, Posner and Obama disagree on regulation's effectiveness in other areas. The new head of the Antitrust Division of the Justice Department has indicated that the division will be more aggressive in enforcing antitrust laws than the Bush Administration was. (See article here.) In the case of financial markets, it may make sense to examine regulations and tighten some up. (Posner suggests we should wait until the economic crisis is over to do so, though.) It seems clear that the new administration favors more regulation and government intervention in the economy regardless of the crisis. Again, we have a case where "a crisis is a terrible thing to waste.

Homeowners Underwater

A recent study that was highlighted in yesterday's Wall Street Journal indicates that a little over 21 percent of homeowners have negative equity (Journal article here.) In some areas of the country, the figure is much higher. A table in the article lists Las Vegas as topping the list with 67.2% of homeowners "underwater." The housing situation will be a drag on the economy for some time yet.

"You never want a serious crisis to go to waste"

According to a Wall Street Journal article November 21, 2008, Rahm Emmanuel, who is President Obama's Chief of Staff, said, "You never want a serious crisis to go to waste." At the time, I thought Emmanuel referred to policy goals such as health care and "green" energy policy. It now appears that he was also talking about overhauling contract law. In trying to keep Chrysler in business, the Obama Administration is putting non-secured creditors ahead of secured creditors, and calling those who complain "speculators." Of course, speculator is a new type of four-letter word.

Lest I be accused of drawing too hasty an inference from the Chrysler plan, one should recall that Obama has Joe Biden as vice-president. It was Biden who waved a copy of Richard Epstein's book, Takings, at the Clarence Thomas hearings and questioned Thomas whether he agreed with Epstein. At some point Thomas reminded Biden that there is a "takings clause" in the U.S. Constitution. (Takings has to do with the requirement that the government compensate fairly those who lose property due to government action. The phrase in the Fifth Amendment is, "...nor shall private property be taken for public use without just compensation.")

Hopefully, the bankruptcy court will follow the law and not the politically expedient. But, since we are in, "the worst crisis since the Great Depression," I fear that politics will decide the issue and the end will justify the means. The long-term threat is that the increased uncertainty regarding lending in the US will raise the cost of capital and reduce the long-run growth rate of the economy.

Thoughts on the Economic Crisis, III

The second part of this series concluded that a source of potential problem in a market economy is the monetary system. There can be too much or too little money, and each can cause problems. In this post, I want to examine the element of time and the financial markets that help cope with problems due to time.

We want to purchase goods and services today, but we also anticipate a similar desire a year from now. Just as trade-offs occur right now--I choose to play golf today rather than to go fishing--so can trade-offs occur over time. I can reduce consumption today, save, and increase my consumption possibilities in the future. Other things equal, current consumption is valued more than future consumption if for no other reason than the future is uncertain. A positive interest rate provides a trade-off between $100 of consumption today for more than $100 of consumption a year from now.

Businesses face problems when their receipts differ in timing from their expenditures. This is most obvious for a new firm. It may take several months of preparation, buying inputs, hiring workers, renting facilities, and so on before the firm has output to sell. The firm's owner must pay for these inputs, facilities, and workers prior to selling any output. The firm owner could have saved the funds to begin the firm, or the owner may be able to borrow some funds. Of course, the borrowed funds have to be repaid later. Even on-going firms often borrow short-term funds to smooth out the flows of receipts and expenditures over time.

Financial markets bring the funds saved by some to the borrowers. Financial institutions include commercial banks, credit unions, insurance companies, investment banks, among others. Another source of funds for businesses are equities, in which firms sell shares of ownership in the firm. Stock markets provide markets for "used shares," increasing the demand for new shares since the owner can sell them later.

Interest rates are the prices that equilibrate supply and demand for funds. If business prospects seem good, the demand for funds increases, which induces interest rates to rise. The higher interest rates provide an incentive for savers to increase how much they are saving. Interest rates reflect preferences of people for current consumption relative to future consumption, the productivity of capital, the relative scarcity of funds, expected inflation rates, and risk. The greater the risk of a borrower, the higher the interest rate the borrower will have to pay for a loan. Prices of financial assets are inversely related to the interest rate. For example, if the price of a bond that pays $1000 in a year is currently $950, the interest rate is (approximately) 5 percent. If the price of the bond increases to $960, the interest rate is now 4 percent.

Since the future is unknown, people have to form expectations about what the economic conditions in the future will be. Probably most people base future expectations upon the past, especially the recent past. Someone wanting to start a new firm must believe that there will be a market for the product in the future or it would be foolish to begin the new enterprise.

Finanacial markets rely on trust. Lenders have to trust that the borrowers will be able to pay them back in the future, and that the borrowers will fulfill their promises. A manufacturer that sells parts to another firm normally doesn't receive payment for a few weeks. The manufacturer trusts that the buyer will ulitmately make the payment. If a check is involved, there has to be trust that the check is good and will not bounce.

What can go wrong? Lots of things. Expectations may change due to new information. Trust can be broken, and if this happens enough, the system can seize up. Expectations may not be met. The demand for a product that an entrepreneur thought would be there when his or her production facilities came on line may not be there because consumer demand has changed, or because other entrepreneurs entered the market sooner. A bank that makes loans anticipates that some loans will not be repaid. If suddenly many more loans default than had been anticipated, the bank's position becomes riskier. It perhaps will reduce loans it is willing to make, making it more difficult for businesses to meet their short-term obligations such as payrolls. If people are laid off, they have a harder time making payments on their loans, which can further impact the bank negatively. If people see the future as riskier than they had previously thought, then interest rates will rise, asset prices fall, and a downward spiral can begin.

In my next post in this series, I will try to tie things together from the previous posts.

Negative Interest Rates Anyone?

According to an article in today's Financial Times, a Fed memo indicates that the best interest rate for the inflation/unemployment conditions today is -5%. Of course, a negative interest rate is not possible. The estimate of -5% comes from the Taylor Rule, which is a monetary rule that prescribes how a central bank should adjust its interest rate in response to macroeconomic developments. An article by an economist at the Fed explaining Taylor Rules can be found by googling Taylor Rule. Greg Mankiw had a piece in the New York Times on the need for a negative interest rate and how to achieve it. The fact that interest rates cannot literally be negative is part of the argument that the current situation needs fiscal stimulus.

Thoughts on the Economic Crisis, II

In my previous post, I concluded that given the complexity of the problem associated with the high degree of specialization of labor that prevails today, one might expect chaos to rule. Yet, it does not. In fact, when the economic environment becomes relatively more uncertain and chaotic, it is called a crisis.

Anyone who has had a basic economics course can recognize that we do not have persistent chaos because the market system functions well most of the time. The prices of goods reflect relative scarcities of goods and services. If people want more pencils than they had previously, the price of pencils increases indicating that pencils are now relatively more scarce. The higher price is a signal to pencil producers to find additional resources and produce more pencils. By doing so, their profits increase. The higher profits, if large enough and sustained enough, may even induce an entrepreneur to enter the industry and begin production of pencils. A natural disaster such as a hurricane that destroys homes and businesses creates a need for resources to be reallocated so that the area that was destroyed can be rebuilt. Again, price changes can provide the signals needed to induce people in other parts of the country to reduce consumption of materials and to induce building supply companies to increase production of lumber, shingles, and so on.

The term "invisible hand" is used to represent the process by which markets operate in an orderly manner. Another term sometimes used to describe markets and some other systems is spontaneous order. That is, order is arrived at spontaneously and not as the result of deliberate and planned actions of a group of people. The order achieved evolves over time through the development and evolution of institutions such as contracts, firms, non-profit organizations, co-ops, courts, government agencies, and so on.

But what about times of economic crisis? The market system would seem to take care of equilibrating quantities of demand and supply in most markets for goods and services. Price changes that signal changes in relative scarcity provide the correct information and signal. A natural disaster--hurricane, drought--can cause a problem for awhile, but the system should adjust over time. So, crises can be related to supply shocks to the economy. The bigger the shock the bigger the problem. Yet, if we just look at the real economy, the markets should correct themselves given some time. So, what else is needed to have a serious economic crisis?

Money is a complicating factor. The price signals mentioned above refer to "real prices" or to "relative prices." If the price of lumber increases, we mean to say that the price of lumber increases relative to the prices of other goods. But if there is money in the economy, then it is possible to have price inflation or deflation. If the inflation is anticiapted and if all prices go up by the same percentage, inflation should not add to the problem. However, that is not the way inflation works. Instead, some prices go up by more than others and the price changes come at different times and with different frequencies. Now if the nominal price of lumber increases 5 percent, it could be associated with a real price increase of 5 percent, or more than 5 percent or less than 5 percent. In fact, it could actually be a price decrease in real terms if all other prices are going up by more than 5 percent. The signal used in a market economy to indicate changes in relative scarcities is less informative in the case of inflation. People are more likely to make incorrect decisions because they interpret a 5 percent increase in the price of lumber as indicating that lumber is now relatively more scarce and should be economized more, when in actual fact it may be relatively less scarce. The more variable the inflation rate the more difficult it is for people to know what is going on in the marketplace.

We see then that an economic crisis can be related to incorrect monetary policy. This is not the end of the story though. We still need to consider the effect of time on the stability of a market economy, and this will be the topic of my next post.