Random Financial Thoughts

The Politics of the Tucson Shootings

2011-01-09T11:44:00.000-08:00

My immediate reaction to the shooting of Congressman Gabrielle Giffords was "Crap, I hope she wasn't a liberal." There are two reasons for that: if she was, then 1) I wouldn't be able to watch or read the news for several weeks without being inundated by stupid commentary about the "irresponsible vitriol" directed at liberals from the political right; and 2) this random, despicable crime, committed by an obvious lunatic, could significantly impede the new Republican House majority's agenda to curb the growth of government control over the economy. It turns out Giffords was/is not particularly liberal, but because she was a Democrat, it looks like many on the left will try to coopt this tragedy for political gain anyway.

It almost goes without saying (at least for the half-dozen people who read this blog from time to time), but I'll say it anyway, that it is idiotic to blame our political discourse for such a tragedy. Besides the fact that political speech is probably more polite and "PC" than at any time in US history, especially when it comes to very emotional and significant political issues, it's unclear that the use of violent imagery and harsh criticism is even positively correlated with political violence, let alone materially so. And any causal relationship is even less clear. Finally, even if colorful political rhetoric could be proven to increase political violence, I think that's just something we have to accept as a society. In a country of 310MM people, the level of political violence is so low that the threat of violence simply doesn't have the intended effect (assuming of course the perpetrator of the threat is not thinking one level deeper and attempting to sabotage the opponents of his target).

I'll end this post by pointing out what a jackass Pima County Sheriff Clarence Dupnik is. Without any evidence (the shooter is not talking), he implied strongly that recent political fights in Arizona, which he equates to prejudice and bigotry, would have a motivating effect on unbalanced people like the shooter to commit violence.

His implication of course is logically inconsistent with the facts concerning the shooting. If the political environment in Arizona is so toxic that unbalanced people could be incited to commit violence, why was there zero security at a campaign event for a sitting congressman? Literally zero -- there wasn't even a security guard on duty at the shopping mall. If the sheriff really believed that political violence was caused by vitriolic rhetoric, and that Arizona was the "capital" and the "Mecca" of such rhetoric, then he was completely negligent in carrying out his duties.

The fact that congressmen generally do not receive security at public events, even liberal congressman who are the targets of Tea Party ire, undermines the credibility of after-the-fact accusations like those of the sheriff's. To be clear, I think it's amazing that important public officials like congressmen do not routinely have security. That's pretty good evidence that the real professionals in the law enforcement establishment do not take political rhetoric seriously.

Fiat money, part 3

2010-08-15T06:41:00.000-07:00

(Follow-up to part 1 and part 2.)

Let’s clear up some potentially confusing points about fiat money on our island:

We said that when the government spends, it increases net dollar wealth, and that when it taxes, it decreases net dollar wealth.

So you can think of the total government debt as the “national savings account”. But it is important to note that when we say "savings", we are really referring to savings in the form of dollars (or Treasuries, which we’ll get to later).

If I chop up some wood and build a bird house for my pet woodpecker, I've created wealth and my net worth (assuming that other people are interested in buying the bird house) has gone up. But my dollar wealth is unchanged. Since the total number of dollars out there is the same but there are more goods it can buy (because that spectacular bird house has been built), overall prices might have to come down. So you could argue that the government has to issue more dollars to keep pace with the amount of “real wealth” that is created.

Where does the extra money "come from"? Is the government racking up a bunch of debt?

You might be confused at this point as to where the money used for deficit spending comes from. There are two possible answers: the government can "print" the money, or it can "borrow" the money.

Let’s start with borrowing, since that’s the case most familiar to a lot of us.

In order to borrow money, the government has to print up a bunch of IOUs and sell them. We'll call the island IOU's "Treasuries" to match the U.S. terminology. So the government prints some Treasuries and exchanges them for cash with "regular" civilians. For now, those civilians represent island citizens, but later we'll consider what happens if they are foreigners.

For instance, if the government collected $500,000 in taxes but wants to spend $520,000, it could issue $20,000 worth of Treasuries and sell them to island residents. In the process, the government has $20,000 worth of cash, and it can proceed to spend or give away the money. If Lenny the Lender purchased $100 worth of government Treasuries, then he's just as wealthy now as he was before. His cash has been reduced by $100 but he now has $100 worth of Treasuries.

So now when we refer to "dollar savings" we'll be referring to cash or Treasuries. Both are a form of dollars; the difference is the Treasuries are scheduled to "turn into" regular cash at a future date. Alternatively, you could say that cash is just a "zero maturity" Treasury, i.e. a Treasury that gets paid back by the government right now.

So how does “printing” money work?

Well, on the island, we can literally print it and spend it. It is our imaginary island after all.

But does the U.S. actually just print money and spend it?

This is a minor point, but the U.S. Treasury works slightly differently. (Thanks to ESM for spelling this out for me.) If the U.S. Treasury wants to "print money", the Treasury issues bonds to the Federal Reserve, and the Fed pays cash to the Treasury. Now the Treasury has cash to spend, and the Fed is holding onto a bunch of bonds. The Fed can either hold the bonds, sell them on the open market, or tear them up. In the last case (which is quite common), we can say that the Treasury effectively printed money, and for some reason, the amount that it printed is not added to the U.S. debt. This is horribly inconsistent, but it’s the way it is. It's as the government periodically get loans and the bank keeps forgetting to collect debt payments.

Intro to Fiat Money Part 2

2010-07-18T11:40:00.000-07:00

To review the ideas from part 1:

1. All the island dollars that people have came from government spending at one time or another.

2. When the government spends, it increases the net dollar wealth of the world. You can think of government spending as the government printing green pieces of paper and exchanging them for good and services.

3. When the government taxes, it decreases net dollar wealth. You might think of taxation as the government collecting money and dumping it into a shredder.

4. Fiat money has value because it’s the only form of payment accepted for island taxes.

A lot of this probably sounds odd if you're used to thinking about gold backed currency. The goal here isn't to attack or defend fiat currency; rather I just want to explain how it works and how these ideas might affect policy decisions.

As Bob and ESM pointed out in the comments to part 1, in year 1 the government has to spend (or give away) at least as much money as it wants to collect in taxes each year; otherwise people won't have money with which to pay their taxes. ESM went further and said that the government has to spend enough for people to pay their taxes and satisfy their demand for dollar savings.

If the government spends or gives away $6000 per person per year and collects $5000, then people will be able to save $1000/person on average. Some people might save more or less (and some could end up in debt), but $1000 has to be the average.

You should also note that in this example, the government ran a deficit of $1000/person. So each year, the government deficit matches the change in private dollar savings. If the government runs a deficit, then total dollar savings must rise, and if the government runs a surplus, total dollar savings must fall. (This might be the opposite of what you thought previously.)

For this reason, some people (though admittedly, not many) refer to the national debt as "the national savings account". People's total accumulated dollar savings must match the government's accumulated dollar debt. It's a closed system after all.

A few other interesting points about this system:

The purpose of taxation is not to raise revenue, at least not on the federal level. The island government prints and destroys its own currency, so it can spend however much it wants.
Of course, printing a lot of money and not destroying very much money can cause the dollar to lose value and trigger inflation. So the real reason for taxation is to reduce the number of dollars floating around to "make room" for the dollars that the government wants to deploy. Another way to say it is that the government taxes in order to reduce aggregate demand and keep prices under control. A second purpose of taxation is to give dollars value in the first place!
Not everyone has to pay taxes for this set-up to work. Even if only people whose last names began with "A" had to pay taxes, dollars would still have value to Mr. Aaronson. But Mr. Bozo would still value dollars since he knows that Mr. Aaronson values them. In other words, Mr. Bozo is happy to accept dollars as payment for calculus tutoring, since Bozo can then use those dollars to buy stuff from Aaronson. So they'll both value dollars. To pick a more realistic example, U.S. dollars have value to Canadians even though they (typically) don't have to pay U.S. taxes.

Next time: How does government borrowing work? Is printing money the same as borrowing?

Intro to fiat money part 1

2010-07-11T10:56:00.000-07:00

The mysterious Bob requested a short "course" on how fiat money works. Considering that our economy runs on fiat money and probably less than 1% of Americans understand it, it's probably important to come up with a simple way to wrap one's head around it.

Imagine we all live on an island, isolated from the rest of the world. (This keeps things simple; we'll talk about international trade later.) People on the island obtain goods and services by trading with each other. Whatever merits this system has, it can be very tedious to enter into a transaction. For example, if you're a calculus tutor and you want some salmon, you have to find someone who has a bunch of salmon and wants calculus tutoring. What are the odds of finding that person in a reasonable amount of time?

So the government of the island issues green pieces of paper called "dollars" and lets people trade with dollars. There's just one problem: These pieces of paper have no intrinsic value, so there's no way I'm giving you some of my stuff in exchange for dollars.

Now let's add one more kink that will actually make these dollars valuable. At the end of each year, every island resident (government worker or otherwise) has to pay a tax of $5000. These pieces of paper will be collected and tossed into a shredder. [Alternately, the taxpayer can simply submit a YouTube video of himself shredding the money he owed.] If anyone fails to turn in $5000, he'll be put out to sea in a raft with nothing but a DVD player with Britney Spears videos and "What's Happening!!" reruns.

Now no matter what you think of the idea of having a "head tax", you have to agree that dollars now have some serious value. They're the only form of payment that the government will accept for tax liabilities.

So now dollars have value and people can use dollars for trade. I can buy fish in exchange for dollars because either the fisherman needs the dollars to pay his taxes, or he knows that somebody else needs them for taxes (and thus that guy will trade for them).

One last problem we have to address: Where do people get dollars from? They need to accumulate dollars in order to pay taxes each year, after all. Saying that they get dollars from trading with other people is a cop out, because those people need to get dollars from somewhere. Even if somehow people "started out" with a certain number of dollars floating around, they will eventually be destroyed at a rate of $5000/resident/year.

The answer is that dollars can only come from one place: the government. The government can create and destroy dollar bills and they're the only ones who can do it.

So the island government decides to hire people to do various jobs around the island such as cleaning seaweed off the beach, maintaining the roads, and running a tropical counter-terrorism unit. The employees are paid in dollars. If the government wants to, it could even supplement the supply of dollars by dropping them from a helicopter and letting people find them.

So dollars "start" in the hands of people who sell their services (or goods) to the government, the dollars are used for trade, and they eventually end up in the hands of people who need to pay taxes (government workers or private sector workers alike.)

Now here's a good question to think about: How much does the government "need" to spend each year? As a follow-up, what happens if they spend more or less than that amount?

Don't you hate traffic? Part 3

2010-07-03T07:00:00.000-07:00

Ok, one last note about charging people to use the road. It's easy to draw the wrong conclusion from my posts. When people hear about these ideas, some of the ideas that pop into their heads are:

1. "Thank goodness there's a huge tax on parking in some places." Manhattan charges an unbelievable 18.375% tax on parking! (Incidentally, residents can get much of it rebated, but out-of-towners are stuck paying the whole thing. I'm not sure if this has been challenged in court yet). Anyway, taxing parking is totally backwards! What's crazy is that if there's one thing I want people to do with their cars, it's to keep them parked in garages. I don't want those things on the roads during busy times. In other words, road space during rush hour is the scarce resource that needs to be rationed via prices; room in parking garages already is rationed by the owner (since he charges for them).

2. "That's why we have a gas tax." A gas tax is not the stupidest thing on earth. As ESM has pointed out to me in the past, the government spends considerable resources keeping the waters safe for oil shipping, and it makes sense to charge the consumers of the oil. There are other externalities associated with gasoline use, so a tax might make sense. But a gas tax doesn't address the traffic problem very well. The guy driving through Nevada at 2 a.m. might be using a lot of gas but he's creating no traffic congestion. But Marginal Matt, who's driving in Manhattan rush hour traffic uses only a litle gas and creates all sorts of delays and aggravation. That's the guy you want to charge.

3. "God bless the DMV. They charge registration fees for cars." Again, cars aren't the problem; using road space when it's scarce is the problem. There may be good reasons to charge a small fee for having a car (the police now have to track it down if it's stolen, etc.), but rationing road space isn't one of them.

Don't you hate traffic? Part 2

2010-06-13T13:34:00.000-07:00

I have a few different loose ends to tie up from the first installment of Don't you hate traffic? .

First, since I've gotten thousands of emails asking about the title of this post, I'll address that first. It's a reference to The Simpsons (clip here) from back when the show was funny. (Yeah, I'm dating myself here.)

Second, how do you deal with privacy issues involved with tolls? If we use EZ-Pass, do we really want Big Brother knowing where you've been driving? I think there's a good way to get around this, which some politicians might not like: Sell EZ-Pass tags the same way we sell pre-paid disposable cell phones. If you buy an "anonymous" pre-paid unit with $100 on it and throw it away when you're done, then you haven't really given up much personal information.

Now finally, let's throw out this assumption that everyone is the same. Different people dislike traffic to varying degrees. Traffic makes me angry and agitated, but other people are in no rush to get anywhere.

So let's say we have a heterogeneous population and roads that aren't sufficient to accommodate everybody. One day I look outside and see 1000 cars on the road, which translates into 2000 units of traffic, using my super-secret traffic grading system.

Presumably, there are some people on the road who really value the road and/or don't particularly mind traffic. Perhaps they're willing to deal with up to 5000 units of traffic at this time. Every single one of them is on the road right now, because after all, there are only 2000 units of traffic out there.

There are also some people who are willing to deal with 3500 units of traffic, some people who can tolerate 2200 units of traffic, etc. and they're all driving now too.

But then there's a guy (call him Marginal Matt) who will only tolerate 2001 units of traffic. He's still driving (since there's only 2000 units) of traffic, but he's getting very little advantage out of having the roads available to him.

Here's the problem: If he would get off the road, there would be a little less traffic for the other 999 people. By deciding to drive, Marginal Matt is creating 2 units of traffic that all of those 999 other drivers has to suffer through and he's only getting 1 unit of advantage to himself.

In other words, he's creating thousands of units of harm and only getting one unit of benefit. Clearly, we need a pricing scheme that gets him off the road.

The optimal toll would balance these two effects. Switching to dollars, if the optimal toll was $10/mile, then there would be much fewer people on the road -- say 600 people instead of 1000. And if the toll is set correctly, then adding that 601st person would create exactly as much economic benefit to him and it would collectively take away from all the existing drivers.

One pleasant aspect of this is that only the people who value the roads the most will use it, and they'll be the ones paying for it. The people who walk to work and then pay an insane city income tax to help pay for roads are getting a raw deal under the current system. Their taxes could be reduced and we could have the drivers pay for the road. The result would be would be less traffic, more business activity (thanks to the lower taxes) and the roads would provide much more value to the residents.

Now I don't know what the optimal toll is, but I know that people do study this sort of thing and have attempted to put a price on traffic.

This system ideally would also end the "need" to subsidize mass transit. It drives me crazy to hear people say that we need to subsidize the subway in NYC since the alternative would be even more nightmarish traffic. When the idea of congestion pricing on roads is suggested as an alternative, people complain that that would increase the price of doing business, which would "get passed on to consumers".

While I don't have the time to delve into all the fallacies embedded in this nonsense, suffice it to say that if we priced roads correctly, a lot of people would take mass transit because it would be much, much cheaper than driving, and in the case of buses, it would be pretty fast (since traffic would be less severe).

In any case, how is it fair that my friend who walks to work has to subsidize the subway? How 'bout charging me for the subway ride that I take to work and charge Marginal Matt a buttload for the amount of congestion he's causing during rush hour?

Vitamins pills and oil spills.

2010-06-04T16:38:00.000-07:00

I recently saw Bjorn Lomborg on television talking about how to get the most bang for your buck when it comes to improving global welfare. (He wrote an article about this in the Wall Street a while back, and it's worth reading.)

He pointed to an economics study done that prioritized different projects that could improve the world:

Providing micronutrients -- particularly vitamin A and zinc -- to 80% of the 140 million or so undernourished children in the world would require a commitment of just $60 million annually, a small fraction of the billions spent each year battling terrorism or combating climate change.

(This is from his WSJ article mentioned earlier.)

So if you had a bunch of money to spend, you could either provide micronutrients to the world's poor or decrease global temperatures (in 100 years) by a tiny fraction of a degree.

Of course, going to micronutrient rallies doesn't help you meet women or make you seem as trendy as getting worked up over various environmental causes.

Ok, fine. But what does this have to do with oil spills? Steven Landsburg made the point today that people get very worked up over the gulf oil spill, but there are bigger economic disasters that a lot of people aren't even aware of:

The BP oil spill threatens to cause something like $10 billion worth of damage. That’s pretty bad. By contrast, an extra trillion dollars worth of federal spending threatens to cause something like $300 billion worth of deadweight loss (that is, underproduction due to tax avoidance and disincentives to work). That’s 30 times worse. How is it that so much angst about the former seems to be coming from people with a history of shrugging their shoulders at the latter?

I can't argue with that. Every single year, we incinerate hundreds of billions of dollars through economic distortions, thanks to the tax code. Does anyone care? If you go to a dinner party tonight (instead of sitting at home, eating Chinese food, and watching Bjorn Lomborg on tv like I'll be doing), are you more likely to hear people lamenting the oil spill or deadweight losses due to taxation? How many people at the party are likely to have heard of "deadweight losses"?

When it comes to world social causes, people are much more likely to get concerned about #30 on the list (global warming) than #1 (micronutrients for the 3rd world). When it comes to economic disasters, people are much more worried about the (admittedly catastrophic) oil spill than a problem that's 30 times as bad.

Don't you hate traffic?

2010-05-24T14:29:00.000-07:00

In his book, The Armchair Economist, Steven Landsburg introduced the concept of taxes and fees that generate no revenue. The concept is so ubiquitous that I thought it'd be useful to show an underappreciated example of it.

I work in Midtown Manhattan. If you look out the window on a weekday at 5 pm, you'll see serious traffic congestion. I used to work near Times Square; if you looked out the window there at almost any time, you saw absolutely horrifying traffic. Consider a few facts:

1. People in Manhattan (at least those that can afford to keep a car there or take a cab) tend to have at least a moderate income; many of them are very wealthy and work long hours. Either way, their time is very valuable.

2. Getting to where they're going must also be incredibly valuable. After all, they're willing to sit in ghastly traffic delays to get there. (The traffic is generally not a surprise, so they knew in advance the trade they were making. And if you are surprised by traffic in Times Square, you should be shipped back to New Jersey.)

3. They're charged a very high toll to get where they're going, but the toll is in the form of lost time, frustration, and unpredictability. (Unpredictability translates into lost time if people have to pad their trip time to get to that important meeting.)

4. The roads and traffic lights are paid for from tax receipts. I doubt the gasoline tax and DMV-related fees cover it, so many other taxes are probably used, e.g. income taxes and sales taxes. These taxes generate large deadweight losses.

Right away, I can see that this arrangement has suboptimality oozing out of its orifices. We use inefficient taxes to build very popular roads. The roads are so popular that there are huge “tolls” (time wasted), and the worst part of all is that nobody benefits from those “tolls”. It's a tax that collects no revenue.

Normally, if I pay a $6 tunnel toll, then I lose $6 and the local government gains $6. That can be used to maintain the tunnel, hire more school teachers, get rid of some of the more destructive taxes, or the money can even be refunded equally to all the residents. Even if the government manages to incinerate half the revenue through bureaucrats' pay and mismanagement, we're still $3 better off than we would be if I paid an equivalent toll that consisted of sitting in traffic. (Even if the bureaucracy is wasteful, it would've been wasteful for income tax revenue and toll revenue alike.)

So let's do a quick thought experiment. Imagine that there are a very large number of people in your city and they're all roughly the same in their behavior and preferences. Yes, that's ridiculous, but we can relax that assumption later. This simplified case can give some serious insight into the problem.

Now let's also imagine that there are roads, which are incredibly valuable, but there are not enough roads to accommodate all the people. In other words, they are a scarce resource. This applies to Manhattan and most cities during rush hour, and it probably does not apply to the smaller suburbs of Kalamazoo.

Ok, now under these assumptions, how many people will use the roads at once? We assumed that the use of these roads is very valuable and so at least some people are going to use the roads. Maybe getting to that meeting a mile away is worth $300 and it really only takes $10 of time, fuel, and wear & tear on your car when the roads are empty.

What if the roads aren't empty, but there are a tiny number of cars on the road? In this case, the roads are slightly less valuable. Sure, now there are a few guys you could have an accident with, and you might have to actually yield to another car once in a while. But being able to use the road is still very valuable. So now if you have a $300 meeting to go to and it costs $12 in time and money to drive, you're going to do it.

How many cars are going to be on the road in equilibrium? What will constrain the growth of traffic? The answer is that if everyone has a meeting that's worth $300 to get to, the traffic will keep building until it costs everybody (remember, we're all alike) just about $300 in time, frustration, fuel, wear & tear, and accident risk. Let's say that magic number is 5000 drivers.

So each driver is “paying” $300 to use the roads and nobody else benefits from that $300 “toll”. Each person gets to his $300 meeting and loses $300 in time, frustration, fuel, wear & tear, and accident risk. I have no idea in advance how much fuel costs, how much their time is worth, etc., but I can still say, assuming the roads can't accommodate everybody, that traffic will increase until the total cost of driving is $300 per mile. At that point, nobody else will decide to jump in his car.

So the road does just about zero good. Each driver spends $300 and gets $300 of benefits. No one on “the other end” of the transaction collects the $300.
Actually, it's even worse than that. I only counted costs to the drivers on the road. But there are costs to the people who didn't drive. They (like the drivers) have to deal with air pollution (again, not a big deal in the suburbs of Kalamazoo, but it can be a big problem in city centers) and noise (try sleeping in Manhattan when you can hear a driver who just discovered how his horn works). While we're at it, the pedestrians are now a little less safe.

Finally, taxes probably had to be raised to build and maintain the road. A few businesses on the margin may have gone under as a result, a few other entrepreneurs decided not to launch their new business in this city, and a few businesses still in operation made one fewer batch of widgets since the price of production went up.
What a great deal! We raise taxes, create some economic distortions in the process, build some roads, the drivers get zero benefit from it, and the non-drivers are made slightly worse off!

Now, I'm not anti-roads or anti-driving. On the contrary, I love both those things. When they're implemented properly they can be extremely welfare-enhancing, they can make you feel like a real man, and they make you think that you really have freedom. I just think that there are much more (economically) efficient implementations.

Let's take a first crack at this idealized case, suppose we got rid of whatever inefficient tax was used for getting road money and instead put a $100/mile toll on the use of the roads. (I'm not being very precise about how the tolls are collected, but that's a detail we can work out later.)

I don't know how many people will choose to drive, but I can guarantee that it will be a lot less than before. This time, if there's only one driver on the road, he faces costs of $110 (the toll plus the $10 from before). Getting to your destination is worth $300 so it's a good deal. So more people will join him. But the number of people can't grow to 5000 anymore since then the cost of driving would be a whopping $400 ($100 toll plus $300 of time/fuel/etc.)

So maybe only 4000 people drive. Each person is getting $300 of benefit, paying a $100 toll, and paying an additional $200 in traffic delays/aggravation/fuel. So the drivers still gain no benefit from the road, but the city raised $400,000 in the process. Now we can ditch those inefficient taxes we implemented to maintain the roads. Imagine that: Rationing a scarce resource using the price system actually improved things!

Now I have no idea what the correct toll is and it would almost certainly vary by time of day. ($100/mile in Manhattan rush hour is high but not really as crazy as it sounds.) And if you are worried about poor people not being able to afford to drive, don't be. If you want to help poor people, give them money or cut their taxes. (Incidentally, this toll plan allows you to eliminate job-killing taxes.) Don't try to help poor people by subsidizing their car use. Does anyone actually think that it'd be a bad thing to eliminate NYC's insane income or sales taxes and replace it with a drive-during-rush-hour tax? (I should also mention that any plan that reduces traffic makes it much, much more practical to travel by bus. Currently in Midtown, a Cub Scout troup can run a three-legged race faster than a city bus can drive.)

But this gets to the heart of why people reflexively distrust politicians who propose ideas such as congestion taxes. (Mayor Bloomberg got to find this out first hand.) Few of us are naïve enough to think that a new tax will replace an old tax. If a politician proposes replacing tax A with tax B, it's a good bet he's pushing to create tax B, leave tax A in place, and then spend a whole lot more money. And that's why this plan will reliably be shot down over and over again.

So I really don’t blame voters for opposing congestion pricing on these grounds. But I do hope that the next time you see a traffic jam, you become enraged at the economic waste before your eyes.

Future post: I’ll toss out that assumption that everyone is the same. And how do you deal with privacy issues?

Price-Gouging as a Remedy for Shortages

2010-05-02T10:19:00.000-07:00

Yesterday, the Boston area suffered a catastrophic failure of its water supply system. A 10-foot diameter pipe carrying water from the Carroll Water Treatment Plant to Boston and neighboring communities ruptured and is not currently usable. Although fresh water is widely available from local reservoirs, treated water is not. It will be a few days in the most optimistic scenario before potable water is available at taps for over 2.5MM people. Reading between the lines of press reports, it was (and maybe still is) a distinct possibility that potable water could be unavailable for weeks, as the pipe is custom-designed, and replacement parts would have to be machined from scratch.

Of course, all of the supermarkets were stripped bare of bottled water and other beverages within hours of the news. There were even reports of fights and near riots over a product which costs approximately $0.25 per bottle.

Local governments announced plans to distribute bottled water (such as they have in storage) free of charge to needy residents.

This situation is instructive from the perspective of economics, and a simple analysis leads us to a solution which is both optimal and politically impossible at the same time.

If owners of bottled water (e.g. supermarkets, convenience stores, normal citizens, and free lancers) were able to sell at any price without fear of being accused of price-gouging, then there would be two beneficial effects:

1) water would be allocated in a more rational way, rather than by luck or by who gets to the supermarket first; and

2) supplies would increase as enterprising people truck bottled water in from other areas.

To offset the problem that poor people will be priced out of the market, the state government could hand out checks to every affected household -- perhaps $10 per person per day (a $30MM per day hit to the annual state budget of almost $30B). It is up to each person to decide how much of that distribution should be spent on bottled water.

It's important to remember that there are other options to drinking bottled water or using it to wash your hands or brush your teeth. It's possible to create your own potable water by boiling tap water for at least 1 minute and then cooling it back down. A pain in the neck to be sure, but boiled water is a cheap substitute.

This is pure speculation, but if implicit price controls were removed, I suspect that the price of bottled water would triple or quadruple initially. And then you would see a mad rush of supply as people from as far away as New York rent trucks to ship bottled water to Boston. The opportunity for a quick profit is very attractive. You could probably fit 2,000 half-liter bottles in the bed of a one-ton pickup truck alone. Attach a trailer, and you could probably pull another 5,000 bottles easily. If there was a gross profit of $0.50 per bottle to be had driving 7,000 bottles up from NY in a pickup truck, I think a lot of New Yorkers would jump at the opportunity. And that's for a random guy with a pickup truck.

The bottom line is that if price-gouging were allowed, the market would clear at an acceptable level, and there would be enough bottled water to satisfy everybody. Those who are willing to make do with a little less, can save the cash distributed by the state. Those who need more water will have to make do with a little less cash.

We see these local shortages from time to time (e.g. gasoline shortages in Florida after hurricanes), and always there is a crackdown on price-gouging. Too bad more people don't recognize that the solution to local shortages is to allow price-gouging. Indeed we should encourage it.

Krugman on Learning from Greece's Debt Crisis

2010-04-13T06:05:00.000-07:00

A friend sent me Krugman's op-ed last week with a note that said "it's annoying when he's right." Instead of writing back, I figured I would post my response here.

Krugman is right about some things with respect to Greece, and even with respect to policy prescriptions for fighting unemployment in the US today, but he goes off the rails in a couple of places. The central point of the article -- that putting in place austerity measures (i.e. cutting the government budget and raising taxes) is counterproductive -- is certainly correct. And his point that Greece is in a completely different position vis a vis the US because it does not own the printing press for the currency in which its debt is denominated is also correct.

But Krugman still uses the terminology of a gold standard or a fixed exchange rate system, which has no application to the US system of a fiat currency with a fully floating exchange rate.

Despite the fact that Krugman's penultimate sentence is a tautology, he fails to understand that the US debt is always manageable from a credit risk perspective because the public debt is nothing more than an interest-bearing form of money. The deficit is self-financing because, at the close of business each trading day, every dollar of deficit spending (as well as every other dollar that was created previously) either finds a home in an interest-bearing government security or earns 0% under somebody's mattress.

The only problem with having too much debt/money is too much aggregate demand, which causes inflation and the mal-investment and perverse behavior associated with it. But the acid test as to whether we have too much debt/money is whether we have full capacity utilization and inflation, which we clearly do not.

Warren Mosler uses full employment (net of the structural rate of unemployment) as his metric for whether the private sector has enough money, although I am not entirely convinced that's useful because the government is quickly raising the rate of structural unemployment through stupid policies (e.g expanding entitlement programs and raising the minimum wage).

Krugman is also not correct when he says that there are no good solutions to the Greek crisis. Mosler's solution of having the European Central Bank (ECB) distribute 1T Euros annually, on a per capita basis to each member country in the European Monetary Union (EMU) is a good one. Aggregate demand would be restrained by the fact that the member countries would still be restricted from spending the money by the terms of the Maastricht Treaty. The penalty for any country breaking the spending restrictions would be for the ECB to withhold the annual payment to that country the next year (a much easier penalty to enforce than actually fining a country 1/2% of GDP -- talk about getting blood from a stone!).

I would add to this solution the idea that the EMU should put in place policies which promote the holding of Greek debt by Greeks and not by European banks. That way, in ten years' time, when Greece gets into trouble again, the Greeks will be left holding the bag themselves, and they can be kicked out of the EMU without too much disruption.

So Krugman almost gets it with respect to the US, but not quite. And he completely fails to realize that the solution to Europe's problems is for the ECB to give each EMU country a kitty of pre-printed money to call on for debt repayment as needed. The EMU countries will not own a Euro printing press individually, but they will have the next best thing.

Implicit Marginal Tax Rates Under Obamacare

2010-03-20T18:12:00.001-07:00

One of the negative consequences of giving subidies to people based on income is that you drive up the implicit marginal tax rate on income for those targeted for the subsidy. High marginal tax rates discourage people from working harder and making more money, which is bad for them and bad for the economy in general.

American society has become accustomed to a progressive income tax in which high income people face higher tax rates than low income people. Because of deductions, tax credits, and subsidies which phase out with income, however, there are many points along the marginal tax rate versus income curve in which low income people face implicit marginal tax rates well in excess of the rate for the highest income tax bracket (currently 35%, going up to 39.6% in 2011).

For example, the earned income tax credit appears to have a phase out which creates an excess marginal tax rate of 21.06%. Combined with a regular income tax rate of 10%, a social security tax rate on wages of 6.20%, and a medicare tax rate on wages of 1.45% (I've even neglected the employer portion of FICA taxes that most economists would claim is paid implicitly by the worker), the total marginal tax rate for a very poor worker with two or more children exceeds the current rate for the highest bracket. I haven't looked into this carefully yet, but rumor has it that there are pretty common situations where a taxpayer faces marginal tax rates approaching 100%.

The new health care reform bill will provide health care insurance subsidies for those making less than 400% of the federal poverty line (which in 2009 was $22,050 per year for a family of four). The subsidies phase out mostly linearly, but with jumps at certain thresholds. I decided to calculate the implicit marginal tax rate of the health care insurance subsidy for a family of four, based on the 2009 federal poverty line. The graph is below:

What isn't shown in the graph is that the marginal tax rate for a family with income at 400% of the federal poverty line ($88,200 in 2009) is infinity. The subsidy completely goes away, and the difference between the cost of the benchmark health insurance plan and $8,379 (i.e. 9.5% of that family's income) is lost to that family if it makes even $1 extra. For my example and my graph, I have assumed of course that the benchmark health insurance plan for a family of four is in excess of $8,379, but I think I'm pretty safe there. Even today such an insurance plan probably costs more than $12K per year, and once Obamacare kicks in, that plan will probably cost 25% higher.

Anyway, these implicit marginal tax rates (fluctuating between 10.90% and 21.65% before exploding to infinity) are due solely to the health care insurance subsidies embedded in Obamacare. Families at the relevant income levels will be facing these marginal tax rates in addition to the ones that they're already familiar with.

New Taxes for Obamacare

2010-03-18T13:08:00.000-07:00

The proposed reconciliation bill has a new 3.8% tax on investment income for taxpayers making more than $200K per year ($250K for married, joint filers). I don't know if the bill will make it through the Senate under reconciliation, but it's certainly got a decent chance. Note that investment income includes capital gains and dividends, so we're talking about the marginal tax rate on dividends going from 15% in 2010 to 39.6% in 2011 and up to 43.4% in 2013. The marginal tax rate on long-term capital gains will go from 15% in 2010 to 20% in 2011 and up to 23.8% in 2013.

That's a remarkable increase and surely will be priced into the stock market at some point.

When one considers that US corporations already pay a 35% income tax, then a corporation which distributes its profits to shareholders via dividends will essentially be returning only (1-35%)*(1-43.4%) = 36.8% of its before-tax profits to the owners of the company after they've paid their income tax.

For corporations which return cash via stock buybacks, (1-35%)*(1-23.8%) = 49.5% of before-tax profits are returned to the owners.

This surely must rank as one of the highest marginal tax rates on corporate income in the developed world. In fact, I'm pretty sure of it. Of OECD member countries only Denmark and France had higher effective corporate income taxes in 2009 (by 9.2% for Denmark and 6.3% for France), and the new rates in 2011 will put the United States in first place by a wide margin for profits distributed through dividends.

Obamacare Game Theory

2010-03-08T07:57:00.000-08:00

There is an interesting game theoretic aspect to the current state of health care reform legislation (aka Obamacare). The Democrats need to pass the Senate bill in the House first, and only then can they fix the provisions currently unacceptable to the House with a followup bill that needs to pass both the Senate and the House. The controversy about reconciliation concerns using reconciliation to pass the followup bill in the Senate with 50 votes (our clownish vice-president would cast the tie-breaking vote, so 50 is all the Democrats need).

Many consider this use of reconciliation to be illegitimate, since it is facilitating the passage of sweeping legislation that doesn't even come close to meeting the eligibility requirements for circumventing the Senate filibuster. I don't agree on that specific point. Although it's a close call, using reconciliation to fix budget-related aspects of the bill in order to attract more votes in the House strikes me as reasonable. After all, the House still has to pass the Senate bill without any guarantees whatsoever. If Democrats tried to do it the other way around -- pass a reconciliation bill first, then I think that would be an egregious attempt at circumvention of the filibuster.

That being said, there is a strong argument that the bill is illegitimate as it stands. There is no doubt that it wouldn't have received 60 votes in the Senate if not for the presence of outrageous provisions used to bribe individual senators. Everybody is rebelling against those provisions now and wants them stripped out of the bill, even some of the senators that negotiated them in the first place, but the bill would not have passed the Senate without them.

For the game theory aspect of Obamacare, I'm going to assume that the Republicans actually have a way of severely impeding a reconcilation bill. I believe this is true. One way is to raise points of order repeatedly against reconciliation bill provisions for violating the Byrd rule. A second is to offer hundreds of amendments to the bill after time for debate has elapsed. Each of these amendments takes a minimum of 15 minutes to vote on, and so it is possible to kill an entire legislative day with 50 or 60 relevant amendments. Do this for long enough, and the Senate grinds to a halt.

Given that the Republicans might actually have it in their power to obstruct a reconciliation bill, the Republican dilemma is as follows:

1) the Senate bill would not pass if House Democrats believed the bill would remain as it is and not be amended immediately; there are just too many House Dems who would vote no on the Senate bill all by itself;

2) some of the most important amendments that skeptical House Dems want to see are provisions that Republicans and the general public support (e.g. stronger restrictions on abortion funding, elimination of the Cornhusker Kickback, Louisiana Purchase, and the Florida Flim-Flam and weakening of the mandate to buy insurance);

3) if enough House Dems think that the Republicans will be forced to allow those amendments to pass, the Senate bill will pass the House.

Essentially the House Dems will play a game of chicken with Senate Republicans. They go first and put the Senate Republicans in a position of having to obstruct popular measures that Republicans themselves support.

The Republicans' quandary is similar to that of the United States during the cold war. How did the United States convince the Soviet Union that it would respond to a ground invasion of Western Europe with a nuclear escalation? Once the invasion is underway after all, the logical decision for the US is not to escalate.

The solution of course is to implement elaborate protocols to convince the other side of the credibility of the threat of retaliation. The United States developed a whole strategy built around nuclear retaliation in Europe.

It kept a few hundred thousand troops on the front lines, which was a force way too small to stop an invasion, but large enough to create a terrible bloodbath for the US if the Soviet Union invaded. The nuclear retaliation strategy was developed in detail at conferences, in military schools, and in the academic literature. And it was widely publicized and discussed by high officials in the US and in Europe, including by US presidents.

All of this was effective in preparing the public for the inevitability of nuclear retaliation and for putting the president of the US on autopilot for following the protocol. As a consequence, the threat was credible to the Soviet Union and functioned effectively as deterrence.

The Senate Republicans can play this game correctly by laying out their strategy of obstruction in advance and publicizing it widely. They need to publicize the points of order they will raise, as well as the hundreds of amendments they'll have prepared to delay a vote on the reconciliation bill. It strikes me as easy to propose thousands of non-frivolous amendments, by the way. All you have to do is propose reducing spending on items in this year's or next year's budget, one at a time.

The Treasury Prints Bonds Like the Fed Prints Cash

2010-02-13T05:42:00.000-08:00

In the wake of Warren Mosler's recent interview on CNBC's Squawk Box, I thought it made sense to clarify a point about government "borrowing." I put the word borrowing in quotes of course because the government is not really borrowing money when it issues Treasury securities. Mosler tried to explain this by running through the way Federal Reserve accounting worked, but I am afraid that most people's eyes glazed over. Certainly Becky Quick at CNBC had no idea what he was talking about.

Generally, people understand that the government retains the power (through the Federal Reserve) to print as much as cash as it wants to buy Treasury bonds and therefore to monetize the public debt. What is not widely understood, though, is that the Treasury itself can spend as much money as it wants without forcing the Fed to do anything at all. We can have laws that arbitrarily prevent the Treasury from printing cash (and we do to a certain extent), but that still does not constrain the Treasury from spending an unlimited amount of money.

How can that be if the Treasury has to raise the cash first from tax revenues or the issuance of Treasury bonds? What if investors, or the Chinese in particular, decide not to buy new Treasury bonds? Well, let's think about what happens when the Treasury's Federal Reserve account is completely depleted, and it wants to spend an additional dollar:

It has an auction for $1 worth of Treasury securities. An investor, usually a bank which has extra cash sitting around in danger of earning 0% interest overnight, bids some positive interest rate in the auction and buys it.

The investor has $1 worth of Treasury securities, and the investor's bank account is debited by $1, which means also that his bank's account at the Federal Reserve is debited by $1 (or, if it is a smaller bank which does not have a Reserve account, there is a debit in that bank's account at a bigger bank, etc.). And the Treasury has $1 credited to its Reserve account.

The Treasury now spends that $1 by transferring it to the bank account of whoever the recipient is (whether it be a social security beneficiary, a doctor who performed Medicare services, a construction company working on a stimulus project, or a bribe to the head of a union who promises to "get out the vote" for a Democratic candidate).

Now, that dollar looks like a credit in the recipient's bank account, but it is also (following the upward chain of accounts) a credit to a big bank's account at the Federal Reserve.

So the total amount of bank reserves at the Fed remains the same. All that has happened is that the total amount of Treasury securities has increased by $1.

Note that the analysis is unchanged if the recipient of the Treasury's largess decides to spend or invest his windfall. Whoever he buys goods or services or stocks from will now have the credit in his bank account and therefore in his bank's Federal Reserve account.

It should be clear by now that the money that the Treasury spent has essentially gone to fund the purchase of the Treasury security which the Treasury originally issued to raise the money to spend in the first place.

It is a perpetual motion machine, and by induction we can see that the Treasury can spend any amount of money and the accounting effect of that spending is that the Treasury prints an amount of Treasury securities equal to the amount of its deficit spending.

We have argued in the past that a Treasury security is not fundamentally different from cash. It is a government IOU, same as cash, except that it earns a positive interest rate rather than no interest. It's true that you can't spend a Treasury bond as easily as cash, but the Federal Reserve stands ready to lend to any member bank an unlimited amount of cash against an equivalent market value of Treasury bonds at slightly below the Fed's target interest rates, so the link between Treasuries and spendable cash is very strong.

So the Treasury's ability to print bonds is equivalent to the ability to print money. By itself, it can increase private sector net financial wealth.

Krugman's Claim that Europe Does as Well as the US

2010-01-12T09:38:00.000-08:00

Krugman argues here that Europe's economy is just as productive and vibrant as the United States' even though Europe is saddled with high taxes, a generous social safety net, and a generally greater role for government in the economy.

His evidence is that even though the United States' growth rate in GDP over the last 15 years appears to be higher than Europe's, if one adjusts for the growth in population, the GDP growth rates are almost identical.

I give Krugman credit for bringing up the reasonable idea of making an adjustment for population growth. I have argued for many years that Japan's "lost decade" in the 1990s, in which its GDP growth rate was approximately 1.5 pts less than ours, could be explained almost entirely by the difference in our population growth rates.

Of course, one could argue that a low population growth rate is a consequence of having poor economic policies. Immigration to your country is less attractive to foreigners than it would otherwise be, and perhaps residents are discouraged from having children.

That being said, the whole idea of comparing growth rates to see which economy is more efficient is stupid. One should look at the overall GDP per capita, wealth level, and standard of living to gauge which economy is doing better. The growth rate is not really of much importance if your standard of living is 28% lower. See here for a list of countries ranked by GDP per capita adjusted for purchasing power parity (PPP).

On top of that, it would seem that growing at the same rate is no great accomplishment for an economy operating at lower productivity. It is much easier to copy what works from a more efficient economy (as the Soviet Union did in the 1930s from the West, as Japan did in the 1950s and 1960s from the United States, and as China is doing now from everybody).

Just to make a simple comparison, France's GDP per capita (PPP adjusted) is 28% lower than that of the US's. That's what we should be focused on -- not whether France has just barely managed to match our GDP growth rate over the last 15 years. The French are still poorer on average, and the most likely reason is the stifling amount of government control over their economy.

Oh, and one final note. The Europeans are getting a free ride off of the United States in many ways, and yet they still have a lower standard of living. The main area is defense, where the US essentially shoulders the entire burden of keeping the world peace.

Why Didn't the Tech Bubble Cause a Financial Crisis?

2010-01-10T19:57:00.000-08:00

On Friday, Paul Krugman had this to say about why the collapse of the tech stock bubble in 2000 didn't bring about the same sort of financial crisis we just experienced.

The short answer is that while the stock bubble created a lot of risk, that risk was fairly widely diffused across the economy. By contrast, the risks created by the housing bubble were strongly concentrated in the financial sector. As a result, the collapse of the housing bubble threatened to bring down the nation’s banks. And banks play a special role in the economy. If they can’t function, the wheels of commerce as a whole grind to a halt.

Why did the bankers take on so much risk? Because it was in their self-interest to do so. By increasing leverage — that is, by making risky investments with borrowed money — banks could increase their short-term profits. And these short-term profits, in turn, were reflected in immense personal bonuses. If the concentration of risk in the banking sector increased the danger of a systemwide financial crisis, well, that wasn’t the bankers’ problem.

Krugman's op-eds are usually infuriating because he writes a lot of false stuff that he knows to be false. In this case, I'm willing to concede that he genuinely doesn't understand what he's talking about.

The true short answer is that the Nasdaq bubble collapse was not an outlier event. It was seen as a reasonably high probability event by everybody throughout the financial system. Options on internet stocks were trading with implied volatility of hundreds of percent per annum, and long-term options on even the boring S&P 500 index were trading at over 20% implied volatility -- extraordinarily high by historical standards. So when the Nasdaq fell over 75% and the S&P fell almost 50% over a period of 18 months, financial professionals were not terribly surprised.

Here's another way to put it. No bank or money manager fund was making non-recourse loans on a stock with a 20% downpayment and no ability to demand variation margin. Yet, that's what a traditional, conservative mortgage on a home is essentially. So when stocks fall 50%, it's not a big shock to the financial system. Few people consider stock market wealth to be as real or as stable as AAA-rated bonds for example.

Homes, on the other hand, had enjoyed low price volatility and had not fallen in nominal price on a nationwide basis since World War II. So when homes across the country fall 35% in nominal price (and over 50% if you look at where most of the mortgage loans were made), this is obviously going to cause a lot of distress throughout the financial system. AAA-rated bonds went from 100 cents on the dollar to 10 cents in some cases. The entities owning AAA-rated bonds did not think they were taking risk. Losses like that simply did not appear on their radar screens. This was very different from the wealth destruction during the tech bubble collapse.

All things considered, I'd have to say that the turmoil caused by the housing fiasco has been pretty mild. The reason is that we have the advantage of a fiat currency system, in which the government can print money at will. The government has made a lot of mistakes which exacerbated the problem, but since the collapse of Lehman in September 2008, the Fed has handled things relatively well (the Treasury less so, but it's done more good than harm).

Are Cars More Dangerous Than Terrorists?

2010-01-01T09:42:00.000-08:00

A reader of Andrew Sullivan's daily dish had this to say in response to Bill Maher's point that cars are more dangerous than terrorists.

In 2008 there were 34,017 deaths (and nearly 100,000 major injuries) related to automobile accidents in the United States. Terrorists would have to blow up 113 Boeing 777-200s each year in order to kill that many people! That is, they'd have to blow up all but six of the 777-200's (which hold 301 people in a 3-tier international setup) currently owned by American Airlines, United Airlines and Continental Airlines (together they own 119 777-200s) and would have to do so every single year, which is probably faster than they can be built. And yet there is hardly any talk of defending the American people from their Buick!

The argument that we shouldn't worry so much about terrorism because cars kill more people than terrorists is seductive to faux intellectuals like Bill Maher. The more general point is that we as a society accept all kinds of risks which are greater than the historical, statistical danger due to terrorism. I'll focus on the comparison to cars because, as far as we know today, the largest risk of violent death in the US comes from car accidents.

The first reason that the analogy is simplistic is that the car is a necessity in modern life. The benefit we derive from cars vastly outweighs the cost. In terms of deaths and injuries, cars almost certainly save far more lives than they end prematurely. There is no benefit to us from terrorism that I can think of, but plenty of costs in addition to the direct damage and fatalities. Second, most car-related casualties happen due to negligence or recklessness, and those casualties usually happen to the people who are directly responsible. One can reduce the risk of traveling in a car dramatically by wearing a seatbelt, driving carefully, and maintaining the car in good working order. Third, society has already come to terms with the risk. This is not something that can be easily duplicated in other areas. Traveling by plane is still far safer than driving the equivalent number of miles in a car, but far more people are afraid of dying in a plane crash than in a car crash. This may be irrational, but it is a reality. Terrorists can dramatically raise the fear associated with flying (rational or not), and if they do that they can degrade our standard of living as they already have done to a significant extent since 9/11.

Finally, it is not clear how effective terrorists can be if they become encouraged by success. The daily dish reader is correct that it is extremely unlikely terrorists could cause as many deaths per year as cars do simply by blowing up planes. But success at blowing up planes encourages more people to join the terrorist/jihadist cause and emboldens the leaders of that cause. It's possible that such success actually increases the probability of nuclear terrorism. Even Bill Maher would understand that a small nuclear explosion in a US city would dramatically change our society for the worse.

The 85% Solution

2009-12-23T05:11:00.000-08:00

It almost goes without saying that the health care reform (HCR) bill that is about to pass the Senate is extraordinarily bad policy. The perceived problem we have with health care in this country is exploding cost. Health care expenditures continue to rise much faster than the rate of inflation.

Now this is not on its face an unacceptable situation. As a country becomes wealthier, it might make sense for a larger and larger fraction of its GDP to be spent on health care. There is an easily approachable limit to how much food, shelter, and I-Phones a person can consume, but given the fact that we all grow old, get sick, and die, the limit to how much health care we can consume over our lifetime is high enough that we won't be bumping against it for quite some time.

But I think most people agree (although perhaps for the wrong reasons) that there is something horribly awry with our current system. Costs are rising much faster than they should, and there are probably some simple adjustments that could be made to contain costs and make health care more affordable.

Anyway, rising health care costs are perceived to be the problem. So, what does the HCR bill do? It subsidizes consumers and taxes providers and producers. That's right, it artificially stimulates demand for health care, and enacts new taxes and fees which artificially suppresses the supply of health care resources.

Brilliant! This ranks right up there with Cash for Clunkers as a textbook case of fallacious reasoning in economics.

That said, I wanted to focus on just one small part of the HCR bill which highlights the lack of thought that goes into the crafting of such legislation. The provision to which I refer requires, in the words of Senator Al Franken, "... health insurance companies to spend 85% of premiums on actual health services -- not administrative costs, TV ads, or gargantuan CEO bonuses..."

No doubt Harry Reid and his pals have put a lot of thought into that number 85% (sorry if i dripped sarcasm on the page here), but isn't it amazing that a government bureaucrat could come up with a single number like that which works for the whole country and for all large group insurance plans (of course, the states will be given the freedom to raise the bar even higher, although one hopes that 100% will be understood as a natural limit)?

Now, one might expect a somewhat more precise and legalistic definition of the phrase "actual health services" in the "actual" bill, and here it is:

(1) on reimbursement for clinical services provided to enrollees under such coverage; [and]
(2) for activities that improve health care quality;

Well that clears it up. Let's do something novel and try to put ourselves in the shoes of a rational human being for a minute, one that responds to incentives and tries to game the wording of vague regulations.

You're the CEO of a health insurance company, and Congress tells you that you have to spend at least 85% of your premium revenue on health care services or activities that improve health care quality. You can do math, so you quickly determine that the amount of money available for other expenses, salaries, and profits is at most (100%-85%)*(total premiums) = (100%-85%)*(total expenditures for health care servides)/85% = 17.65% * (total expenditures for health care services).

The amount of money available scales linearly with total health care expenditures, which is interesting. Now if you can just find a way to spend more on health care, without increasing your administrative and marketing expenses, you can pay yourself, your employees, and your stockholders more money. Hmmm.

Suppose you cut co-pays and deductibles and encourage your customers to get more health care. You could pay doctors more too, and even fund all kinds of ridiculous perquisites for doctors under the category "activities that improve health care quality."

Of course you would have to raise health care premiums for all this to work, and normally you would be constrained by competition from other health care insurance providers. But under the new law, all of the other providers would be thinking the same way. All the incentives are now skewed towards increasing health care benefits and costs, with commensurately higher premiums to pay for it all.

The intent of this language, I guess, was to provide an incentive to insurance companies to cut administrative expenses. But that incentive was always there. All this provision will manage to do is remove any incentive to cut costs for "actual" health care services. Perversely, it does the opposite.

Does Lack of Health Insurance Cause 45K Deaths Per Year in the US?

2009-11-17T06:49:00.000-08:00

This paper has been cited by a lot of people recently, including Nicholas Kristof in his November 12th op-ed (I'll have more to say about Kristof later as he has been spreading health care falsehoods under the guise of countering health care myths).

The research has been interpreted as demonstrating that approximately 45K people die every year in the US because of lack of health insurance.

This is almost certainly wrong.

I note the following points to keep in mind about the paper:

1) the principal author is PNHP (Physicians for a National Health Plan) founder Dr. David Himmelstein;

2) in the paper itself the authors do not claim to have shown a causal relationship between lack of health insurance and higher mortality; they only claim to have shown that there is a positive correlation.

PNHP has an extreme agenda. The group was formed to promote socialized medicine in the US. In addition, PNHP recognizes that its goal of equal access to health care is undermined if a private market for medical services is allowed to develop in parallel with the government run network (such a 2-tier system exists in the UK). Therefore, PNHP wants essentially to ban private medical practice. Himmelstein et al want to make it impossible for someone to pay to see a doctor.

The fact that Himmelstein is the principal author of the paper does not necessarily mean that the paper is wrong (although one should probably be more skeptical than usual). Even if the paper is substantially correct, we should keep in mind that Himmelstein's political agenda may interfere in a number of ways. For example, data that undermines his political agenda may have been suppressed or at least not released publicly. Also, he may spin, or allow others to spin, the paper's results in a way which is not justified by the data.

I think the latter concern is clearly at play right now, and primarily with respect to the rather widespread confusion about causality vs correlation. That is, when sticking to the science, the paper only makes a claim about there being a positive correlation between lack of insurance and mortality rates (1.4x higher mortality rates for the uninsured vs the insured population when adjusted for a variety of factors). But correlation is not causation. Although the uninsured have a higher mortality rate, it may be due to some factor other than the lack of insurance. This is important because it might be that even if these people were given insurance for free, their mortality rates would remain high. I suspect this to be the case, at least in part.

Although not specifically mentioned in the Himmelstein paper (a surprising and telling omission I think), a reasonable hypothesis is that there is self-selection involved among people who are uninsured. People who are responsible about their health, who care about their health, and who therefore will go to the doctor when they are sick and then stick to a prescribed course of treatment, those people are more likely to care enough to go out and make sure they have insurance. It is the lazy, irresponsible people who will be skewed towards being uninsured.

I think that this effect is real, even in a system where most people get insurance through their employer. Remember, most honest economists would agree that health insurance is paid for out of employee wages, not out of company profits. All other things being equal, jobs which do not provide health insurance will pay higher wages than jobs that do. People who do not value health insurance will choose those jobs that do not provide health insurance because they will earn commensurately higher wages.

The authors of the paper try to normalize for various factors, including income, education, ethnicity, and current health status. But they cannot control for personal responsibility. In fact, their attempt to normalize for health status might exacerbate the effect they have captured (i.e. it makes the correlation between lack of insurance and mortality rates higher) because people who are already sick are probably focusing more on getting health insurance than people who are healthy. In other words, those who have good health status and are short-sighted about their health are more likely to be uninsured. So those without insurance are probably in a healthier pool after controlling for income, education, and ethnicity.

[To be fair, I should mention that the authors think that the effect of controlling for health status can go the other way because those who have poor health status at the start of the study might have already suffered from lack of health insurance.]

In any case, the paper only claims correlation, not causation. The researchers did not have access to cause of death data, and, accordingly, there was no way to know if lack of insurance played any role at all in the excess death rate for the "normalized" pool of uninsured.

Perhaps by design, however, the authors of the paper have created a perception in the media that causation has been proved and that 45K deaths per year could be prevented if we extended health insurance coverage to every US resident. I think that if you cornered Himmelstein himself, he would back off of that claim very quickly.

This paper finds that there is actually little correlation between excess mortality for the uninsured when mortality is restricted to "amenable" causes of death. Additionally, it finds that there is no change in the relative mortality rates for the uninsured pool of people once they become eligible for Medicare coverage at age 65. That is, giving the uninsured insurance does not improve their survival rates relative to the insured, at least once they've reached age 65.

Of course, as I've expressed before, even if the lack of health insurance causes excess mortality rates, we have to judge that effect relative to other wealth or income based factors that cause excess mortality. Eating cheap, starchy food, living in crime-ridden neighborhoods, driving unsafe cars, and working in dangerous jobs all cause excess deaths among the poor and are clearly direct consequences of being poor. If the money required to give out free health insurance could get better results in these other areas, then we shouldn't waste our limited resources on universal health insurance.

Minimum Wage Laws and Entry Level Jobs

2009-10-31T12:27:00.000-07:00

It is interesting to compare Bob Herbert's article in the NY Times yesterday about unemployment among recent college graduates with a Wall Street Journal op-ed from earlier this month about the effect of the recent minimum wage hike.

Here's Herbert from October 30, 2009:

As jobs become increasingly scarce, more and more college graduates are working for free, at internships, which is great for employers but something of a handicap for a young man or woman who has to pay for food or a place to live.

"The whole idea of apprenticeships is coming back into vogue, as it was 100 years ago," said John Noble, director of the Office of Career Counseling at Williams College. "Certain industries, such as the media, TV, radio and so on, have always exploited recent graduates, giving them a chance to get into a very competitive field in exchange for making them work for no — or low — pay. But now this is spreading to many other industries."

Lonnie Dunlap, who heads the career services program at Northwestern University and has been advising young people on careers since the mid-70s, said today’s graduates are experiencing the worst employment market she’s ever seen.

...

Like Mr. Noble, she mentioned the growing use of interns versus paid employees and said she can see the value of such unpaid work for some recent graduates, "though, of course, not everyone can afford to do that."

Herbert concludes:

If we’re having trouble finding employment for even these kids, then we’re doing something profoundly wrong.

Ahh, but what could we be doing wrong?

From the WSJ article on October 3, 2009, aptly subtitled “The minimum wage hike has driven the wages of teen employees down to $0.00”:

Yesterday's September labor market report was lousy by any measure, with 263,000 lost jobs and the jobless rate climbing to 9.8%. But for one group of Americans it was especially awful: the least skilled, especially young workers. Washington will deny the reality, and the media won't make the connection, but one reason for these job losses is the rising minimum wage.

Earlier this year, economist David Neumark of the University of California, Irvine, wrote on these pages that the 70-cent-an-hour increase in the minimum wage would cost some 300,000 jobs. Sure enough, the mandated increase to $7.25 took effect in July, and right on cue the August and September jobless numbers confirm the rapid disappearance of jobs for teenagers.

The September teen unemployment rate hit 25.9%, the highest rate since World War II and up from 23.8% in July. Some 330,000 teen jobs have vanished in two months. Hardest hit of all: black male teens, whose unemployment rate shot up to a catastrophic 50.4%. It was merely a terrible 39.2% in July.

...

As the minimum wage has risen, the gap between the overall unemployment rate and the teen rate has widened, as it did again last month. (See nearby chart.) The current Congress has spent billions of dollars—including $1.5 billion in the stimulus bill—on summer youth employment programs and job training. Yet the jobless numbers suggest that the minimum wage destroyed far more jobs than the government programs helped to create.

Now, I don’t want to mislead you; Herbert is writing specifically about college graduates, and the numbers from the WSJ article are for teenagers. However, there is obviously a strong correlation. Recent college graduates are usually unskilled and trying to land their first real jobs, just like teenagers. And employers are not currently willing to pay $7.25/hour (plus the 7.65% employer portion of FICA taxes) for an on-the-job trainee of limited productivity.

The fact that zero wage internships are widely available means that the need for young, unskilled workers is there (after all, taking on interns is not exactly free – interns do require some supervision from paid employees), but that given the choice between paying zero (which is legal) and minimum wage, employers choose zero because the minimum wage does not make economic sense.

It is highly likely that there is some hourly wage between zero and $7.25/hour that could better clear the market for entry level labor and could match hundreds of thousands of additional entry level workers with entry level jobs. But the federal government, in its unbounded wisdom, has made that wage illegal.

I recently remarked to an economist friend of mine that economics must be a depressing field in which to be a researcher. In the hard sciences, new research is often translated into practical applications which benefit society. In economics, however, ideas that were worked out and widely accepted by practitioners centuries ago are not only not implemented, but are contradicted and disparaged by those who wield the most power over our society.

I suppose that we should feel fortunate that lawmakers don't try to repeal the law of gravity, even as they try again and again to repeal the law of supply and demand.

The Nobel Peace Prize and the Cause of World Peace

2009-10-09T18:02:00.000-07:00

Although this post does not pertain to economics directly, I think there are general economic principles at work in every aspect of human life. As such, no topic is off-topic for this blog (isn't that convenient?).

Most observers are stunned by the announcement today that President Obama is the winner of the 2009 Nobel Peace Prize. I have to confess (brag really) that it was not so much a surprise to me. Before I was even out of bed this morning my wife turned on her laptop to check the news and immediately gasped and said "Guess who won the Peace Prize." I immediately said "Don't tell me it was Obama."

The Peace Prize, as well as the Literature Prize, are quite different from the science Nobel Prizes in that they are essentially political in nature. Although there are sometimes controversies about how important Nobel Prize winning scientific research is or whether the particular people who were awarded the prize actually deserved it more than others, there is rarely controversy about the work itself. The prize winning work is almost always already accepted as correct and already considered a significant contribution to human knowledge (although there was at least one prize given for erroneous research). Not so for the Peace and Literature Prizes.

I note in passing only that a Peace Prize, but not a scientific prize, has been awarded for global warming research.

The Peace Prize is unique in that the prize committee sees it as a vehicle for promoting world peace, rather than just recognizing important and completed work. And the committee clearly believes that it can promote world peace by enhancing the stature of the recipient and encouraging him to keep doing what he's doing.

Choosing Obama is logical in the sense that the committee wishes to encourage his recent overtures to the world, his professed commitment to peaceful diplomacy, and his apparent desire to reduce the military capacity of the United States. I think the timing in particular proved irresistible to the committee because the award could possibly influence Obama's pending decisions on escalating the war in Afghanistan and taking more aggressive measures against Iran.

But the choice is overtly political because it is not at all clear that Obama's professed peace-making strategy is correct. There are reasonable people (and I count myself as one of them) who believe that the current strategy is one of appeasement which actually does great harm to the cause of world peace.

The simple truth is that there are a lot of evil people in the world, and many of them accumulate vast powers through the apparatus of a state. I've seen references to medical studies which estimate that roughly 1% of humans are literally psychopaths. Probably a reasonable percentage of psychopaths are clever enough that they can play by society's rules in order to survive into adulthood unscathed and unjailed.

It is probably also true that a much larger percentage of people are capable of being trained to become psychopaths in practice. That is, they have moral consciences but can be indoctrinated to suppress them in order to achieve a greater good for their people, their cause, their country, or their religion.

Many of these psychopaths end up in control of states. In fact, in undemocratic states, there is probably a selection bias in favor of leaders who are violent psychopaths (whereas in democratic states there appears to be a selection bias in favor of narcissists).

Whatever the root cause, history is replete with examples of countries that start wars for no good reason except to accumulate power and wealth and to subjugate other people.

George Bush was widely derided for his Manichean world view -- which is that there are good people and bad people, and that the good people have to stand up to the bad people. But Winston Churchill had the same view, and he is generally recognized as an inspiring and brilliant leader. The main difference is that Winston Churchill was a lot better at speaking off the cuff (and was much more of a warmonger).

I'm beating around the bush (no pun intended), but my central point is one that Winston Churchill believed in and one that Ronald Reagan made into a campaign slogan -- that peace comes through military strength.

The US spends more than 4% of its GDP on defense. It is roughly equal to the total military spending of the rest of the world combined. Is this necessary? Is it overkill? I'm not sure of what the right number is, but the size and strength of the US military should be above the level at which other countries don't even think about challenging us.

You don't want a potential adversary to get even a glimmer of an idea that it is possible to initimidate the US militarily. Because if an adversary doesn't even think to try, we will have real and stable peace.

In financial terms, one might describe this idea thusly: the convenience yield of having a huge military capacity is equal to the potential cost of the devastating wars that such a capacity allows us to avoid. Given the shockingly high cost of war between modern countries in terms of human suffering and economic loss, that convenience yield may well be far in excess of 4% of GDP.

Now that might not be so comforting to a left-wing politician in Oslo who thinks that the United States is just as susceptible to being taken over by a psychopath as any other (especially since, in his view, it was ruled by a psychopath for the last eight years).

But the truth is the system of government we have in the US makes immoral military aggression extremely difficult and unlikely. Bush-haters hyperventiliate a lot about Iraq, but whether you think the Iraq war was smart or dumb, farsighted or rash, justified or not, it is necessary to ignore completely the prior 15 years of Iraq's history to judge the motivations for the Iraq war as immoral. According to any reasonable moral calculus, the 10 years of economic sanctions which preceded the Iraq war were far less moral than the war itself.

And given the surprising, suicidal hatred shown by some of our enemies on 9/11, it was not unreasonable to use our power to preempt a latent, albeit uncertain, threat. That this threat was hyped as more short-term than it really was (although perhaps not more than it was genuinely perceived to be) doesn't change the fact that it was a rational decision and not a psychopathic one.

Anyway, I think that what has kept the reasonably stable peace during the two decades since the end of the Cold War has been the United States' dominant military power, and the willingness to use it to maintain the peace on land and on the high seas.

The Nobel Peace Prize Committee disagrees and wishes to use the selection of Obama to promote its idea that global peace is attained by holding hands and singing kumbaya around campfires. Ten thousand years of human history says that the committee is wrong. Let's hope that Obama will come to see that before real damage is done.

What is a Waste of Resources?

2009-09-13T19:54:00.001-07:00

Obama promises to cut $500B of waste, fraud, and abuse out of Medicare and Medicaid over 10 years. To say that this claim has been met with skepticism would be an understatement.

I am not nearly so skeptical because what Obama and the left wing are really demanding from Congress is more power to ration government provided health care, as well as to pay drug companies, medical equipment companies, doctors, and hospitals less for their products and services (which will of course lead to more rationing).

I think the savings in terms of money could easily materialize. The problem I have is that saving the government little green pieces of paper is not a worthy goal in and of itself. After all, the government can create little green pieces of paper almost for free.

If the government were to save $50B/yr in Medicare costs by cutting Medicare reimbursement rates and by raising the eligibility age from 65 to 67 years, would anybody think that is real savings? How about if the government mandated that no doctor be allowed to make more than $100K per year? Or that all drugs currently on the market are deemed no longer on patent? All of these changes would dramatically lower the cost of government provided health care, but would they actually prevent the waste of or increase the supply of health care resources?

Resources are tangible things -- valuable services, goods, products, information, trained people -- and not little green pieces of paper. Tackling waste means freeing up or increasing the amount, quality, and availability of resources. Paying people less doesn't do that.

Consider the following paired examples:

1.
(A) A drug company wins a patent extension which allows it to keep charging high prices for a successful and effective cancer drug;

(B) A drug company realizes that its new cancer drug provides essentially no benefit over existing ones, but decides to spend $1B developing and promoting it anyway because it calculates that it can capture a significant share of the market and generate a net profit;

2.
(A) a health insurance company CEO is granted a bonus that exceeds the industry average by $10MM even though by most measures he is doing a mediocre job;

(B) a health insurance company with an antiquated billing and reimbursement system spends $10MM more than it should this year on administration costs;

3.
(A) a doctor submits fraudulent claims to Medicare for services he never performed;

(B) a doctor orders unnecessary MRI tests for most of his patients because he has an equity interest in the MRI facility;

4.
(A) a doctor has to pay $150K/yr in malpractice insurance;

(B) a doctor orders a wide range of unnecessary tests for a patient, in order to protect himself from a potential malpractice suit in case of an adverse outcome;

I believe that to first order the (A) examples are merely (possibly unfair) transfers of money from one entity to another, but not a waste of resources.

The (B) examples represent true waste. Real (mostly human) resources are being used which could have been deployed better elsewhere.

It is not surprising that the focus of politicans is on the (A) examples. Perceived unfair transfers of money get people riled up, and being natural demogogues, our politicans cater to that anger.

Ironically, putting in place policies that curtail the (A) examples will, if anything, decrease the supply of health care resources (which is not necessarily a bad thing - see further down).

Reducing the amount of money transferred to the health care industry in the aggegate (even including outrageous examples of overpayment, abuse, and fraud) will not encourage an increase in supply.

When Obama and his speechwriters make the mistake of lumping corporate profits in with overhead (as they do repeatedly), it is clear that they don't understand any of this at all.

Now I am not claiming that we should tolerate overpayment and fraud. Far from it. A distortion in favor of the health care industry is just as bad as a distortion against it. As only one part of a complex economy, the health care industry should have no stronger claim on aggregate resources than any other area. Too many people becoming doctors, for instance, is as bad as too few. [How we could know how many is the right number is something that the free market is best at determining, by the way.]

Finally, here's a trio of hypothetical examples. Which of these represent a waste of resources?

5.
(A) a drug company spends $100MM on a public and doctor-focused advertising campaign to introduce its new product;

(B) a drug company spends $100MM in litigation defending itself against claims that its product causes serious problems in approximately 1% of patients;

(C) a drug company spends $2B developing a new cancer drug that gives terminal patients a 25% probability of living an extra 2 months;

I am inclined to believe that (A) and (B) are wasteful, but (C) is not.

Advertising is a complex subject. Some economists consider marketing expense a dead weight loss to the economy. I have always felt that it has some informational value for consumers, but it also appears to be necessary for free market competition.

The competition hypothesis seems less convincing in the case of drug companies, however, since they only compete directly in those rare instances when they have identical drugs on the market.

The benefits of litigation are difficult to quantify as well. Obviously, one way that the sanctity of contracts is upheld and consumers are protected is through litigation. But our system has gone awry, and you probably couldn't find one serious economist today who didn't think that the US is an overly litigious society and that the costs of litigation are excessive.

As for example 5.(C), the drug company would be wasting resources only if its prospects for making a profit depended upon the market price for the drug being anomalously high. It is in the nature of our 3rd party payer system for medical care to create such inefficiencies. Since consumers don't see the true cost, they make inefficient cost benefit decisions.

Still, my sense is that the medical community has generally made sound choices when it comes to approving expensive new drugs. My evidence is that hundreds of miraculous drugs have been invented over the last 30 years, and yet drug companies account for only about 1.5% of world GDP (in the US, it's about 2%). I would be willing to spend that fraction of my income on Claritin. Fortunately, it's much cheaper than that.

Health Care Rationing

2009-08-24T05:52:00.000-07:00

There will be rationing under a government health insurance system. That is just simple economics. If you give away a valuable thing for free, then demand will exceed available supply. The government will have to allocate health care resources according to some formula, and I guarantee you, this will be extremely controversial and morally agonizing.

Proponents of a government health plan point out that in a free market rationing is also done, but it is done by price rather than by bureaucrats and lawmakers. The price rises until demand and supply are matched, and those unwilling or unable to pay that market clearing price will receive less health care.

This is certainly true, but rationing by price is more efficient and morally sound. Those that value health care a lot will be more likely to obtain it than those who don't value it very much. It is important to remember that health is not something everybody values equally. And pretty much everybody makes tradeoffs between health and money. That is why some people are willing to be coal miners or firefighters or football players, or are willing to work overtime with little vacation or even rest. It is also why some people don't eat healthy foods or exercise or stop smoking.

Some people care a lot about having (painful) surgery so they can continue to play tennis. Others not so much.

When you have rigid rules divvying up resources, you inevitably wind up giving something the government bureaucrats say is worth X to somebody who values it at X/10. Meanwhile, a person who values that thing at 10X must go without.

Perhaps most important of all, rationing by price will lead to more production of the health care services that are the highest price and therefore in the most demand versus available resources. In the long term, a market-based system will produce vastly more health care resources for everybody.

It's amazing that some people (read Barack Obama, Nancy Pelosi, Harry Reid, and other Democratic leaders) so easily forget the lessons of the Soviet Union and Communist China. Government control of the market stifles economic growth. It has been shown empirically that government bureaucrats simply can't do as good a job as the free market at pricing goods and services, providing incentives, and stimulating increases in productivity.

Some people want to believe health care is or should be exempt from market forces, but it isn’t, and it shouldn’t be.

Health Care Fundamentals

2009-08-14T12:39:00.000-07:00

Health care is fundamentally no different from any other area of the economy. We live in a world of limited resources. Therefore, we need a mechanism to allocate those resources efficiently and fairly. Every individual decision about allocating a resource comes with a cost and a benefit, and neither benefits nor costs are the same across all individuals. As with every other area of the economy, a free market, in which individual consumers can make their cost-benefit decisions freely, and individual employees, employers, and companies can make their cost-benefit decisions freely, will provide a more efficient allocation of resources than a government controlled market. But perhaps not a fairer allocation.

Liberals are being disingenuous when they claim that giving the government more control will make the system more efficient. It will not. It cannot. I will get into the weeds on this later, but for now I think that most liberals want more government control over health care for one reason and one reason alone -- "fairness."

They have accepted to a certain degree that free markets lead to unequal outcomes in general consumption, in housing, in leisure time, and even in education. But they think that health care should not be treated as just another commodity. Poor people should not get worse health care than rich people. A person should not have to die early because he is poor. A corollary of course is that a rich person should not get better health care than a poor person, and a rich person should not be allowed to live longer because he is rich.

I have brought up the point about "fairness" and redistribution of wealth/income/consumption before, and I have basically accepted that there is no right answer. I have put "fairness" in quotes because there are many people who don't believe that unequal outcomes are necessarily unfair. Be that as it may, people value equality of outcomes differently, with liberals tending to value equality of outcomes higher than conservatives. I lean towards the conservative side. I believe there should be a safety net providing a floor on poverty, but I certainly don't believe in taking more than we are currently taking from the rich to provide for it. I cannot say that I am right, and those who are more liberal are wrong (and vice versa). We are just starting from different axioms.

The two claims I can make with confidence, however, are these:

1) treating consumption of health care as fundamentally different from other types of consumption is simplistic and wrong; and

2) a free market in health care in the US will lead to unequal outcomes but will make far more health care resources available for consumption by all (including the rest of the world, not just Americans).
　
To back up my claim in (1), I'll make two points. First, being poor is bad for health, regardless of the level of health care received. Poor people eat less nutritious food, they live in unhealthier places, they are exposed to more violence in their neighborhoods, they drive less safe cars, and they have more stress due to lack of money. There is a recent UK study that showed that low job status, which presumably leads to more stress, was a significant contributor to poor health. So to consider health care as having special moral implications is naive.

Second, we live in a world where many hard-working, smart people go into fields other than medicine. When somebody decides to become a financial analyst rather than a doctor, that decision reduces our aggregate health care resources, and therefore has consequences (probably negative) for the health of other people in the future. To the extent that such a career decision is largely an economic one, and it usually is, there is an entanglement between the economics of health care and the economics of all other fields, so that it is kind of meaningless to treat health care as an isolated area of the economy where the free market should not apply.
　
I will have more to say about (2) in later posts.

Cash for Clunkers -- The Final Phase

2009-08-09T09:34:00.000-07:00

I've been obsessed with this topic because it is perhaps the most obviously and perfectly stupid government program I have ever seen. It's not all that important because it represents only a few billion dollars (as of this moment, $3B in total) of government waste and distortion in a $13T economy, but it does serve as a reminder that government can enact incredibly bad policy in a very short time. The forces of rationality and prudence take time to gather and gain critical mass, but by then it is often too late. Something to ponder as the Democrats try to ram health care reform through Congress without meaningful analysis and debate.

I predict that by the end of the year, you will see stories appear in the media which are highly critical of the results of the Cash for Clunkers program.

To wit:

1) the boost in GDP for the 3rd quarter was temporary -- this will be exacerbated by the way GDP is calculated; inventory drawdowns count towards GDP, but inventory builds do not [Update: Oops, I got this exactly backwards. Inventory builds count towards GDP and drawdowns do not. What I described would be correct for what is called the Final Sales number];

2) the boost to the auto industry was temporary; although domestic car sales had until recently been running at an unsustainably low level (9MM/yr, although there are over 200MM cars in the US), the Cash for Clunkers boost is unsustainable as well and has cannibalized future sales; in addition, Cash for Clunkers has induced many people to buy new cars who probably shouldn't have bought them, and those people will either be dumping them soon or going a good long time before buying another new car;

3) a detailed analysis shows the environmental/energy savings of the program (in terms of carbon emission or imported oil -- both questionable metrics in any case) was nil or negative because the mileage improvement was offset by the energy used to make new cars and destroy old ones, and the old cars weren't driven nearly as much on average as the new cars;

4) used car market prices rose making it harder for poor people to afford a car;

5) engine parts for older cars became scarce making it difficult for owners of clunkers to keep them running at an affordable price;

6) the lion's share of the government largesse actually went to car dealers rather than clunker owners because dealers raised prices on eligible new cars in the face of very high demand;

7) many clunker trade-in buyers ended up with buyer's remorse as they realized they traded in a $2,000 car for a $4,500 rebate but actually paid $2,500 more for a new car than they would have had to if the government hadn't distorted the market;

8) many clunker trade-in buyers were tricked into spending more than they could afford for a new car that they didn't really need or want;

9) new car buyers who didn't have a clunker to trade in had to pay far more than they would have had to just a couple of months before;

10) Cash for Clunkers was effectively a huge subsidy for car dealers as the program provided them with free cash, free advertising, and a huge distortion in customer preferences towards consuming new cars;

Keep in mind points (7) and (9) above as you read stories about auto inventories becoming depleted in the face of huge Cash for Clunkers demand. I suspect that clunker owners are getting no advantage out of the program at this point relative to the deals that existed in June. And yet they will keep buying anyway because human beings are susceptible to marketing schemes that make it look like a special deal is to be had. On top of that, they will be buying "eligible" new cars from depleted inventory, which means that they probably won't even be buying their first choice car (e.g. model, options, color).

Clunker trade-in buyers, regular car buyers, and taxpayers have become dupes of the auto industry.

More Cash for Clunkers

2009-08-05T11:05:00.000-07:00

I admit it. I have a bug up my butt about this Cash For Clunkers program. I have a bug up my butt about health care reform too (at least all of the proposals currently on the table), but health care reform is ridiculously complex, and I don't feel I have my act together enough to opine (yet). Cash For Clunkers, however, is straightforward enough that it can perhaps be a teachable moment, as certain moral preeners like to say.

Positive news stories about Cash for Clunkers have dominated media coverage in the last week as the Senate ponders whether to join the House in adding $2B to the program. I see web video interviews with happy car buyers who just traded in their 15 year-old pickup truck to buy a hybrid SUV. I see Wall Street research papers about the positive effect on GDP -- upwards of 0.40% boost this quarter, and I see administration flacks talking up how good the program is for the economy and the environment. Most people believe that this government program is a smashing success (no pun intended).

I was gratified therefore to see Jonah Goldberg's article today. Jonah gets to the nub of the issue, which is Frederic Bastiat's main theme in his 1850 essay That Which is Seen and That Which is Unseen.

In this case, the government is managing to juice GDP this quarter by encouraging new car sales, but it will come at the expense of GDP in future quarters. What is unseen here is that many people made the decision to buy a new car only because the government was essentially giving them several thousand dollars off of the dealer price. Those who were planning to buy a new car anyway have done so earlier than they were planning but won't need another for quite a while. Those who weren't planning on buying a new car now have a lot less spending power to use for a new refrigerator or a new computer or for remodeling a bathroom. That is an unseen loss to GDP.

Then there is the unseen effect of removing cheap cars from the market. Perhaps a landscaper was getting ready to start a business, but he can only afford to purchase a clunker pickup for $3,000 to get started. Alas, they are not available anymore. The lowest price he can pay now is $5,000 because of the diminished supply.

The simplest analysis though focuses on what was destroyed. The government is paying people to destroy something of economic value. That something could have been used for recreation, or it could have been used to contribute to GDP. To make matters worse, resources were used to destroy those things (the car demolition and towing operators' resources), and even more resources (the car manufacturers' resources) were used to create expensive replacements for the things that were destroyed.

I hope Jonah's article is the beginning of some pushback from people who actually understand economics.

There is one other idiocy in the program. As my friend DJ pointed out with respect to the (admittedly stupid) CAFE standards, the government at least gets the math correct for CAFE by calculating the arithmetic average of the gallons per mile that cars get rather than miles per gallon. The reason is that all other things being equal, a 10mpg car uses twice as much gas as a 20mpg car, but a 20mpg car only uses 50% more gas than a 30mpg car.

The Cash for Clunkers program, of course, only looks to the arithmetic improvement (in the case of a new SUV/minivan/pickup truck, 2mpg-4mpg for the $3,500 rebate and 5+mpg for the $4,500 rebate). The improvement is 50% when you go from a 10 mpg SUV to a 15mpg SUV, but it is half as much in going from an 18mpg SUV to a 23mpg SUV. True to form, the government has a floor mpg on new SUVs of 18mpg, thereby ensuring that you are in the un-sweet part of the non-linear gas mileage improvement curve.

This brings me to yet another point in my rambling screed. The theory behind laws based on gas mileage (like CAFE and CARS) is that gas mileage is a good measure of how efficient a vehicle is. But it really isn't because gas mileage scales inversely with the weight and size of a car. Extra size and weight usually means extra passenger safety and extra carrying capacity. I have seen plenty of discussion about the tradeoff between passenger safety and higher CAFE standards, but I haven't seen much about the tradeoff between carrying capacity and higher CAFE standards.

The government obviously recognizes this tradeoff to some extent because it exempts larger trucks and buses from the CAFE standards, but I wonder why it doesn't distinguish between an 8-passenger minivan and a 4-passenger Ford Focus. A family with 3 kids in car seats isn't going to fit into most sedans, yet it fits comfortably into any minivan, with plenty of room for storage. Would the government rather the family drive two "fuel efficient" cars to its holiday destination or one gas-guzzling minivan?

Cash for Clunkers and the Broken Window Fallacy

2009-07-24T12:45:00.000-07:00

The Consumer Assistance to Recycle and Save (CARS) Act (a.k.a. Cash for Clunkers) was passed and signed into law last month and can now be implemented thanks to the publication today of rules by the National Highway Traffic Safety Administration (NHTSA). I was going to write about this proposed (at the time) law a while ago, but I honestly didn't think such idiocy would actually pass the Congress. My bad.

The CARS program pays people up to $4,500 for buying a new car if they trade in an old car which gets 18mpg or less. This already sounds like a pretty dumb and pretty obvious government handout to the auto industry. Wouldn't it be nice if the government could just be honest and hand out cash to their favored industries and lobbyists? It would certainly save a lot of time and resources to pay off your political supporters in a straightforward way.

It gets worse, however, because some in Congress have actually convinced themselves (or at least their constituents) that the purpose of the CARS Act is to reduce fuel consumption and carbon dioxide emissions by getting cars with poor gas mileage off the road. Therefore, the old trade-ins must be destroyed. The following excerpt from the NHTSA's rules is practically Orwellian:

The agency has determined that a quick, inexpensive, and environmentally safe process exists to disable the engine of the trade-in vehicle while in the dealer’s possession. Removing the engine oil from the crankcase, replacing it with a 40 percent solution of sodium silicate (a substance used in similar concentrations in many common vehicle applications, including patching mufflers and radiators), and running the engine for a short period of time at low speeds renders the engine inoperable. Generally, this will require just two quarts of the sodium silicate solution. The retail price for two quarts of this solution (enough to disable the largest engine under the program) is under $7, and the time involved should not substantially exceed that of a typical oil change. The agency has tested this method at its Vehicle Research and Test Center and found it safe, quick, and effective. As with many materials used in the vehicle service area of a dealership, certain common precautions need to be taken when using sodium silicate. The same is true with regard to workers who may come in contact with the substance during the crushing or shredding of the engine block. We have discussed the matter with the EPA and the Occupational Safety and Health Administration (OSHA) and are aware of no detrimental effects related to the disposal of the engine block with this material in it.

I'm surprised that they don't require the cars to be buried and then the ground above sown with salt.

The CARS program has been variously described as an economic stimulus, as good for the environment, and as a way to reduce our dependence on foreign oil.

If one gives this even one minute of thought (something that Congress apparently did not), it becomes clear that, except for war, vengeance, and spite, no good could possibly come from destroying something of economic value. There is something called the broken window fallacy, introduced by Frederic Bastiat in 1850, and I refer you to the following link for a discussion.

Unfortunately, the CARS program is essentially a program to break windows. It encourages society to destroy all eligible clunkers with market values up to $4,500.

As we can infer from their market value, clunkers in fact have an important role to play in our economy and our society. They can actually move people and stuff from place to place at reasonably high speeds, and to the extent that a significant majority of people in this country can't actually afford to buy a new car, or even a slightly used one, clunkers allow those people to enjoy the fruits of a technology that has been around for the last hundred years.

This law is particularly annoying because the cutoff fuel efficiency for clunkers is 18mpg, and my 2000 Buick Regal gets 19mpg. The market value is probably barely higher than $4,500, but I figure I could have smashed a few things, collected the insurance money, and then traded it in.

Arthur Laffer's WSJ Op-Ed

2009-06-10T18:47:00.000-07:00

I'm a fan of Art Laffer, and I think he is one of very few economists you see on TV who actually understands fiat currency economics.

However, his article today left me scratching my head. The following paragraph in particular makes no sense to me:

With an increased trust in the overall banking system, the panic demand for money has begun to and should continue to recede. The dramatic drop in output and employment in the U.S. economy will also reduce the demand for money. Reduced demand for money combined with rapid growth in money is a surefire recipe for inflation and higher interest rates. The higher interest rates themselves will also further reduce the demand for money, thereby exacerbating inflationary pressures. It's a catch-22.

Let me try to parse it.

To start, the first sentence doesn't capture the complexity of how the crisis unfolded. "Demand" for money usually means a desire to borrow for the purpose of spending ("spending" includes investment in a business, by the way, and not just consumption). Money demand increases when the economy is growing, and prospects look rosy. And higher demand with fixed supply means higher interest rates.

However, this bears no relation to the crisis. People didn't want money so they could spend it. They just wanted to move it to a safe place. There was a collective loss of faith in the creditworthiness of the financial system. In September 2008, T-bill rates were effectively pinned at zero (there were even some scattered trades at negative yields). That shows just the opposite of a demand for a money. Yields on all risky fixed-income products sky-rocketed, but this wasn't because of a sudden spike in the demand to borrow. It was due to a belief that defaults were imminent. That's a big difference.

The Fed's response, of course, was to devise a number of programs to flood the market with money as a way to induce investors to buy the risky products again. The flood of money hasn't worked all that well actually. Other things have. What brought down the interbank lending rate (i.e. Libor) wasn't so much the flood of money but the government's increasingly explicit guarantee of all of the big banks. What brought down spreads in the agency debenture and agency mortgage market was the Fed's direct purchase program. What brought down credit spreads in the consumer loan market is the Term Asset-Backed Loan Facility (TALF) which basically grants a government subsidy to investors in the form of a free put option.

It's all pretty obvious when you think about it. If you don't want to loan Chrysler money because you think they'll default, you're not going to change your mind just because the Fed is willing to lend you $100MM interest-free to do it. You still have to pay back the Fed after all.

Laffer's second sentence is unobjectionable. A recession causes a reduction in the demand for money since business prospects look bleaker and people are more inclined to save money rather than spend it. I should point out that causality works the other way as well. An increase in the desire to save money means less consumption and investment and therefore less economic activity.

The third sentence is completely screwed up. Reduced demand for money is offset by the Fed's increase in the supply of money which lowers the price of money (i.e. the interest rate), which in turn raises the demand for money (since the price is lower). Yes, when the demand rises again (due to the lowered price), the cycle will renew itself. The economy will start growing again, and inflation will start to pick up, but interest rates will be wherever the Fed wants them to be.

Short-term interest rates will go up only if the Fed chooses to raise them (by reducing the money supply) in order to fight inflation. Intermediate-term rates will go up only if the market anticipates that the Fed will raise short-term interest rates. Long-term rates are driven by more complicated factors including risk premia, but let's just say that if the Fed maintains its inflation-fighting credibility, long-term rates will remain moderate.

The fourth sentence in our excerpt starts out ok, but then ends with a completely false statement. Yes, higher interest rates will reduce the demand for money (which had already been raised by lower interest rates and subsequently a growing economy), but this will serve to quash inflation, not stoke it. Higher interest rates do not exacerbate inflation; they do exactly the opposite. They discourage borrowing and spending and encourage saving. They reduce the aggregate demand for goods and services and therefore cause prices to rise less quickly (or even drop). Yes, some economists have theorized that there can be a small short-term cost-push effect on prices in which businesses try to pass on their higher borrowing costs to the consumer, but this isn't real inflation. It is at worst a very short-term and very small effect. At best, it doesn't exist.

Finally, I disagree with Laffer that the Fed is in a Catch-22. A better metaphor is that the Fed is trying to thread a needle. It must aggressively lower the price of money in order to boost aggregate demand for goods and services, but once the economy is safely back on track, it must move quickly to drain the excess liquidity from the system and raise interest rates. If the Fed moves too soon, the economy could be thrown back into recession (this was the Bank of Japan's mistake 10 years ago). If the Fed moves too late, then inflation could get out of hand.

What Does It Mean to Create a Job?

2009-05-25T11:30:00.000-07:00

Obama claims that various government spending programs create or save jobs, but what does that really mean? Can the government prevent GM from going bankrupt and save hundreds of thousands of jobs? Can the government raise taxes on carbon and create jobs? Can the government stimulus package create jobs just by throwing money around willy-nilly?

It is important to define first what we mean by a job. The common definition is an activity which a person performs on a regular basis, which produces something of value, and for which that person receives compensation in the form of money and other benefits.

Under this definition, the government can create jobs by just hiring people to do something useful (e.g. picking up litter on the Washington Mall). It can also subsidize private sector employers in order to avoid layoffs of otherwise money-losing employees or to prevent the elimination of money-losing positions.

Finally, if you loosen the meaning of the word "value" in our definition of "job" above, the government can create jobs out of thin air by paying people to do whatever, e.g. see http://tinyurl.com/q6ljq2.

As a pseudo-economist, I prefer an alternative definition of the word "job." A job should be self-sustaining in the sense that the value produced by the employee exceeds the all-in cost of his employment (which includes compensation, benefits, taxes, insurance, and the marginal cost of maintaining and supervising that employee).

According to this definition, government subsidies and direct spending are unlikely to create jobs. They perhaps might save jobs if there is a temporary dislocation which could be mitigated through government action. Arguably, various government programs to stabilize the banking system have saved real jobs in the banking industry and throughout the economy.

But a job created by an artificial boost in demand for the goods and services produced by that job (i.e. through increased government spending) is, well, artificial. The value of the goods and services is inflated by arbitrary government action, and so the net benefit to society of that job is illusory.

My sense is that the private sector is much better than the government at finding profitable employment opportunities and thus creating real jobs. Even if a government bureaucrat were to think of a great new business opportunity which would gainfully and profitably employ dozens of people, you still wouldn't need the government to bring it to fruition. If such a business could create real jobs, then by definition it would be profitable and somebody in the private sector would be willing to seize the opportunity.

One way in which the government can create real jobs (under either definition) is by imposing new regulations. New regulations force businesses to hire people just to ensure compliance with those regulations. In the financial industry, the resources devoted to compliance with existing state and federal regulation is staggering, and the number of employees dedicated to compliance issues easily reaches into the tens of thousands. And of course even financial regulation pales in comparison to the income tax code in terms of complexity and cost and the number of workers who make their living from it (numbering in the millions). I suspect the coming tweaks to the income tax and banking regulation will directly create tens of thousands of jobs over the next two years.

Of course, there is an obvious problem with this method of job creation. New regulation creates new jobs, but not necessarily NET new jobs. Existing jobs may be lost at the same time if certain businesses become unprofitable under the new regulatory scheme.

The new Carbon Cap and Trade Plan is a case in point. Its implementation will certainly drive the creation of new jobs devoted to researching, implementing, and managing so-called green technologies, as well as managing the transition to the new cap and trade system itself, but there is no doubt that a great many current jobs will disappear as a direct result. Claims of the administration notwithstanding, nobody really knows what the final tally will be. And that's just for jobs. The tally in terms of our productivity and our standard of living is even more difficult to calculate, although I predict that it will be very large and negative.

Comparing the FairTax to the Income Tax -- Does the FairTax Depress Consumption?

2009-05-03T04:44:00.000-07:00

The FairTax is a proposed national retail sales tax that would be designed to replace the income tax in the United States. It is explained quite well in the Wikipedia entry http://en.wikipedia.org/wiki/FairTax . FairTax proponents claim that a sales tax rate of 23% ($23 of every $100 spent) would be revenue neutral. Detractors claim that the 23% rate really amounts to a 30% sales tax (an increase of $23 in the after-tax cost for every $77 of goods and services).

A sales tax appropriately puts the tax burden on those who are using/consuming society's resources (whether natural or man-made), rather than on those who are creating value in society. You can probably guess that this blogger is a proponent of such a tax.

It's a good thing (or at least a fair thing) that such a tax hits those who consume the most, but we don't want to punish consumption too much. We want people to enjoy a high standard of living, and clearly too little consumption can cause near-term dislocations in the economy. Americans have historically not had a problem with being too frugal in the aggregate. The Japanese have, however, and perhaps a sudden jump to a very large sales tax could have negative consequences for the Japanese economy or a similar high savings rate, export-driven economy.

Does a sales tax really depress consumption more than the income tax, however? I think probably not. It is important to understand that under a primarily income tax-based system consumption is done with after-tax dollars.

Take the following example of a sole proprietor who has flexible work hours and finds himself in a situation where his marginal return for an extra hour of labor is $100. Under the income tax, he chooses to work an additional hour, makes an additional $100 and is taxed at a marginal rate of 25%. He will have $75 left after tax, and if he spends that money on dinner for four at a Chinese restaurant, he and his family will be well-fed for the night but will have no extra money left over from his hour of work. He has exchanged an hour of labor for some Chinese food.

Now let's consider the same situation under a sales tax similar to the proposed FairTax. We will assume a 25% tax rate using the FairTax definition of the tax rate (i.e. prices of goods and services are gross of taxes, and the amount of the tax is 25% of that gross price). Under the sales tax system, the proprietor will have $100 after tax. The Chinese dinner will cost him $100 ($75 price + $25 tax), and at the end of the day, he will be in the same situation as under the income tax.

FairTax proponents have come under criticism for claiming that the sales tax is only 25% in this example. Critics claim that the tax is really $25/$75 = 33.3%. I certainly agree with the critics that the sales tax is 33.3% and not 25%, but the FairTax people are also correct in pointing out that the income tax is never calculated this way. It is very easy to see in the example that a 33.3% rate of sales tax is equivalent to a 25% rate of income tax. It would be nice if we could get the government to admit that when somebody works to make $75 of after-tax income and pay $25 in tax that perhaps the real tax rate is 33.3% and not 25%.

One more example:

Let's suppose our businessman is also an amateur plumber, and he needs some plumbing work done in his house. He is more productive as a businessman than as a plumber, but he can hold his own against quality plumbers in the local area. Plumbers in the area make $75/hour, so it makes no sense for him actually to work as a plumber.

If he hires a plumber at $75/hour to do the required work in his house, he has to pay $100/hour under a 25% sales tax system. By doing the work himself he saves himself $100/hour, which is exactly what he would have been making doing his regular job. He is indifferent to doing the plumbing work himself at a 25% tax rate, but if the tax rate were higher, he would probably spend his time on the lower productivity plumbing job rather than on his higher productivity regular job.

Clearly, this is an inefficiency. It would be nice if the businessman did what he does best, and the professional plumber got to do more work doing what the plumber does best, but because there is no sales tax charged on work you do for yourself, there is an extra incentive to be a do-it-yourselfer.

If you do the same analysis under an income tax, however, the results are identical. In this case, there is no income tax charged on work you do for yourself, so there is the same incentive to be a do-it-yourselfer.

We see that the income tax discourages both production (because you get less money for your work) and consumption (because you're paying for your consumption with after-tax dollars). The sales tax/FairTax depresses consumption because it directly increases the cost of goods and services. But does it discourage work?

A blinkered economist might argue that it does. The utility of the dollars you earn is lower because their consumptive value is lower, so you would be getting less value for your labor. I think in practice, however, the decrease in the utility of dollars earned is mitigated by the fact that you earn more on your savings. If you can earn a high return on savings, it encourages you to go out and accumulate money with which to invest. People do tend to value having money in the bank, anyway, even if they have no plans to spend it. Overall, I think it is pretty clear that work is discouraged a lot less under a Fair Tax than under the current income tax.

An important side effect is that productivity will rise and the cost of goods and services will drop. So, even though the Fair Tax directly increases the cost of goods and services to the end consumer, the increase in productivity might very well go a long way towards offsetting that increase. There is no such offset under the income tax.

Why the Income Tax is Bad

2009-04-22T07:37:00.000-07:00

As I've explained in previous posts and in comments to previous posts, the federal government doesn't impose a tax to raise revenue per se. It does so to remove dollar financial wealth from the private sector, thereby curbing aggregate demand for goods and services. This dampens inflation and maintains the value of the dollar, which is important for economic stability and growth.

When discussing the efficacy of various tax systems, however, it is easier to speak in terms of tax revenue, and that's what I'll do here.

The vast majority of federal government revenue comes from the personal and corporate income tax. There have been proposals over the years to replace the income tax partially or completely with other types of taxes or revenue raising schemes. Other taxes that have been considered and used at various times and in various jurisdictions include import and/or export tariffs, head taxes, real estate taxes, personal property taxes, intangible property taxes, sales taxes, and value added taxes.

Below, I'll quickly run through the problems with our current tax system, most of which are unique to the income tax:

1) Income is difficult, perhaps impossible to define. Most people would agree that reimbursement for expenses, compensation for damages, money borrowed, return of money lent, return of capital on an equity investment, and de minimus gifts of goods and services should not be considered income for tax purposes. But if you try to craft rigorous rules that tax transfers of items of value between two entities and yet exclude the things that should not be considered income, you find loopholes and unintended consequences everywhere.

2) Because of (1) above, the income tax code is horribly complex and the cost of compliance is outrageous; estimates as high as 5-10% of GDP have been posited for the annual burden/cost of compliance; when one thinks about the brainpower dedicated to finding loopholes in the tax code as well as trying to close them and litigating them, it almost makes one despair.

3) The complexity leads to law-abiding citizens running afoul of the law by accident or because of the malice of government officials; just as damaging, the complexity tempts normally law-abiding citizens to become scofflaws, a slippery slope which probably undermines respect for the law in general;

4) The income tax is necessarily very intrusive; citizens must divulge to the state very personal details about their businesses, their investments, their families, and their spending and giving habits; the income tax strengthens the state vis a vis the individual and makes oppression far more likely;

5) From a purely economic perspective, there can be nothing worse than discouraging work and production, but that's what the income tax does, particularly a progressive income tax;

6) In addition to (5) above, the tax code can also motivate an individual or company to enter into inefficient transactions in order to maximize after-tax income, rather than pre-tax income.

7) The income tax is relatively inefficient because it is very easy to hide income; also, it is hard to predict how much revenue will be raised from an increase in the tax rate because the incentive to hide or shield income (or not to work at all) increases as the tax rate increases.

8) Because of the intrusion of the income tax into all aspects of the economy, it is tempting for lawmakers to use the income tax to encourage socially desirable behavior and discourage socially harmful behavior; as pointed out in (1) above, however, the complexity of taxing income makes the risk of harmful unintended consequences very high.

9) Since the time of the New Deal, taxes have been used to redistribute wealth from rich to poor; whether or not one believes the government should be redistributing wealth, income taxes are a bad way to do it; income -- particularly, taxable income -- is not a good measure of a person's wealth; some rich people have low incomes, and some not so rich people have high incomes; an income tax just taxes those who are the most productive, not those who have the most wealth (a wealth tax would be better), or those who use the most resources (a sales tax would be better).

Hennessey's Blog and Netting of Govt Assets Against Debt

2009-04-10T20:03:00.000-07:00

Keith Hennessey was a senior White House economic advisor to President Bush. He recently started a very interesting and informative blog. On Wednesday, he discussed (and disagreed with) Budget Director Peter Orszag's claim that the effective government debt is smaller than the reported number because the government owns a sizable amount of assets that should be netted against that debt.

http://keithhennessey.com/2009/04/08/dont-hide-the-debt/

I've enjoyed Hennessey's blog, but he appears to be confused about the way a fiat currency system works. I don't think he's alone among top government economists. For starters, Hennessey refers to Treasury bonds as IOUs which need to be redeemed in cash, which he seems to imply is something tangible.

It is not only Treasury bonds that are IOUs, of course, but money itself. A little green piece of paper with Benjamin Franklin's picture on it is nothing more and nothing less than a government IOU. When the government redeems Treasury bonds, it is simply replacing an interest-bearing IOU (barely interest-bearing, in the case of short-term T-bills today) with a non-interest bearing IOU.

In the UK they are somewhat more explicit about the credit-based, fiat monetary system there. The 5 pound notes read "I promise to pay the bearer on demand the sum of 5 pounds." The "I" refers to the Bank of England, and if you take the note to the Bank, they will indeed exchange it for 5 pounds -- either another 5 pound note or a handful of smaller notes and coins which add up to 5 pounds.

The point is that a dollar, whether it is green or electronic, is an IOU of the United States government, where the government is somewhat vague about what it in fact owes the holder. The IOU is imbued with value by two things: 1) the willingness of the government to provide some real goods and services in exchange for those IOUs ; and more importantly, 2) the government's demand that certain people pay IOUs back to the government in exchange for staying out of jail (i.e. taxation). These two things create demand for government IOUs and make them valuable.

The government, of course, can create as many IOUs as it wants. Sometimes it does it in the form of interest-bearing Treasury bills, notes, or bonds, and sometimes it does it in the form of non-interest bearing numbers in a reserve account at the Fed (i.e. cash). Actually, sometimes it does it in the form of a promise to pay pension and medical benefits in the future (e.g. Social Security and Medicare), but that is a discussion for another time.

Of course, there is a practical limitation on how many IOUs the government can create before inflation becomes a problem. Inflation can be mitigated by tempting people to exchange some of their non-interest bearing IOUs for interest-bearing ones (whether Treasury bonds or deposits at the Fed) which can't be spent easily. The Fed does this by offering a higher interest rate on overnight repurchase agreements, thus reducing aggregate demand for real goods and services by incentivizing people to save rather than spend. But if the government continues to create IOUs much faster than nominal GDP is growing, it is inevitable that the IOUs will depreciate against the value of real goods and services, and we will have destabilizing inflation.

With all of that said, I'll address two points that Hennessey made with which I strongly disagree. First, he disparages Orszag's idea of netting out assets of the government with the outstanding stock of IOUs. Looking at the assets of the government as being available to pay claims, i.e. to pay off and extinguish IOUs, netting is certainly appropriate to some degree because the assets help to maintain the value (real and perceived) of the IOUs backed by the government. In the case of financial assets, particularly relatively liquid, relatively short-term assets which actually spin off cash flows, the fungibility with IOUs is apparent. Financial assets should clearly be netted, although the financial assets do need to be valued appropriately (i.e. not anywhere near face value).

Second, Hennessey claims that when the government borrows to buy financial assets there is a "crowding out" effect. This is pure rubbish. There is no such thing as "crowding out" due to the issuance of Treasury bonds, whether it was done to offset government spending, investing, or tax cuts. For every dollar the Treasury receives from the issuance of Treasury bonds, a dollar is sent back to the private sector, by definition. Net IOUs remains the same.

The fallacy embedded in Hennessey's Alan I. Gorp example is that Alan would have the $100. Alan either spends that $100, pays down his own bank debt with it, or deposits it in a savings account at another bank. As long as Alan doesn't put the money under his mattress, it ends up at a bank. If the money did end up under a mattress, then the Fed could inject (i.e. create) an extra $100 into the banking system without spurring inflation.

Expanding the example back to the government level, we see that if the government issues $1T of bonds to pay for $1T of so-called toxic assets, the next effect is that the private sector in aggregate has received $1T of low-interest government IOUs in exchange for $1T of toxic assets. No doubt this would make the private sector a lot more confident about the creditworthiness of financial intermediaries and counterparties. It would also provide $1T of good assets that could be used to collateralize lending. I'm not saying such a swap is the right thing to do, but it certainly would spur investment and aggregate demand, rather than "crowd" it out.

The only way for the government to starve the private sector of investment funds is to run a budget surplus. This removes IOUs from the system, thus reducing aggregate net financial wealth. The reduction in aggregate net financial wealth would tend to reduce aggregate demand and be disinflationary/deflationary.

Government Spending and Other People's Money

2009-04-05T08:00:00.000-07:00

A friend told me recently that Milton Friedman divided spending into four categories:

1) spending your own money on yourself;

2) spending your own money on other people (e.g. a gift);

3) spending other people's money on yourself (e.g. using a corporate expense account);

4) spending other people's money on other people (e.g. spending by government bureaucrats).

The first kind of spending is the most efficient. Since you are presumably aware of what you want, you will purchase goods and services which will make you happy. Since it is your own money you are spending, you will be careful about not over-paying.

The second kind of spending is certainly less efficient. To some extent you are guessing at what the needs of the "other people" are, and you are certainly not going to be privy to their utility function. It's your money you're spending, so you may try to spend wisely and not over-pay, but sometimes -- particularly if it's a gift -- paying above a certain amount of money is part of your goal. There is a lot of evidence that gift items (e.g. a bottle of perfume) will not sell at all if priced too cheaply. We've all had that experience. You see a great gift for $20, but decide not to get it because it's not expensive enough. If the same gift were $50, it would be perfect.

The third kind of spending is also less efficient than the first. You end up spending the money on things you need and desire, but you are less concerned with price. You end up buying things that you wouldn't if you had to use your own money. At least you know that the purchases will be enjoyed and thus not be a total waste. Furthermore, there is at least some incentive to keep costs down, since you will look greedy to other people if you spend too wildly.

The fourth kind of spending is the least efficient of all. You have all of the problems of both the second and third type of spending without any of the mitigating factors. Because you're spending money on other people and not yourself, you really don't have to worry about looking greedy if you spend too much.

Often there is a perverse incentive to overspend because a key metric used to gauge success is the amount of money allocated. How many times have you heard a politician boast about how much money he allocated for this or that project? You certainly never hear of a congressman boasting that he got $100MM for building a highway in his state but was able to cut costs and return $20MM to the federal government.

And the government bureaucracy is even more perversely incentivized. I've worked in a government research laboratory where at the end of the fiscal year we frantically spent any remaining money in our budget because if it wasn't all spent, we would be allocated less money the next year.

Milton Friedman's succinct categorization makes it clear why government spending should be minimized. If the solution to today's economic problems lies in the government getting more money into the private sector, it should be accomplished by tax cuts and/or transfer payments, not government projects.

Latest South Park episode is on the money

2009-03-27T07:15:00.000-07:00

http://www.southparkstudios.com/episodes/220760/

Ironically, this is one of the clearest expositions of what ails the economy. The private sector -- particularly the consumer -- is overleveraged. The government has simply not been running large enough budget deficits to sustain sufficient private sector net financial wealth commensurate with the level of aggregate demand we had grown accustomed to. Aggregate demand was sustained instead through financial engineering and excessive leverage.

Now we are in the inevitable deleveraging stage, which is extremely disruptive and painful. The best and most effective way to shorten this stage is for the owner of the money printing press to fire it up and to disburse money as fast and as equitably as possible to the private sector. In the South Park episode, the owner of the printing press is Kyle with his no spending limit American Express platinum card. In the real world, it is the Federal government.

I am more optimistic about the economy in the intermediate term because of the automatic stabilizers built into the Federal budget. As the economy weakens, the budget deficit grows, and this works to correct the problem. So far, though, the government has done too little on the fiscal side. The stimulus in 2008 was done in a timely fashion, and it was the right idea, but it was far too small. The actions of the Obama administration so far have been a waste. They are more focused on seizing an opportunity to enact a long-term liberal agenda than they are in getting the economy going again.

Still, the economy will be well on its way to recovery in 12-18 months. The recovery could be faster and stronger if the right fiscal policies were enacted, but it appears we can never count on the government to do the right thing.

Money Market Fund Regulation

2009-03-26T20:10:00.000-07:00

There is some talk of an overhaul of the regulatory scheme for our financial system. Quite frankly, that's wholly unnecessary, and I suspect it will turn out to be counterproductive. As I will discuss in future posts, the government is primarily responsible for the unfolding economic disaster -- both because its interference in the housing market inflated the bubble and because it has failed to inject sufficient money into the private sector in a timely manner to mitigate the bubble's collapse.

The near meltdown of money market funds after Lehman's bankruptcy last September did underscore a vulnerability in this area of the market. There is only one change that is needed, however, an obvious one that addresses one of my long-term pet peeves.

Money market funds should not be allowed to fix their NAV per share at $1. The NAV per share should accurately reflect the market value of the portfolio. It's insane that it has been otherwise for as long as money funds have been existence. I suppose it is a vestige of a time when mathematicians hadn't worked out long division to more than 3 decimal places.

Using a market value NAV is important for two reasons:

First, not using a fair NAV for redemptions and purchases allows arbitrageurs to take advantage of existing shareholders. To see this, consider a sudden drop in the short-term interest rate of 200bps (this has actually happened twice in the past year). An arbitrageur can invest the next day at $1/share and earn the legacy interest rate for several weeks or months (i.e. a rate 200bps higher than the prevailing rate) at the expense of existing shareholders, who will earn less interest than they would have. The reverse works as well. An invested arbitrageur can redeem at $1/share if short-term interest rates were to rise suddenly. The arbitrageur takes his money out and earns the higher prevailing rate, once again at the expense of shareholders who will earn the lower legacy interest rate (and even less than they would have thanks to the arbitrageur).

Second, and more importantly, runs on money market funds are less likely to get started and less likely to grow. The NAV problem is one of the reasons runs start. The smartest investors see the underlying assets going down in value and take their money out while the NAV is still $1/share and the getting is good. Once a run begins, however, the fair NAV method helps to nip it in the bud. The manager of the fund starts selling assets to meet the redemption requests. This lowers the price of the assets, leading to a lower NAV per share and a higher implied fund yield. By the basic law of supply and demand, a lower price discourages current investors from redeeming and encourages new investors to purchase shares. Stability.

Unfortunately, I doubt that the Feds are going to figure this out.

The AIG Bonus Outrage

2009-03-19T14:00:00.000-07:00

The outrage here is that people are outraged. The government response is particularly outrageous.

I don't know the details of whether these bonuses were deserved in some moral sense, but the fact is these bonuses are contractually obligated and should be paid. If the government had a problem with paying large amounts of compensation to employees in order for them to stay and clean up the mess they created, it should have raised the issue when AIG was teetering on the edge of bankruptcy. After all, the bonuses would not be paid in the event of bankruptcy, so the government had some leverage to demand that employees take a pay cut. But it is too late for that now.

Personally, I don't even have a problem with paying smart, hard-working people a lot of money to try to mitigate the damage. It seems rational to pay them to stay if they can do a better job than their potential replacements. The fact that these same employees were responsible for losing a lot of money is irrelevant. I think the administration was getting a bad rap for this, and its initial instincts were correct.

Now, though, the administration and congress (and I include Republicans here) are acting like tyrants. It is completely unacceptable -- morally and constitutionally -- for them to try to pressure people to give up their contractual rights based on popular outrage, or worse, to pass taxes aimed at punishing them. The tax bill just passed by the House is essentially a bill of attainder, which is specifically proscribed by Article I of the constitution.

Any congressman who voted for this bill is guilty of a violation of his sacred oath to uphold and defend the constitution. We'll soon see if Obama also violates the oath he took just two short months ago.

The Employee Free Choice Act should be stopped

2009-03-16T09:36:00.000-07:00

Once upon a time, perhaps 100 years ago, unions may have made sense. When the economy was industrialized and dominated by a handful of monopolies, when labor mobility was restricted, when communications were inefficient, labor might have been at such a large negotiating disadvantage that perhaps unions were needed to counter exploitation from the so-called "owners of capital."

But unions are an anachronism today. At any given time, even during a deep recession, there are millions of job opportunities, offered by hundreds of thousands of companies throughout the United States. Indeed, with the growth of the internet, it is possible to take a job on the other side of the country (or even outside the country) without having to move. Furthermore, the US government has zealously applied antitrust law to break up monopolies and prevent any one sector of the economy from becoming dominated by a single corporate entity.

From an economic perspective unions are bad for at least three reasons.

First, the union bureaucracy is a dead weight loss to the economy. That is, the time and effort spent operating unions, regulating them, defending them, and fighting them could be better spent producing real goods and services which improve our aggregate standard of living.

Second, unions extract higher compensation for low-productivity jobs, which (a) is an unfair transfer of wealth to union members, which inevitably comes at the expense of non-union workers in the form of uncompensated higher prices for goods and services; and (b) causes a misallocation of labor. For example, an auto worker producing $50/hour in value but being paid $45/hour will not do a different job in which he is capable of producing $60/hour in value but is paid only $40/hour.

Finally, unionized workers are not properly incentivized to work hard and do a good job because both their upside and their downside is limited. No matter how good an employee is, his compensation will be constrained by the union contract. No matter how bad an employee is, his firing will be fought by the union. In my view, the main problem we have with public education is that the powerful teachers' unions strip the teaching profession of any traces of a meritocracy.

As for the Employee Free Choice Act (EFCA), it is hard to overstate the deceit of its proponents.

Under current law, workplace union organization starts with a card check process, in which employees are asked by organizers to sign a card requesting representation by a union. If at least 30% of workers sign the cards, then the organizers can hold a secret ballot election which determines by majority vote whether or not a union will be formed. If at least 50% of workers sign the cards, the organizers generally will just present the cards to the National Labor Relations Board (NLRB) for union certification, but then the company can insist on a secret ballot election. Either way, there will almost always be a secret ballot election in which the will of the majority is expressed. If a majority votes against unionization, then a union will not be formed.

One of the changes the EFCA would make is the following: if more than 50% of the employees sign the authorization card, the union will be certified automatically. There will be no secret ballot election.

It's pretty obvious that the EFCA does the exact opposite of its name. Workers will have to decide out in the open, possibly under duress, whether or not to sign an authorization card. And if 1 out of 2 of their fellow workers sign the card, they won't be able to retract their decision to sign (i.e. their decision to support unionization publicly) in a secret ballot election.

I can't sugarcoat this. The EFCA is a desperate measure created to fight declining union membership by trying to force unionization on reluctant workers through intimidation. Its proponents who argue otherwise are malicious liars.

Paul Krugman award for Intellectual Dishonesty

2009-03-09T06:00:00.000-07:00

Paul Krugman is a smart guy, and presumably he understands economics, having been a John Bates Clark Medal winner and a Nobel Prize winner. But he clearly lets his leftish political views shape his economic commentary.

The Economist has written the following: "... his past columns reveal[s] a growing tendency to attribute all the world's ills to George Bush ... Overall, the effect is to give lay readers the illusion that Mr. Krugman's ... personal political beliefs can somehow be derived empirically from economic theory."

If anything, this understates Krugman's bias. For shamelessly and dishonestly using his stature as a world-class economist to justify and promote his personal political beliefs, Krugman is, in my opinion, the most intellectually dishonest economic commentator alive today.

I have decided to shine some light on intellectually dishonest commentary from time to time by copying an idea that other bloggers have used, which is to offer an award dedicated to the most well-known offender.

The inaugural winner is Dorothy Brown, a professor of tax law at Emory University, for her op-ed in the NY Times today about the unfairness of the preferential tax rate on stock dividends and capital gains (p. A23 of Mar 9, 2009 print edition).

Dorothy writes nine paragraphs explaining that the tax rate on dividends and capital gains is only 15%, -- in contrast to the maximum rate of 35% on ordinary income -- and that this is some crazy aberration which benefits rich people and penalizes poor people. The reader is led to believe that there is simply no rational basis for a preferential capital gains tax rate and furthermore that there would be no negative consequences to equalizing the rate at the ordinary income tax rate.

Given that Dorothy is a professor of tax law, we can assume that she knows the real reason behind the preferential capital gains rate. To wit, the earnings on C corporations are already taxed at the corporate level (35% rate) before they are distributed. Until either the corporate level tax is repealed, a corporate tax deduction is allowed for dividends, or a tax credit (a.k.a franking credit) is passed along to stockholders, the United States will remain virtually the only country in the developed world that taxes stock investors twice. I figure the least our friendly, neighborhood tax collector can do is give a small discount when he comes around for the second time.

Ironically, the real aberration in our tax code was that stock dividends were taxed at a higher rate than capital gains, which fortunately the Bush administration remedied in 2003. The aberration was causing corporations to hoard excess cash, or at best use it for stock buybacks (which strikes me as rather inefficient and less than transparent) instead of paying it out to shareholders.

I am looking forward to Dorothy's next op-ed in which I expect she will decry the unfairness of municipal bonds. After all, the rich are paying zero tax on the interest! I'm sure that she can come up with a good solution, something along the lines of having an alternative minimum tax framework for people who have too much municipal bond interest income. Yeah, that's the ticket...

The Economic Hole -- What's the fastest way out?

2009-03-05T10:48:00.000-08:00

I continue to believe that the fastest and best way out of the current economic crisis is for the government to put about $1.5T into the private sector immediately.

Government spending is NOT the right way to do it. It is extremely wasteful of human and natural resources. Resource allocation (i.e. spending) by politicians, lobbyists, and government bureaucrats is an economic evil. Sometimes a necessary evil, but an evil nonetheless. If it can be avoided, it should be avoided. In this case, most economists agree the goal is to put money into the private sector. Additional government spending is not necessary to do this -- all you need are net government transfers, which can be accomplished by cutting taxes or giving people checks.

I agree with Warren Mosler (http://www.moslereconomics.com) that the most efficient way to stimulate aggregate demand is to have a wage tax holiday. I think an income tax holiday may also be necessary to get enough money into the private sector. Cutting taxes on economic activity is obviously a good thing in general because it removes impediments to economic activity. Cutting taxes on wages and income is best of all because it incentivizes that very activity (i.e. production) which makes us all wealthier (in the standard of living sense).

Democrats won't accept an income tax cut, let alone an income tax holiday. For them it is a "giveaway" to the rich, as Democrats believe in redistribution of wealth as a desirable goal. I don't agree with them, but there is no right or wrong on the issue. It is an axiomatic difference between Republicans and Democrats, and right now the Democrats are in control.

The next best thing is to give every (and I mean "every") permanent American resident a check -- a big check. A check for $5,000. Bill Gates gets a check for $5,000. So does his wife and each of his kids. The President gets a check, as well as every member of congress. The CEO of GM gets a check and the CEO of Citigroup too. But also the elementary school teacher and every one of the kids in her class. The woman on welfare who hasn't worked in 5 years gets a check. The 100 year old great, great grandmother who has been on social security for 40 years. The newborn baby of illegal immigrants, as well as every newborn in the maternity ward in the poorest hospital in Alabama. Everybody serving in the armed forces, every college student, everybody. Even members of the Al Qaeda sleeper cell who have been here 5 years and have already earned their green cards.

Democrats should love this because it is redistribution of wealth in purest form. There is no so-called "taxpayer" who is paying for this. Whether or not you paid taxes in the past has nothing to do with whether this is on balance good or bad for you personally. In theory, this is on balance bad for people who have substantial net financial wealth (which includes foreign central banks holding lots of Treasuries) and good for people who have zero or negative net financial wealth. It diminishes the value of each dollar by creating more of them. It directly stokes inflation by driving aggregate demand higher while not directly increasing the capacity of the economy to produce goods and services. In normal times, it would be unfair and perhaps destabilizing to do this.

However, the problem we have today is deleveraging, deflation and falling aggregate demand. It is a vicious cycle that weakens creditworthiness and discourages investment and consumption, leading to more deleveraging and deflation. On balance, wealthy people too will benefit from an injection of money to fight deflation, spur aggregate demand and stabilize creditworthiness.

The beautiful thing about giving money directly back to the people is that there is no waste of resources whatsoever. No politician or lobbyist is directing thousands of workers to build schools in Milwaukee which nobody will use. No government bureaucrat is going to direct thousands of workers to toil away building a zero-emissions coal plant before the technology is ready. Those resources will be available to be allocated by the private sector -- by hundreds of millions of people making billions of economic decisions each year. This sounds like a novel idea, but it is called capitalism, and it is a distinctly more efficient economic system than what the Soviet Union created in the 20th century.

You may wonder, and the talking heads on CNBC will certainly ask, "How can the government pay for this huge handout? How can the government sell enough debt? Will the Chinese keep buying it? How can our children pay it back?"

The short answer is that the government owns a dollar printing press and doesn't need to borrow money from anybody. In fact, the bonds the government issues are no more debts than the dollars in which they are denominated. Government bonds are best thought of as liquidity sponges that soak up excess dollars and create a positive interest rate floor on savings. And if the Chinese want to hold their dollars, they have a choice between interest bearing Treasuries and non-interest bearing dollars at the Federal Reserve. If they don't want to hold their dollars, then they have to sell them to somebody else who will now have them.

Does taxing high incomes mean taxing the rich?

2009-03-04T11:07:00.000-08:00

Politicians (particularly Democrats) and the media talk about high income and wealth as if they were the same thing. In fact, they aren't as correlated as you might think. Many rich people have low incomes (at least low taxable income), and many high earners are not yet rich.

A reasonable definition of rich is that level of wealth where you feel comfortable enough financially to quit your job. You can provide for all of your family's needs, live comfortably, and cover plausible emergencies or catastrophic events, just from the nest egg you have accumulated and the investment returns on that nest egg.

How much do you need to be rich? Most financially savvy people who have thought about the issue think that $3MM is a bare minimum. In today's low interest rate environment, you probably need more, but let's use $3MM as our benchmark.

Obama's tax plan says that households making over $250K are rich. Well, let's take a look at a household that's well into that "rich" bracket -- a 35-year old couple where both husband and wife work and are doing very well. Combined, they make $400K per year. They recently started making that kind of money and up until the present haven't been able to save much. They used to have $150K in retirement savings, which is now down to $100K, and they used to have $100K of equity in their house, but which is now basically nothing.

They have two kids in pre-school, a $400K mortgage, two 5-yr old cars and the usual assortment of modern amenities (groceries from Whole Foods, utilities, cell phones, broadband internet, cable tv, once a week housekeeper, landscaper, once a week babysitter, 2 vacations a year, etc).

I estimate that a fairly tight family budget would total at least $100K/yr outside of mortgage interest and taxes. This includes maintenance and insurance on the house and the cars (plus depreciation on the cars since they need to be replaced every ten years). Their current taxes are as follows:

Federal Income tax: $95K
FICA tax: $20K
State Income tax: $20K
Property tax: $5K
Mortgage interest $24K

At the end of the year, they get to save about $136K, and that's by being pretty frugal. So at that rate of saving, this couple won't be rich for over 15 years (this includes investment earnings on their savings), by which time the definition of rich will have moved from $3MM to $5MM.

Don't get me wrong, this family is quite affluent. They are living in a nice house and can easily afford the basic necessities of life. Their spending each year exceeds the total annual income of the vast majority of US households. But these people have very hectic lives, do not feel financially secure, and they are very worried about losing their incomes.

It is also important to recognize that much of the spending that seems extravagant is not really discretionary, but rather necessary to support a two-earner household. Pre-school ($15/yr), babysitters ($3K/yr), housekeeping ($5K/yr), maintaining more than one car ($3K/yr) -- these are items that a one-earner family can do without. So hiking taxes on income but not allowing deductions for these types of expenses definitely penalizes two-income families.

Anyway, my overall point is that income is a poor metric to use to decide who is rich. Income, at least wage income, is a better measure for determining how productive you are, although certainly far from perfect.

I would argue even further that wealth is not the right metric to use to determine who deserves to pay more for the burden of government. If you're rich, but you don't consume, then your wealth doesn't hurt anybody. You are not hogging finite resources for your own enjoyment.

A perfect example is Warren Buffett. He is worth tens of billions of dollars, but the guy probably hasn't spent more than $10MM for himself and his family in his entire lifetime. His vast accumulation of dollars doesn't do me any harm as long as he's not going to use it to consume (i.e. spend it), thereby raising the cost of resources (human, man-made, or natural) for everybody else.

So perhaps the people who deserve to pay the most are those who consume the most. By the way, even poor people can consume quite a great deal. My guess is that the inequality in rates of consumption in the US is far smaller than it is for net worth or income. Consumption should be the true measure of an individual's burden on society and his moral responsibility to pay.

Earmarks -- Why are they really bad?

2009-03-03T12:43:00.001-08:00

Obama has claimed before (and will soon claim again) that earmarks are a miniscule portion of the budget and therefore not that big an issue. But he's missing the point, probably intentionally.

The reason the earmark process is so bad is that it is a form of bribery. If congressman Blue Dog Democrat in Alabama doesn't want to go along with a 12% increase in the State Department budget or a 10% increase in Amtrak subsidies, well, maybe his vote can be bought by funding an $819K catfish genetics research project in his district. We're seeing this with the new 2009 Omnibus Budget bill. A lot of congressmen have qualms about the vastly increased spending in this bill, but the 8,500 different earmark projects (worth about $7.7B) embedded in it make its likelihood of passage very high.

Everybody knows an earmark is bad in and of itself because it is far more likely to be an inefficient allocation of money. It wouldn't be an earmark if it could survive scrutiny from the full congress, so it had to be tucked away in a bill where nobody could see it or remove it.

But the really bad thing about earmarks is never discussed. The earmark process corrupts the law-making function of congress. In essence, it is a legal form of bribery. It leads to a far less representative democracy and a far more inefficient government than we would otherwise have.

Is the Government Spending Taxpayer Money?

2009-03-02T09:33:00.000-08:00

Who loses when the government wastes money?

Certainly not the past taxpayers or current taxpayers -- that money is a sunk cost. Maybe future taxpayers lose (nobody knows for sure who these people will be) if government officials try to remedy unhealthy deficits with future tax rate hikes.

But unhealthy deficits can instead cause future government spending and transfer payments to fall, or if government policies remain unchanged, cause the value of the dollar to drop. In the former case, beneficiaries of government spending and transfers (e.g. retired people, low-income people, or industries with powerful lobbies) will suffer. In the latter case, holders of finanical wealth in dollars will lose out. The big holders of dollar financial wealth, by the way, include large foreign holders of treasuries like foreign central banks and sovereign wealth funds.

I am not arguing that government waste doesn't have negative consequences -- it does, and waste should be avoided. But the losers include everyone except the direct beneficiaries of that waste. Past and current taxpayers do not have any special direct exposure to the negative consequences of waste, and probably not future taxpayers either. Given the tremendous political pressure not to reduce spending or to raise taxes significantly, it can be argued that the biggest direct losers of unhealthy deficits are entities with significant net wealth exposed to the value of the dollar. That is, wealthy people, who do not necessarily have a lot of taxable income, and foreign governments, who do not pay US income taxes at all. The winners are government employees, those entities with Washington connections, and people and companies which have negative financial net worth.

Good (spending cuts) = Bad (repeal of tax cuts)

2009-02-26T08:46:00.000-08:00

I have seen this line (snipped out of a bloomberg story) reported elsewhere:

"Obama pledged that his administration will 'go through our books page by page, line by line' to cut wasteful or inefficient spending, and said officials have already found $2T in deficit reduction."

The $2T (presumably over a 10yr time horizon) includes the extra "revenues" coming from letting the Bush tax cuts expire for people making over $250K (worth more than $60B/yr I'm guessing). This is thoroughly dishonest. A tax hike is not equivalent to cutting spending. From an economist's point of view, taxes (particularly income taxes) are bad and government spending is bad. They might be necessary, but they are bad and should be minimized. Cutting government spending should never be in the same category as raising taxes. Good does not equal bad.

There is a larger point here that Republicans and Democrats alike completely don't understand. Democrats are always claiming that judicious government spending is good because it can help grow the economy and increase government revenues. Republicans are always claiming that tax cuts are good because it can help grow the economy and increase government revenues. Always in the analysis is this idea that higher government revenues are good.

Why?

The government is not some private business where the goal is to maximize revenues. The goal of government is to facilitate the maintenance of a high standard of living and growth in that standard of living of the residents of the country. That is the proper goal. If somebody wants to argue that increasing government revenues is an important step towards that goal, they can make that case, but it sure isn't obvious to me.

It is particularly crazy to analyze policies based on government net revenues when we have a fiat currency system in which the government can print an unlimited amount of money. The larger goal once again should be maintenance of a high standard of living. This might include a sub-goal of maintaining the value of the currency, so maybe the government should be careful about how much money it prints, but we have to stop thinking of the government as a private business.

Why aren't the banks lending?

2009-02-25T08:13:00.000-08:00

We keep hearing that the economy is going south because the banks aren't lending money, and the banks aren't lending money because their balance sheets are clogged with toxic assets that nobody knows how to value.

It is certainly true that the banks aren't lending money, and this is certainly very bad for the economy, but the balance sheet argument is fundamentally flawed. There are two reasons banks aren't lending money:

(1) they think almost no borrower is creditworthy because of the outlook for the economy; and

(2) the market value of almost any loan they make to an entity other than the US government is at best 80% of par (i.e. worth at least 20% less than what they loaned).

The first reason should be obvious. Creditworthiness, and therefore bank profitability, is supercyclical. When the economy is good, companies are making money, unemployment is low, refinancing is easy, and everybody is a good credit. When the economy is bad, it's the reverse. And the fact that asset prices are falling fast just makes the risk of lending even higher because you never know when you might want the money back to buy something really cheap (there is opportunity cost on top of credit risk).

The second reason is more directly tied to asset prices, and it is something I haven't seen discussed much in newspapers, on TV, or elsewhere. The illiquid sectors of the fixed income market are incredibly distressed. The prices of assets are shockingly low relative to fundamental value. People keep blathering on about toxic assets, but there is no such thing as a toxic asset. "Toxic" means poisonous -- capable of causing injury or death -- and certainly implies that you would pay to get rid of it. But the so-called toxic assets have positive value. They are assets, not liabilities. They got the name "toxic" because their market value, and in many cases, their fundamental value (which is quite different as I'll explain), is now much lower than it used to be.

Now, if the fundamental value of an asset is much lower than where a bank is marking it on its books, then that is an issue of dishonest accounting and possibly fraud. I'll concede that a lot of banks have this problem, but I think the vast majority of them are domiciled in Europe and Asia.

If the market value of an asset is much lower than where a bank is marking it on its books (but the fundamental value is in the ballpark), then that is a potential liquidity problem. If the bank is forced to delever (e.g. pay back demand loans like poor George Bailey in It's a Wonderful Life), then it might have to sell that asset in a distressed market and end up with a lot less capital than it and its regulators thought it had.

Banks have a liquidity problem which has been mitigated substantially by government action over the past 6 months, but it is still acute. By making new loans at par that they can't sell for anything remotely close to par (think of buying a new car in the morning, and then trying to sell it back to the dealer in the afternoon), they are just exacerbating their liquidity problem.

I will give just one example of how distressed prices are in the fixed income market. Consider the following mortgage-backed security:

WAMU 2006-AR10 1A1 (CUSIP: 93363EAA3)

This is something that some lazy commentator on CNBC might call a toxic asset. This bond is backed currently by 790 individual jumbo mortgage loans. The average FICO score of the mortgagors is 730, the average age of the loans is 30 months, the average loan size is $700K, and the average original loan-to-value ratio was 68%. All of the loans are so-called 5/1 hybrid ARMs, which means that they have a fixed rate (average is 6.3% for these loans) for 5 years, and then they reset to a floating rate (which is on average Libor + 2.2%) for the remaining 25 years.

These are pretty good loans, solid loans, to wealthy people living in expensive neighborhoods. The current loan-to-value ratio is obviously much higher than 68% right now because home values have declined even in good neighborhoods, but it's certainly not over 100%. The performance of the loans has been deteriorating modestly over the last year, and the percentage of delinquent loans is now 7.3%.

However, the particular bond mentioned above (the 1A1 class) is the supersenior bond in the deal structure. It has over 10% credit protection from other bonds in the deal which are subordinate to it. So for this bond to take its first dollar of principal loss due to foreclosures, the mortgage pool would have to suffer over 10% realized credit loss. Given that the average loss severity on a foreclosure for this deal is less than 50%, you would need at least 20% of the loans to default to touch the supersenior bond. In recognition of this fact, S&P and Fitch still assign this bond a AAA rating, although Fitch has had the bond on negative credit watch since August 2008.

The 1A1 bond is paying a 5.9% coupon and has been averaging about 1.5 pts (i.e. 1.5%) of principal paydown each month. Even in an extremely pessimistic scenario, it won't take more than 10 pts of principal loss total. If it was Fannie Mae guaranteed, this bond would probably be priced higher than 103. How much would you pay for this bond?

Well, I paid 54.5 cents on the dollar for this bond two weeks ago. It was offered at 59, and I bid 52.5 to start. In retrospect, I probably could have bought it lower. If this bond returns less than a 12% per annum yield over the next 4 years, I'll buy a hat and then eat it.

Another point -- it's absolute garbage that nobody knows how to price this ... garbage. This stuff trades. The problem isn't so much lack of transparency; it's that the prices are ridiculously low. It is as if the risk-free interest rate is 12% in the non-agency mortgage backed securities world and 1% everywhere else. If the government really thinks that these assets are clogging balance sheets, then it should hire some smart unemployed Wall Street bond traders and start buying this stuff up. I figure the government will get a couple billion dollars worth before the effective "risk-free" interest rate in this sector collapses to less than 5%. The market will heal, new loans will make sense again, and the government will turn a profit to boot.

S&P hits new low as Nero pours kerosene

2009-02-23T13:51:00.000-08:00

Two news items struck me as the S&P index hit an 11-year low today -- yet more proof that our political leadership is not up to the task of addressing the economic crisis.

First, our dear leader called for fiscal restraint and cutting the deficit in half, indicating that he will "continue the failed policies of the last" 20 years and view the national debt as a "burden." Does anybody in Washington understand fiat currency economics? The private sector is starving for net financial wealth (dollars or treasury bonds -- same difference), and the administration is worried about the deficit. Oy!

I think part of the reason people are confused about this is that there has been an unfortunate conflation of government spending (which is generally bad) and government deficits (which generally are not). Government spending is generally bad because it means that significant economic resources are allocated (inevitably inefficiently) by politicians, lobbyists, and bureaucrats. But giving money to people, via either transfer payments or tax cuts is not resource allocation. Money comprises little green pieces of paper or bytes in a computer. Nobody is being forced to build a highway in West Virginia or a bridge in Alaska to get a check.

The stimulus bill is an abomination (an Obamanation?) mainly because instead of directly getting little green pieces of paper into the hands of the private sector it tries to do it indirectly over many years through government spending. Even the non-spending parts of the bill, e.g. expansion of benefits for the unemployed (which encourages people to stay unemployed), or aid to state governments (which encourages the expansion of government at the state level), provide the wrong incentives.

Warren Mosler (http://www.moslereconomics.com/) and others have been calling for suspension of the wage tax for 2009. That would be an excellent start. It gets money into the private sector fast and incentivizes work. I have no doubt that if this plan were implemented, the S&P would rally 20% within a week.

The second interesting news item was a report that the execrable Harry Reid was on CNBC talking up investment in alternative energy as priority number one. The world is fast-moving these days, and it seems to have left poor Harry far behind -- about 7.5 months behind. We are awash in oil, despite the sub-$40/barrel price, the supply of domestic natural gas is spiking (google around for Terry Engelder and Marcellus formation), and demand for everything is falling off a cliff. Harry and the rest of his minions remind me of the metaphor about rearranging the deck chairs on the Titanic. Only instead they are installing solar panels on the roof and clean coal technology in the boiler room.