Does President Obama Understand Animal Spirits?

The recent Economist has an editorial about President Obama's handling of BP and the oil spill in the Gulf. The page entitled "Lexington" also discusses Obama's relationship with business. The claim that some on the right make that Obama is socialist is refuted. Of course, whether the refutation is correct or not depends on one's definition of socialism. Traditionally, socialism refers to government ownership of the means of production. By this definition, Obama is not a socialist. According to some political scientists, modern socialism refers to an enlarged welfare state and expanded social safety nets. By this definition, I would classify Obama as socialist, but I would also classify most in the Democratic Party as socialist then. My colleague in Hope's Political Science Department, Jeff Poulet, argues that the older definition should be adhered to, and I will do so.

The Lexington page made an interesting point though, and one with which I would concur. It said that Obama doesn't understand business. The same could probably be said of many politicians of both major parties. Academics who support business often have no actual experience in business, and may not understand business. A case could be made that Ayn Rand, who wrote so glowingly about the businessperson who stood firm to his or her beliefs and who was successful in spite of government didn't seem to realize how often business people seek government help in one way or another.

When I visit a business, especially a manufacturing concern, I am struck by the amount of capital equipment used to make the product. The equipment is costly and generates increased labor productivity and higher wages. To purchase the equipment, the firm must have raised funds from stockholders, or from savings of the entrepreneur, or through borrowing, or from profits. Yet, for many politicians, profit is almost a dirty word.

The optimistic faith of an entrepreneur who steps out and begins a business is courageous. Most new businesses fail. This is where the "animal spirits" mentioned by Keynes in his General Theory comes into play. Would anyone start a new business on the basis of mathematical expectation alone? Keynes argued no because the future is unknown. Instead, people often have a spontaneous urge to action rather than inaction.

I question whether Obama or many other politicians and even many academics appreciate the risk and courage it takes to start a business. And even for businesses that have been around awhile and have grown, there is still a huge risk in expanding and building new facilities. Hiring workers involves a great responsibility. I have also spoken with business owners who speak of lost sleep worrying about how they can keep employees employed. I admire people who are willing to step out, risk their savings, in order to create new products or services and employment for others.

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.

Securitization and the Financial Crisis

A major component of the current financial crisis involves the "toxic assets" on the balance sheets of many banks. These assets include derivatives that were manufactured to reduce and spread risk. There is an interesting article in the newest Journal of Economic Perspectives entitled, "The Economics of Structured Finance" and was written by Joshua Coval, Jakub Jurek, and Erik Stafford. They illustrate how the collatorized debt obligations (CDOs) could be created such that a lower level of risk is attached to one of the obligations. I illustrate with an example they use in their article.
Suppose there are two identical bonds and each has a probablitity of default equal to 10%. Let the bonds each pay $1 if there is no default and $0 if there is a default. Combine the two securities into a portfolio and create two tranches, each of which pays $1. But one of the tranches--the junior tranche--bears the first $1 of losses to the porfolio while the other--the senior trance--bears a loss only if the capital of the junior tranche has been wiped out. To determine the expected cash flow for the senior tranche, we need to know the likelihood of observing both bonds defaulting. That depends on whether the probabilities of default for the two bonds are correlated. If they are uncorrelated, then the probability of default for the senior tranche is 1%. The senior tranche will sell for a higher price than the junior tranche. If the probabilities of default are correlated, then the risk associated with the senior tranch will be greater than 1%.
The authors then develop a simulation study involving more complex securities with different assumptions about the correlation of risks associated with the underlying assets. They show two things in their simulations. First, they find that small errors in assessing the riskiness of an asset are magnified by the collateralized debt obligations structure. Second, structured securities experience more exposure to systmatic risk. They state, "Unlike traditional corporate bonds, whose fortunes are primarily driven by firm-specific considerations, the performance of securities created by tranching large asset pools is strongly affected by the performance of the economy as a whole." (p. 23).
As housing prices fell and defaults increased, the system-wide problems became obvious and the prices of CDOs fell. In the extreme, no one is willing to buy some of these assets because they do not know the actual risk associated with them.