Deepish Thought

Harvard economist Greg Mankiw supports the “plague on both your houses” view of Congress’ role in the Freddie & Fannie fiasco.

Events are moving so quickly that this post is already two massive bailouts behind the times. However, the quasi-nationalization of Freddie and Fannie is such a significant event in the history of finance and government that it bares belated comment.

One of the (many) great tragedies of the Bush administration is that its reputation for untrustworthiness, incompetence, and blatant political hackery became so overpowering that people stopped listening. So on the rare occasions when the administration displayed the foresight so conspicuously lacking in Iraq and New Orleans, nobody listened.

The Bush administration repeatedly warned that Freddie Mac and Fannie May were dangers to the stability of the financial system. Congress, determined to show that the administration doesn’t have a monopoly on self righteous, arrogant bungling, and always mindful of the flow of campaign contributions, chose not to listen. The result is that taxpayers are on the hook for Freddie and Fannie’s losses.

Congress has (shamefully) shown itself to be not so very different from the administration. When it came to Freddie and Fannie, Congress chose to believe what was personally and politically convenient, regardless of the evidence. Faced with a crisis, Congress reached for the quick fix solution of having Freddie and Fannie expand their operations, without considering the risk. Ignoring outside advice they took their cue from lobbyists who wanted to use the housing crisis to help Freddie and Fannie escape the restrictions imposed as a result of their respective accounting scandals.

Finally, Congress appears to be dead set on learning nothing from the experience. The political groundwork is already being laid for the resurrection of Fannie and Freddie. No doubt bigger, more political and even less transparent than before.

Perhaps the most depressing aspect of this whole sad saga is that it really deosn’t seem to matter much who controls Congress.  Between 2002 and 2006 the Bush administration and the Republican Congress put on a master class in bad government. Sadly, it appears from their recent performance that congressional Democrats were taking notes.

One of the things that has always struck me about the US is what a spectacularly wealthy country it is. Or alternatively, how pathetically poor New Zealand is by comparison. Occasionally data crops up that depressingly reinforces this impression.

The cunning cartographers responsible for this map of the US have replaced the name of each state with the name of a country that generates similar GDP.

Embarrassingly, it turns out that New Zealand’s GDP roughly approximates that of Washington DC (population 580,000, area 177 square km).

I just came across this intriguing article on using the dollar auction as a model for understanding the war in a Iraq. This is not the only applicable economic model. For example, you could gain insight into the administration’s decision making on Iraq by considering the Asset Substitution Problem.

Imagine a firm that is mostly financed by debt. The bondholders of the firm will tend to prefer that management adopt a conservative strategy, in order to maximize the chance that the debt will be paid off.  However a conservative  strategy has little appeal for shareholders, since low risk implies low return and thus low net profits.  For this reason the shareholders will tend to prefer higher risk/higher reward strategies, since these increase the probability that there will be something left over after the debt has been paid.

Since the shareholders control the firm, they can have management adopt a strategy that increases the chance of losses for the bondholders in the hope that there will be some return to the shareholders. In effect, the shareholders can choose to gamble with bondholder’s money.

Applying this model to the situation in Iraq, the American public are the bondholders while the the administration takes the role of shareholder.

At this point the President’s reputation is pretty much shot. If he adopts a conservative strategy in Iraq, say phased withdrawal, his administration will almost certainly be remembered as one of the worst in US history. If however he adopts a riskier strategy, like continuing the surge, there is a slight chance that the situation will turn around, which in turn might redeem his standing.

From the President’s perspective there is nothing to lose, his reputation already being shot, and everything to gain. A small chance at redemption is very much better than no chance at all. It should thus not come as a surprise that the President is vigorously opposed to any admission of defeat in Iraq.

It should also not be surprising that the American public, who will ultimately carry the cost of the much more likely negative outcome of gambling in Iraq, are less than enthusiastic about doubling down.

In the commercial world bondholders control the gambling tendencies of stockholders through including covenants (contractual limitations on management) in debt agreements, which is generally effective.

In the political sphere, Congress is supposed to counter any executive tendency towards gambling with the lives and treasure of the nation. However, with the focus on not appearing soft in the run-up to the 2008 election, there seems to be little stomach in Congress for reigning in the President. For the moment it appears that our only alternative is to hope that the President’s gamble pays off.

I just watched Thomas Friedman, in a particularly insightful interview with Jim Lehrer, give an excellent explanation of why putting a price on carbon is important if the US is even remotely serious about addressing global warming. It went a little bit like this:

Imagine I came to you 25 years ago (before cell phones) and said, “I have this brilliant new product. For just a $1000 I’ll sell you a phone with no wires that is small enough to carry around in your pocket. It’ll change your life.” You might say something like, “Well a $1000 is a lot of money, but you know what, this will change my life – I’ll buy one”. I could then take your $1000, do some more research, and then come back a year later and say, “You know that phone I sold you, well now I have a smaller, better one – only $850″ and so on. Pretty soon everyone would have a cell phone.

Now imagine I came to you and said, “You see these lights in the ceiling here. They cost you about $100 a year to run. Well I have a new, carbon free way to power those lights. It’ll only cost you $150 a year.” What would be your likely response?

Unlike for the cell phone, the low carbon power supply won’t improve your life in any obvious way (unless global warming is actually keeping you up at night), so there is very little incentive to pay extra for the low carbon alternative.

Now imagine that the cost of carbon externalities were being included in the price of energy and I come to you and say, “You see these lights that cost you $160 a year. Well I have a new, carbon free way to power those lights. It’ll only cost you $150 a year.” What would your response be now?

Of the two scenarios, which is more likely to result in a low carbon energy infrastructure in the US?

There are a couple of ways we might include the environmental costs of CO2 in the price of energy. A carbon tax or a system of tradable carbon credits.

A carbon tax is politically difficult for any politician to advocate because it would (obviously) raise the price of energy. However there is an approach that might make a carbon tax politically viable. Harvard economist Greg Mankiw has suggested that the US could replace FICA taxes (payroll taxes that fund Social Security and Medicare) with a carbon tax. This might work politically because the total tax burden wouldn’t increase. It is particularly attractive economically because it would shift the burden of taxes from an economically positive activity (work) to a negative externality (global warming).

The main problem with a carbon tax is that it falls evenly across all CO2 producing activities. The result of such a tax is likely to be a modest reduction in emissions, through higher prices reducing demand and motivating efficiency improvements, across the whole spectrum of CO2 generating activities. This is not an economically optimum result.

From an economic perspective we would like to maximize the economic value we get from utilizing the limited resource that is the environment’s ability to safely absorb CO2. In other words, we would like for whatever CO2 emissions we find acceptable to be associated with those high value activities where avoiding emissions is either difficult or prohibitively expensive.

In order to achieve this result we need a system for allocating our carbon emissions around the economy. This is the genius of tradable emissions credits. By creating a market for trading CO2 emissions we would also be creating a mechanism that allowsthe economy to reorganize itself in order to to achieve maximum output for the allowable level of CO2 emissions.

This is not simply pie in the sky economic theory. A cap and trade system has been used very successfully to control SO2 emissions in the US. Under this system the government allocated a fixed supply of pollution permits amoung SO2 emitters. Permit holders that managed to reduce their emissions at reasonable cost were then able to sell their excess credits to organizations that faced more expensive constraints. The system led to a rapid reduction in SO2 emissions in the US at very little overall cost to the economy.

Despite its success, the SO2 system is not without issues. Simply allocating emissions credits to existing polluters is a somewhat questionable approach. It distorts the market in favor of existing SO2 generating activities, which receive credits for free, over possibly higher value new activities, which would have to buy them. This wasn’t a big issue for SO2, which is created by a limited number of activities, but would be a significant problem if the same approach were applied to CO2. In addition, the system potentially created an incentive for companies to increase SO2 output prior to the start date so as to receive higher emission allocations when the system got under way.

Quite apart from these criticisms, an SO2 style cap and trade system for CO2 would not generate any new sources of government revenue, which would mean foregoing the non-environmental benefits of Mankiw’s tax approach.

Fortunately, there is a way of combining both approaches in order to achieve maximum economic benefit. Instead of simply allocating CO2 credits to existing polluters, the government could have an annual auction of credits for the coming year (the credits being subsequently tradable). The revenue from this auction could then be used, as carbon tax revenue would have been in Mankiw’s proposal, to replace FICA taxes.

In addition to being economically sound, this proposal combines six great political selling points, adding up to across the spectrum political appeal:

1. No net new taxes
2. Higher employment (through eliminating tax on employment)
3. Harnessing the power of the market
4. Rewarding innovation
5. Punishing polluters
6. Aggressively combating global warming

The question is whether there are any politicians out there, especially viable presidential candidates, who would be willing to champion such a radical approach?

Having wasted a good part of the morning watching CNBC, I now know that practically everyone involved with Wall Street wants, needs and expects the Fed to cut interest rates. What I don’t know is whether, objectively speaking, this is really a good idea.

From Wall Street’s perspective a rate cut is a no-brainer. If the Fed declines to act a great many investment bankers, hedge fund managers and other assorted masters of the universe will suffer from severely depressed annual bonuses, which could disastrously affect the sales of designer handbags and German sports cars.

Looking from outside the hot house of Wall Street the case for a cut looks somewhat more ambiguous. On one hand there is obviously a danger that the problems in the credit markets will spill over into the real economy. On the other the Fed risks creating significant ‘moral hazard’ problems if it starts stepping in to prop up the markets every time investors get into trouble after making questionable decisions. In addition, a rate cut could cause a slide in the value of the dollar, which in turn could re-ignite inflation. Perhaps even more important, a significant rate cut could diminish Wall Street’s incentive to sort out the significant problems in the mortgage backed securities market.

While I would hate to see the economy tip into recession, I would also hate to see the clearly dysfunctional mortgage industry avoid a much needed shake out.

Some interesting insights into inequality and unhappiness. Particularly interesting given that inequality will likely be a big issue in the democratic primary and possibly in the 2008 election.

This week the New Zealand stock exchange ‘shockingly’ came out in favor of looser monetary policy. The main reason the NZX is pushing this ‘bold’ reform appears to be that interest rates are inconveniently high.

The NZX50 has essentially doubled since 2003 despite New Zealand consistently having some of the highest interest rates in the OECD. Unsatisfied with this very solid performance the NZX has apparently been watching the low interest rate fueled Dow over the past couple of years and come to the conclusion that things could be even more fun if only those killjoy central bankers weren’t so fixated on controlling inflation.

Of course Wall Street hasn’t looked so hot over the past couple of weeks. The resulting panic has also knocked around the NZX, which suggests a second reason that NZX management may be interested in monetary policy reform. They may be trying to create a kiwi version of the ‘Greenspan Put’. Essentially a Reserve Bank that takes a ‘balanced view’ would chop interest rates whenever the markets take a tumble, helping to mitigate losses. Such a policy reduces the risk inherent in the share market and thus tends to increase valuations, which wouldn’t upset the NZX in the slightest.

While a ‘balanced’ monetary policy may well be in the best interests of the NZX, a come what may attitude to inflation has some serious downsides. Contrary to some reports inflation is very far from dead. In fact it is likely to be back about thirty seconds after we conclude it doesn’t matter anymore. To paraphrase a famous quote, ‘The price of stable money is eternal vigilance’.

Inspired by reading a review of Bryan Caplan’s book, “The Myth of the Rational Voter: Why Democracies Choose Bad Politics“, I have decided to take on the herculean task of attempting to justify democracy (I am such a hero).

Mr Caplan has apparently taken a careful look at the voters who form the bedrock of the democratic system and come to the (some would say obvious) conclusion that democracy is built on very shaky ground. This is not an entirely new idea. Winston Churchill clearly anticipated Mr Caplan’s case when he observed that, “The best argument against democracy is a five minute conversation with the average voter.”

The problem with Mr Caplan’s argument is the implied assumption that we should expect good government from democracy. Good government, whatever that may be, is far too lofty a goal for any political system. Certainly, I’m not aware of any such system that has consistently provided it.

Flawed as it obviously is, democracy does have two very important benefits that justify Mr Churchill’s other famous observation, “It has been said that democracy is the worst form of government except for all the others that have been tried.”

Firstly, while it does not by any means guarantee good government, functional democracies are reasonably effective at moderating bad government. The worst governments tend to be those in which one narrow section of society is able to seize control and relentlessly pursue their own interests. In a working democracy, the need to capture majority support means that the government is always a coalition of interest groups (although these interest groups may all belong to one “broad church” political party). These interest groups may all want to pursue dubious policies, but they don’t ever all want the same dubious policies. The resulting tension between interest groups within the ruling coalition tends to prevent the government from careening off the rails in obedience to the desires of one narrow section of society.

Secondly, democracy provides a means of transferring power between different groups without resorting to firearms. Whether for demographic, economic, social or technological reasons all societies from time to time experience shifts in the balance of power. In non-democratic countries these shifts are often accompanied by violence, as new power structures forcibly supplant the old. In functional democracies however voting provides a signal to the existing regime that it is time to go. The quid pro quo for a government that accepts the will of the voters is not being subject to retribution from the new regime, and in fact having the opportunity to regain its former perks at some later date.

Since the consequence of losing power in democracy is merely a period of opposition followed by a probable return to power, there is very little incentive for the ruling group to resist being dumped out of office. For this reason there tends to be very little political violence in genuine democracies, an observation that is sadly not true for most non-democratic states.

So while democracy may be a decidedly mediocre system of government dependent on the will of disinterested, ill informed and often wildly irrational voters, it at least avoids the worst pitfalls of the known alternatives.

One of my favorite economics lecturers* once posed a very interesting question.  Why do most house break-ins happen on the poor side of town?

There are several possible answers to this question such as convenience, fewer alarm systems and less police interest.  Another explanation, which had never occurred to me, is that the poor side of town is where all the cash is found.  Wealthy people have bank accounts and credit cards, so they tend not to have a lot of cash lying around.  Poor people on the other hand are often un-banked.  All of their income is either in cash or immediately converted into cash, which they store in their homes.

Breaking into the homes of rich people is often not especially profitable because the goods the thief steals have to be converted into cash via a fence at a rate of cents on the dollar.  Cash stolen from the homes of the poor however, can be spent at full face value and is a lot more convenient to carry.

All of which raises the interesting question of why don’t the poor get bank accounts.  The short answer is that there are fewer banks on the poor side of town.  Banks tend to avoid poor neighborhoods because the deposits are smaller, the creditworthiness of customers is lower and customer service cost higher (especially in immigrant communities where English proficiency is low).

Regulations do exist that attempt to force banks to provide services in disadvantaged communities, however the relative lack of banking services in really poor communities suggest that these measures are at best partially effective.

Fundamentally, government mandates that force businesses to engage in unprofitable operations tend to be unstable for several reasons.  Firstly, the businesses tend to take any opportunity to minimize or close these operations.  Secondly, the oversight agencies tend to be captured by the industries they regulate.  If government officials are recruited from and tend to retire to the industry they oversee it isn’t difficult to predict where their sympathies will lie.  Finally, the regulations tend to be chipped away over time through industry lobbying.

It would be far better if someone came up with a profitable, and thus long term sustainable, model for banking low income communities.  Eventually someone will.  While poor customers may not be that valuable individually, in aggregate that represent a potentially enormous source of new funds and new loan opportunities.

From a historical perspective, Bank of America is now the nation’s largest retail bank at least in part because its founder, Amadeo Giannini, went after middle income customers that his competitors of the time considered too small to bother with.

Perhaps there is a  similar success story awaiting the person who figures out how to profitably provide banking services to poor Americans.

*Dr Michael Brandl of the at the University of Texas (http://brandl.easyjournal.com/)