Saturday, June 26, 2010

New Yorkers Against Unfair Taxes

Today I saw a beverage delivery truck with a brief advertisement for "New Yorkers Against Unfair Taxes," a group that opposes beverage taxes. I couldn't help but immediately, in my head, run through the pros and cons of the group's likely position, in addition to the irony in its beliefs.

Let's start with the basics of taxation in general. Taxes are always destructive because they are taken from the only segment of society that produces wealth, the private sector. This is not to say the government does nothing with the money it receives in taxes, but rather to say that the private sector uses money efficiently since it only receives money on condition that its services are desired (the private sector does not simply take money from anyone against their will, only the government is permitted that power through taxation). So we score one point for "New Yorkers Against Unfair Taxes" because they appreciate the danger of a tax.

Now we need to get more nuanced. The group explicitly opposes beverage taxes for a number of reasons that correctly reflect the harmful nature of taxes (jobs are at stake, economy is in a recession, etc.). But are beverage taxes the only type of dangerous tax? Of course not, the group is simply comprised of individuals whose interests are aligned with the beverage industry and so their primary concern is about beverage taxes. The detrimental implication here is that the only harmful tax is the beverage tax, an untrue and misleading sentiment.

What about the name of the organization, which purports to be against unfair taxes? How does one differentiate between a fair and an unfair tax? If I were forced against my will to provide a useful definition for a fair tax, I would probably say it is a tax that everyone pays at the same amount (we're all human so there is no reason why one human should bear more or less of a tax than any other human!). Ironically, since the beverage tax is a sales tax, it is precisely that (a tax that everyone pays at the same amount), yet the group claims it is unfair. The shame here is that the group is correct in opposing the beverage tax, but also appears to be approaching the issue from the wrong direction.

And so now we should elaborate on that wrong direction. Is it even possible for any tax to be a fair tax? One could hypothesize that the notion of "fair beatings with a baseball bat" could be described as hitting everyone with the bat equally hard and doing it for the same amount of time. However, it seems like one should also ask the question of whether there is any fairness in administering the beatings in the first place, however fair they might be. And so I would pose the questions: on what grounds can any institution in society forcefully extract wealth from individuals who haven't even done anything wrong? Why is the issue here this tax as opposed to taxes?

I sympathize with "New Yorkers Against Unfair Taxes" because it looks as though the heart of the organization is generally in the right place. A beverage tax would indeed be harmful for a whole slew of reasons, especially in the midst of a serious economic downturn. However, the group should think through its beliefs and take those beliefs to their logical conclusions. That is, all taxes are destructive for the same reasons that the beverage tax is destructive. I would guess that with enough thought and without the desire to come off as "reasonable" to the public, the group could one day come to that very conclusion. Don't worry, I won't be holding my breath.

Monday, June 21, 2010

Vindicated on Obama's Mortgage Program

On February 25, 2010 I posted about a ridiculous program that President Obama initiated to try to ban foreclosures. It didn't take much foresight on my part to predict it would fail.

As absolutely shocking as this might sound, the program has turned out to be a failure.

Friday, June 18, 2010

How to Save the World

After more than two years in the midst of the worst downturn since the Great Depression, we have finally found the cure to all of our ills. This cure was not arrived at easily. It required painstaking effort on the part of one man. This one man dedicated countless hours to deep and dedicated research of world history, as well as an unconscionably thorough analysis of the world's most recent advances in all fields. But we have finally been saved by President Obama.
President Barack Obama on Friday urged other G20 countries to boost domestic demand and in-crease exchange rate flexibility to encourage global growth and rebalance the world economy.
I will not even glorify the absurdity of this statement with a rebuttal of my own. Modern economics is dead and this is yet another perfect example.

Tuesday, June 15, 2010

Wait, who is the barbarian/kook/loon?

A few weeks ago I watched Off the Grid: Life on the Mesa, a documentary about a community living in the desert in New Mexico. The inhabitants, while diverse in many respects, all share the desire to get away from modern society. Specifically, their gripe was with the existence of government; they all just want to be left alone.

I sympathized with the predilection for freedom, but could not help feeling horrified and a bit disgusted with the conditions that these individuals live in. We are literally talking about people who did not appear to shower, who live in various enclosures (none of which qualify as a house by even the most primitive standards), and who spend their time simply trying to survive (which they do successfully if the word survive is defined in its absolute most basic sense of "continuing to be alive").

But there was one quote by a woman being interviewed that blew me away when I heard it. In fact, although the quote blew me away a few weeks ago when I heard it, only now do I realize how much more significant it really is.

To paraphrase, the woman stated that there aren't many rules on the "Mesa," other than that you are expected not to kill anyone or steal from anyone. Think about that. These individuals have figured out that a community of people could live by just two rules. They don't need rules about what to believe, how to spend their wealth, what to do in their free time, what not to do in their free time, who to help, who not to help, etc.

What impressed me about the quote a few weeks ago is that it essentially represents exactly what I think. That is, aside from individuals not causing each other physical harm or stealing from one another (the definition of actions that I consider to be wrong/immoral/unethical), what other rules could you possibly devise that wouldn't simultaneously infringe upon those first two rules?

What made me decide to post about this documentary now is that individuals who live under circumstances that would scare the daylights out of just about anybody, have managed to live under just two rules, while the rest of society with all of its advances and luxuries, can't seem to do the same.

I am sure there are objections to the above statement that all amount to "the reason why our society is so advanced is because of all the rules and the reason why their community is so primitive is because they lack rules." There is just one big problem with that belief. The concept of rules is that they exist to prevent something worse from happening that would happen were it not for the existence of the rules. The ideal is obviously to have no rules, assuming of course that everyone acted properly with no conflicts arising. So it seems to me that one of the most basic marks of a society that should call itself advanced and modern, is that it have as few rules as possible, to reflect the fact that it is... advanced and modern since conflict is minimal so rules aren't really necessary.

What it all comes down to is sort of an embarrassment. A bunch of dirty and unsophisticated individuals are living in New Mexico in a more advanced and modern manner than the rest of us. Take away the material differences and that's really what it comes down to.

Monday, May 24, 2010

Intellectual Consistency #2

Does there ever come a point at which each person would question the necessity for the existence of government? Notice, I am not asking if it is preferable; I am only asking if there is something (i.e. a law, action, prohibition, requirement, etc.) that the government could "do" that would make each person question its very existence.

I am asking because the recent financial crisis has supposedly shown that the free market has failed (I say supposedly because I don't believe this to be the case at all). As a result, the assumption is that we require government supervision and regulation to fix it. So in order to remain consistent, it seems like there should be a parallel standard for the government; that is, if the government fails at something, we should take away its ability to continue doing it.

It seems to me that there are more people who would instinctively criticize the free market for something, and automatically say the government should fix it. In fact, I would bet there are more people that would advocate total government control (from a perceived omnipresent failure of the free market), than would advocate a total free market without government at all.

At the end of the day, I'm not curious about whether a person would ever believe having no government is plausible or preferable. What I am curious about is if each person has the intellectual consistency to at least say "since each failure of the free market warrants an increase in government intervention, that means that each failure of the government should warrant a decrease in government intervention."

Of course, I'm not optimistic about this being the case. No matter how many times the government makes a mistake, the reaction is always that we need more government to prevent the mistake from ever happening again... until it inevitably happens again. Not to mention, how often do people even admit that the government made a mistake, and not react as though the government is a clumsy child (i.e. by properly saying "I've had enough, the government is no longer permitted to do this ever again," rather than the typical reaction which is something to the effect of "Awww, it was just poorly implemented and an honest mistake, it won't happen again if we give it the resources to do X").

So I really want to know: if you have any intellectual consistency, what would it take for you to think that the government is a nuisance through and through and should no longer exist? Or let me make it more pointed: if we theoretically established and agreed beyond a reasonable doubt that everything the government does is harmful, would you then admit that it should not exist, or would you continue searching for ways to make it less harmful?

Sunday, May 23, 2010

Conflict Resolution: The Non-State Alternative

This is just an anecdote which probably won't be very convincing, but the point is it got me thinking. This morning I walked to my local deli to get breakfast. I placed my order and walked over to the cash register to pay. The total was $10.90. I handed the cashier a credit card only to find out that their machine was broken. She asked if I had cash and after searching in my pocket pulled out exactly $9. She then asked if I was willing to use the ATM machine to get enough to pay the bill. Knowing the ATM machine would charge me anywhere from 15% - 20% of the cost of the meal itself, I politely declined. We both stood there somewhat awkwardly while the chef continued to prepare my meal, unaware of the situation. After a few seconds I proposed giving her the $9 now, and paying the remainder in a week since I visit this deli for breakfast literally every single week. In fact, to make my offer more convincing, I told the chef (who knows me) that I would pay them an extra $1.90 next week when I'm back again, to which he immediately replied "no problem," and turned back to the grill knowing how minor of an issue it was since we see each other every week.

After everything was resolved, I walked out and thought to myself: how could the government possibly improve upon this situation?

I realize that many people believe the government is only useful in circumstances of serious conflict (which this clearly was not), but there are plenty of people who believe there really isn't any situation at all that could not potentially be improved by the government, hence my inquiry.

One action the government could have taken would be to institute a law requiring that if an individual is unable to pay the entirety of any bill at the moment of sale, that individual may not purchase the product or service at all. Under this scenario, my deli would end up not selling its food for less than it typically considers necessary, a situation which appears positive at first glance. But in addition, I would probably leave disgruntled, and the deli would probably have lost a considerable profit (even assuming I never came back with the extra $1.90). I might even decide never to come back there for breakfast again after being frustrated that a situation seemingly so easy to resolve in one of a million ways, instead had to be resolved with my walking out food-less and the deli remaining money-less.

Another action the government could have taken would be to institute a law requiring that if an individual is unable to pay the entirety of any bill at the moment of sale, the seller is required to negotiate a deal and is subsequently required to make the sale. Under this scenario, I would end up with my food after paying less than I normally would, which appears positive at first glance. But in addition, the store would resent my not bringing enough to pay the whole bill, and the store would also resent being forced to negotiate with someone that did not bring enough to pay the whole bill. The next time I return to the deli, the chef might decide to add something "special" to my food, if he were angry enough. Or if I were still willing to risk tainted food and come back to the deli again anyway, I might be incentivized to bring less than the total bill (this time on purpose) knowing the deli is forced to negotiate with me.

Think about what was achieved this morning without any laws: I had less money than I needed, the deli still made me my food, I will eventually make the deli whole, and both the deli and I will continue to do business with each other in the future. This might seem insignificant, but it is just one example of the many different types of conflict we face in society every day. It is also just one example of how people are perfectly capable of negotiating arrangements that allow for long-lasting relationships, without anyone else or anything else having to guide them along the way.

The most telling aspect of what happened this morning is the fact that the government could have instituted a law mandating to take place exactly what did actually take place without a law, and yet that mandated law solution would still be sub-optimal. The difference is that when nobody is forced to do something, there is greater potential for future friendly relations even if a somewhat unpleasant negotiation takes place. On the other hand, when one party is forced to do something against its will, the other party might benefit, but the first party might decide to never engage again with the second party going forward, or at the very least bear resentment forever more.

When the means employed is communication and negotiation, there is of course no guarantee that each party is as satisfied as it could be under the most ideal situation. However, there is a guarantee that each party leaves the encounter knowing it did its very best without anybody being forced to, and as long as the two parties leave the encounter without killing each other (which is most likely the case), there is a good chance they might interact with each other again in the future (or maybe they choose not to, but we surely don't need an institution to tell them to do so or not to do so). Only when force is used is there potential for eternal conflict. Is that what we want?

Wednesday, May 5, 2010

Intellectual Consistency #1

The number 1 in the title of this post is there because I foresee writing many future posts about the same topic. The idea of intellectual consistency is about applying similar standards to similar situations. It seems very straight-forward but as this future series of posts will demonstrate, it isn't always straight forward.

The first example I would like to give about intellectual consistency pertains to the regulatory reform being proposed in response to the financial crisis. The specifics of the reform is actually irrelevant here. The idea I would like to put forward should really not be very earth shattering: if individuals in the private sector have agendas based on their personal biases, incentives, and goals, the individuals in the public sector face the exact same thing.

What all the reform proposals are asking people to do, is assume that while individuals in the private sector have a set of pursuits called X, the individuals in the public sector have a set of pursuits called Y. Though the private sector is motivated by gain, the public sector is motivated by altruism. I am sure there have been many books written about the corruption in government so I won't bother to rehash it here. While the salary for a public official is, strictly speaking, not always the best (although in many instances public sector salaries are better than private sector salaries, though I would imagine for highly specialized jobs the private sector trumps the government sector), there are plenty of other benefits to working in the public sector. Power. Financial compensation "on the side." Power. Fully-paid-for invitations to fancy gatherings with other public officials. And power. Don't tell me for a second those are just minor harmless altruistic perks.

If those who propose regulatory reform want us to believe that a bunch of wildcat bankers went over the top which caused the economy to end up where it is now, then that automatically should trigger in everyone's mind the fact that politicians can also go over the top and cause our economy to end up in a very similar place. There can be no double standard. The wildcat bankers are human and so are the politicians. They are either both susceptible to doing bad things, or neither is susceptible to doing bad things. By the way, here is one of those altruistic things that the public sector does.

What I consider most important to address here though is how the results of these potentially bad actions from the private sector and public sector are actually dealt with. In general, if someone in the private sector makes a mistake, he has to pay for it in some way. CEOs that generate poor performance for a company are fired. Traders who make a wrong bet lose money. The random individual who falls asleep at his job gets fired. I am obviously ignoring failures that would take place in the private sector, but don't, because the public sector chooses to bail them out; just don't forget it is the public sector that protected that failure.

How does the public sector compare? When the government failed in preventing the financial crisis in any way, it asked for more oversight. When the government fails to efficiently use the only resources it promised it needed for a program like [insert literally any government program here], it asks the people for more money. The public sector apparently is the only institution that deserves to thrive on failure.

We need to start applying intellectual consistency to both the public and private sectors. This means recognizing that all the faults in the private sector are replicated in the public sector. The only difference is that the private sector is constantly (and properly) being made to pay for mistakes so they don't happen again, while the public sector, as a matter of policy, gets rewarded every time it screws up.

Wednesday, April 21, 2010

Is Full Disclosure the Solution?

Goldman Sachs is being sued by the SEC for details related to the sale of a collateralized debt obligation that might or might not have been truthfully or dishonestly disclosed to clients. This latest hoopla in the financial services industry brings to mind a belief that has plagued, and will always plague, the investment business: with enough disclosure and/or information regarding an investment, an individual can be fully protected from disaster.

While investment practitioners, statisticians, and economists have correctly understood that risk can be minimized while uncertainty can't (an idea first proposed by the economist Frank Knight), there is something very different about when the government (or one of its appendages like the SEC) markets itself as the protector of investors. The difference is that the government is implicitly claiming it can protect against something (through "uncovering" bad practices, or making things "fully disclosed," or creating "transparency," etc.) that it can't. Who could possibly be helped by a false sense of security?

The government is treating the issue of what Fabrice Tourre did and did not disclose to investors as though it makes a difference. It does not. When an investor makes a decision to buy or sell a security, he implicitly assumes that the person who is buying or selling the security from him, knows less than he does (if the investor thought the person buying or selling the security knew more, our investor would not make the investment!). Whether or not an individual or entity related to the investment really does know more or less than the investor, still does not change the fact that uncertainty might prove that investor wrong, regardless.

A perfect example is real estate which everyone "knew" goes up indefinitely. If the government had successfully made sure everyone involved in real estate transactions was being honest, would that have saved them when the real estate market crashed? No, it would just give them one less thing to complain about when it came to a bad decision they made. The issue of loss is what is driving investors (and the SEC, which is trying to cater to investors) to cry "fraud" when they never would have cried "fraud" if their investments went up rather than down. From a legal standpoint, either both of the two possible circumstances (gain or loss) is fraudulent or neither circumstance is fraudulent.

But what if knowledge, that the investor's counterparty is very smart, will make the investor change his mind (a question I anticipate will arise from the statement I made about how investors implicitly assume their counterparty knows less)? This is entirely beside the point when it comes to legality. Should law really be based on the perception that an investor might or might not have about the person he is doing business with? How do you prove perception? What if an investor knew that Paulson (to take the actual issue the SEC is dealing with right now) was on the other side of the trade but thought that Paulson is stupid? If our investor lost money in that instance would it no longer be fraud just because the investor knew about Paulson, thought he is stupid, and therefore made the trade anyway? Or what if our investor didn't know Paulson's identity, still made the investment, and made money? Would the SEC still complain? Should laws pertaining to financial markets then be based on whether an investor makes money? Or what if investor's don't know that their counterparty's grandmother's best friend's cousin is an astrologer who believes the investor is making a horrible mistake (and this astrologer has a great track record too!)? There is an infinite amount of detail that could be disclosed to an investor, none of which changes the fact that the investor needs to know there are lots of ways he might lose money. Disclosing information about a counterparty, what that counterparty thinks, or what that counterparty ate for breakfast, is entirely immaterial.

But there is still a bigger problem here alluded to in an earlier paragraph. The very existence of the SEC gives investors a false sense of security when it comes to investing. We have seen that the SEC does not do its job because Bernie Madoff and countless others have pulled off various schemes that lost investor money (I might add that even when the SEC was tipped off about these schemes it did nothing). When investors are given a false sense of security as a result of the existence of a government regulator, they are more likely to make an investment... and then potentially lose money that they might have been less willing to invest if they knew nobody was claiming to protect them. As radical as this idea might sound, would it be worse if no entity existed to supposedly protect investors (which obviously the SEC doesn't even do, but unfortunately people think it does) thereby making investors fully aware there is a very good chance of loss from any number of unanticipated events? I would argue that under this scenario, most of the individuals who would still be willing to make investments would be the ones with a bigger risk appetite (a characteristic all investors, but not all individuals, should have!). The goal should not be to get as many people investing as possible (which is what entities like the SEC seem to be trying to accomplish). Investing should only be for people who have a risk appetite. Why are we trying to give the impression that with just enough disclosure of information or with a specific type of information, uncertainty can be taken out of investing (a venture extremely prone to uncertainty), when uncertainty can never be taken out of anything? Or why are we trying to say that X amount of disclosure is sufficient for there to be no legal problem, but a Y amount of disclosure (assuming Y > X) isn't necessary? Where is the cutoff?

This is all yet another example of the unintended consequences of government policy. Whether or not Goldman Sachs (which could be vilified for lots of other reasons, but not this one) disclosed information to clients about the beliefs of another party in an investment makes absolutely no difference here, or at the very least no legal difference. Investing is an activity inherently full of uncertainty and the more people realize that the better. This whole fiasco could have been avoided if investors were made to feel less protected by the government in their investments, something that abolishing the SEC would go a long way towards accomplishing. In fact, imagine for a moment that the SEC ends up finding Goldman Sachs guilty of fraud. Everyone will perceive that to be an example of how effective the SEC is at protecting investors. Well guess how that might affect the willingness of people to invest? So, are you really confident enough in the SEC to give those people that impression?

Thursday, April 15, 2010

Tuesday, April 13, 2010

How to Run a Successful Business: Send Out a Survey Every 10 Years

Imagine all of a sudden in your neighborhood a man standing outside a recently vacated building began handing out a survey. This survey contained the following question: If we dont know how many people live in this neighborhood, how do we know how many sandwiches we need? It then asked for you to write in how many people live with you. Here are some of the questions that, in turn, would probably pop into your head:

1. Why hasn't any other successful business in the neighborhood sent out a similar survey?

2. What does the number of people in the neighborhood have to do with how many sandwiches this apparent-future-sandwich-maker should make? If they are cheap, won't more people buy them, probably even from neighboring towns, and if they are expensive then fewer people will buy them? Why a survey with one question meant to provide an answer to something that is contingent on so many other factors?

3. Shouldn't the sandwich-maker be determining how many sandwiches to make as he goes along? Isn't it better to decide to make more sandwiches if after the first few rounds they all sell out quickly giving the sandwich-maker a big profit? Or to make fewer sandwiches if the opposite happens?

I bring up this anecdote because on my way home today, I saw an advertisement for the U.S. Census on the subway that said, "If we don't know how many people we have, how do we know how many trains we need?" I actually could not think of a more beautifully absurd example of why the subway system should not be run by government.

If the individuals who run the subway system are determining how many trains they need based on the census, there should be no surprise as to why the subway system is a loss-producing venture, in every single year of its existence. Literally.

A more reasonable method of determining output would of course be a profit and loss mechanism. But wait! Since the subway system is run by the government, there is no such thing as a profit and loss mechanism. That is precisely why they need to do the equivalent of "feeling around in the dark" by asking how many people there are in the area. If the subway system actually reacted, in the way a business would, to the fact that it produces losses year after year, it would have shut down long ago. In fact, a private investor or company would probably have bought the subway system and would be running it the way your local sandwich shop is run: keep operating as long as you make a profit (which means you are satiating customer needs) and innovate to try to make more profit (further satiate customer needs).

It is truly a testament to the capabilities of government agencies that they produced an advertisement like this which better than anything else displays ineptitude at its greatest.

Monday, April 5, 2010

Greenspan's Slip of the Pen

Alan Greenspan, also known as "The Maestro" (although for the amount of praise afforded to Ben Bernanke, the nickname might soon be stolen by the current Federal Reserve Chairman) has recently been working on an academic paper in an attempt to divert, rightfully or wrongfully, criticism directed at him for the financial crisis we currently face. His paper, called "The Crisis," rehashes many of the arguments he has made since the conclusion of his tenure as to the causes of the crisis, including securitization of subprime mortgages, the global savings glut, unfettered markets free of any semblance of regulation, and the rare black swan event (he calls it the "hundred year flood"). I didn't expect to extract much from his paper, which I assumed from the beginning would be just an aggregation of his previous arguments deflecting blame, until I came across two paragraphs near the end that were undoubtedly glossed over by the author himself, and made my jaw drop in their frank and profound implications.

Greenspan is discussing the role of monetary policy in potentially defusing bubbles when he writes,

There are no examples, to my knowledge, of a successful incremental defusing of a bubble that left prosperity in tact. Successful incremental tightening by central banks to gradually defuse a bubble requires a short-term feedback response.
But, policy impacts an economy with long and variable lags of as much as one to two years. How does the FOMC for example know in real time if its incremental ever-greater tightening is impacting the economy at a pace the policy requires? How much in advance will it have to tighten to defuse the bubble without disabling the economy? But more relevantly, unless incremental Fed tightening significantly raises risk aversion (and long-term interest rates) or disables the economy enough to undercut the cash flow that supports the relevant asset prices, I see little prospect of success.

Did you catch that? How does the FOMC for example know in real time if its incremental ever-greater tightening is impacting the economy at a pace the policy requires? I have another question to add to his astute observation: how does the FOMC for example know in real time if its incremental ever-greater loosening is impacting the economy at a pace the policy requires when times are tough? And here is another: how does the FOMC ever know the consequences of its policy actions that affect not just the United States but the entire world?

Greenspan would probably defend himself by saying that no actor in the economy ever knows what the definitive consequences of his actions might be, but of course that would ignore the fact that most actors in the economy face some sort of profit/loss decision-making process that the FOMC committee does not, and it would also ignore the fact that an individual actor's decisions (whether individual or corporation) do not affect the well-being of the entire world economy. Given Greenspan's slip of the pen, it might be time to substantively and radically reevaluate the role of the Federal Reserve knowing that unfortunately, the FOMC, through no deliberate fault of its own but rather through structural/institutional necessity, makes its decisions with blinders on.

Friday, March 26, 2010

But I don't want your help!

For lunch today I decided to pick up Chinese food from a very highly regarded restaurant in my area. As I approached the entrance, I noticed a group of people protesting outside. They held signs and chanted about how the restaurant employs sweatshop labor in sweatshop conditions. Though the restaurant happens to be a very nice one and therefore made it hard for me to believe it could qualify as a sweatshop environment, I mentally yielded the protesters the benefit of the doubt since I had not actually ever entered the kitchen. But by the time I walked into the restaurant, I had already thought of some serious problems with the protest.

The first problem was the irony inherent in the fact that it was protesters protesting and not the employees of the restaurant. Why is this ironic? If the employees found the conditions in the restaurant to be so horrific... they wouldn't work there! Don't walk an old lady across the street if she doesn't want to cross the street! Notice, this is not my attempt to make a statement about how the working conditions must be pleasant at the restaurant, it is to make a statement that employment at this restaurant must be the employees' next best option above all else, otherwise they would be working elsewhere. By protesting at the restaurant, the protesters are potentially risking the employment of the individuals they are supposedly trying to help.

The second problem is even more ironic than the first. Even if we grant that the working conditions are that of sweatshop labor, and that the employees are somehow miserable but choose to stay even if alternative options are better, what are the consequences of this protest? The protesters are trying to raise recognition of the conditions at the restaurant. By pointing this out, they hope that the restaurant will either improve conditions, or have customers choose to stop frequenting the restaurant in disgust to teach the restaurant a lesson. If the restaurant improves conditions, this might very well cost an amount of money that forces the restaurant to fire some of the employees. Are the fired employees now better off? If, on the other hand, customers stop eating at this restaurant, that means less of the good produced by this restaurant (food) is desired, and less labor input is necessary to produce it. Once again, some of the employees could get fired.

This analysis holds true for all protests that take place outside businesses. The well-being of the people the protests are supposedly trying to help is directly endangered by the protests themselves. In fact, the most beneficial act that an individual could do on behalf of an unhappy employee at a business, is to encourage more people to buy what the business produces. Only when demand for the business' product goes up is there a chance that the working conditions will get improved (or the employees will get paid more, or more employees will get hired, etc.).

Tuesday, March 23, 2010

Restricting Choice

We often appreciate having many options in the things that we do. There are different colors in clothes, different sizes in shoes, different lengths of time for massages, etc. Chances are, if anyone proposed limiting our decision-making in any of the just-listed goods/services, we would be very resentful. What if I don't want to choose between a red sweater or blue sweater, but instead want a black sweater? What if my feet don't fit into a size 5 or 15, but rather a size 10? Or what if I neither like to wear sweaters nor like to wear shoes? Instead, I prefer light jackets and sandals. But no matter how simple and logical all of this is, support for the recent health care reform bill seems to emanate from an alternate realm in which restricted options are actually the preference.

I can only think of one criticism of the above that could be offered as a reason for desiring fewer choices: what if not everyone can make a desirable choice and by limiting others' choices we could give everyone at least something? This is not a novel argument, in general. It has been used to justify various collectivist ventures throughout history, whether that be for a country as a whole or for a particular program within a country. The most important question to ask of such a proposal is how does the non-restrictive status quo in certain industries fare when it comes to concern for those who can't make a desirable choice?

We might as well use some of the examples listed above. With clothing, we don't just choose among colors, we also choose among different types. What do we know about the different types of clothing? For one, there are tons! There is clothing catering to the extremely wealthy (that often looks so fashionable the average person often hopes only a small segment of the population will even wear it), and there is clothing catering to those less well off. With shoes we see the same thing. And that goes for massages too, with both high-end spas in existence and cheaper spa-like operations offering their services too. Nobody's options are restricted in these goods/services, yet we see an abundant variety that could cater to just about everyone. We also have non-monetary transactions that take place like clothing donation and friendly massages, for those who either can't or don't want to pay.

So then why are there so many problems with health care? Well, the market for health care is not remotely close to as freely operating as the markets I just described. Just think about it. There are various medical associations with exclusive memberships that drive up the cost for everyone if medical providers are required to join. There are pharmaceutical companies whose products are patented, preventing competitors from driving down prices. These are the types of things that indirectly restrict choices (indirectly in the sense that nobody is telling you that you can only shop at this medical provider, but rather someone is telling potential medical providers that they can only be medical providers if they do X and Y). The cure for these ills is not a superficial correction of the undesired outcome ("just give this guy what he can't get"); it is a critical examination of the underlying fundamental characteristics of the problem at hand ("what is it about this situation that is making this guy unable to get what he wants?").

What one should begin to realize is that by requiring everyone to purchase health care, in addition to the already choice-restrictive elements of the health care market, we are moving in the exact opposite direction of that which we would move in if we wanted to emulate the clothing, shoe, or massage markets. There is irony in the fear of what might happen if we do so because we already see the bad outcome of restricting choices. There is a painfully consequential misunderstanding of the status quo. We do not currently have many options when it comes to health-related services. So if right now we recognize many problems with health provisions, and right now we recognize that the provision of health care is not full of options, why would we want to further restrict our choices? I thought the current outcome is the problem! There is indeed a serious issue with health care in this country, but the solution is not even more of the failed same, no matter how much it might be marketed as "change."

Thursday, March 18, 2010

How Big is Too Big?

Senator Chris Dodd has a plan to give the Federal Reserve the power to split large firms into smaller pieces. The rationale here is that during the current financial crisis, we witnessed large firms ready to go belly up and take the economy down too. The assumptions here are that large firms can bring down the economy and by splitting them into parts when they get too big, we can save the economy.

I have a few questions:

1. In the normal course of events in the marketplace, companies are aggregated and companies are broken apart. The metric for these decisions is profit and loss. If there is value to be created by merging companies, they will be merged. If there is value to be unleashed by splitting a company in two, that company will be split in two. There are individuals who put their time and money on the line to make the right decision. In the case of the Federal Reserve, how will it determine when companies are too big and does the Federal Reserve face the same incentives as companies in the marketplace to make the right decision?

2. There are many large companies in the world, not just in the financial industry. The laws of economics are obviously not suspended for this one specific industry. Why do we not concern ourselves when a large non-financial company is about to go under (and being content with the knowledge that its assets will be sold off to others who will use them more productively), but we begin envisioning The End Times when a financial firm is about to go under (as if there is this gigantic piece of wealth, encompassed by the financial firm, that is about to just vanish, taking everything and everyone down with it and leaving nothing in its tracks for the rest of the world to survive on)?

Monday, March 15, 2010

Area's Sole Water Seller Refuses to Pay for Water at Full Price

Before I link to the article that spurred the above title, I thought it would be beneficial to flesh out exactly what the title refers to. Imagine some type of catastrophe happens, like an earthquake for instance, and it turns out that there is essentially only 1 person in the area who also happens to have an abundance of water for sale. It should be self-evident that the water is probably going to cost more than it would under normal circumstances (demand for water is up and the 1 person only has his limited supply, so the price has to go up to bring supply and demand into equilibrium). In addition, it should be self-evident that if someone else in the area were to have water and offered to sell it to our individual, he should probably turn it down seeing as he has plenty of his own. And finally on top of that, it should be self-evident that if our individual were to actually decide to buy water from someone else, it better be at a significant discount, otherwise why would he of all people buy it?

Now that we worked out some basic assumptions in a metaphorical example, let's get to the article that made all of that randomness come to my mind. Bloomberg is reporting that Goldman Sachs is demanding more collateral from counter-parties than it is willing to put up itself. For example, in derivatives contracts with hedge funds, Goldman Sachs is expecting those funds to put up more cash as collateral than Goldman itself would put up if it entered a similar contract in a similar position as the hedge fund. This has allowed Goldman Sachs to benefit significantly from the arrangement. What is not mentioned in the article, however, is how the hedge funds benefit as well since they are voluntarily choosing to enter this agreement even though the terms to outsiders might appear unequal. Nobody is making the hedge funds work with Goldman Sachs, but they are choosing to do so anyway.

The reason for this seemingly sinister situation is summed up by Richard Lindsey, a former director at the SEC. "If you're seen as a major player and you have a product that people can't get elsewhere, you have the negotiating power." Exactly like the water seller. Goldman is benefiting from its clout, and the hedge funds are benefiting from doing business with a reputable business that is offering terms better than could be found elsewhere in the marketplace. It is entirely possible that without Goldman, those hedge funds would experience even worse terms or might be forced to not engage in derivatives transactions at all.

There is nothing inherently wrong with being in a position of power in the marketplace as long as that position of power is not artificially supported by an extra-market institution (like the government, for instance). And while I would be more than willing to entertain the idea that Goldman Sachs is in fact supported artificially by the government, that topic is beyond the scope of this post. The reason for the remark about artificial support is that as long as the position is not being maintained through any forceful means (like using tax money to support a business which might otherwise not be supported at all), the position of power can only be achieved if it is legitimate and warranted (people voluntarily do business with the company because they want to, not because they are being forced to). Without force, companies cannot grow big and powerful unless they offer better products to buyers. The same way that an individual should look favorably upon the water seller for providing a much-needed commodity in the marketplace during a difficult time (even at a higher price, because nobody else is even willing or has the ability to offer it!), the hedge funds should be thanking Goldman Sachs (and Goldman Sachs should be thanking its customers) for providing a good that they need when few other businesses offer it on the same terms.

Friday, March 12, 2010

Characterizing Causation

When a catalyst is thought to bring about something positive, we look favorably on the catalyst. When the catalyst is viewed as having engendered harm, we view it with scorn. A court-ordered report has revealed that JPMorgan and Citigroup helped bring about the collapse of Lehman Brothers. The implication here is obvious: by helping cause the collapse of Lehman Brothers, JPMorgan and Citigroup have done something wrong. In fact, a representative of Citigroup quoted in the article even states that after reviewing the report, the examiner "has not identified any wrongdoing on Citi's part." She made the comment because wrongdoing is the implication.

I found the article's headline to be especially irksome because failure is critical to a healthy marketplace and because I knew the article would reference as bad, actions taken by Citigroup and JPMorgan that put Lehman Brothers over the edge, as if the same actions could have put Lehman Brothers over the edge if it weren't so over-leveraged in the first place thanks to the Federal Reserve's easy money policies (since the central bank puts money in the economy, the problem of too much money is the fault of the central bank). Anton Valukas, the examiner, makes this evident when he says that "the demands for collateral by Lehman's lenders had direct impact on Lehman's liquidity." You don't say! But here is what I say: so what?

The problem with trying to erase Citigroup's guilt and JPMorgan's guilt is twofold: they were unquestionably responsible for Lehman Brothers' collapse, and we should be happy that they were. If you as a consumer stop frequenting your local seafood restaurant because you or someone you know was poisoned by it, outside observers would hardly accuse you of wrongdoing if your actions helped bring down the restaurant. In addition, the sooner you and others stop frequenting a restaurant with poisoned food, the better off everyone is because resources previously used in operating a poisoned-food seafood restaurant can now be used for something potentially better. Another example is that of short sellers who uncover accounting fraud at public firms thereby doing society a service by helping to bring about the end of those companies' fraudulent activities and putting them out of business.

When Citigroup and JPMorgan demanded more collateral from Lehman Brothers, this was an indication that Lehman wasn't doing so well. If you lend someone money with his car as collateral, and he keeps coming back to you for more money, chances are you will demand more collateral from him. Not only are you in your right to do so, but you are also smart to do so because by asking for more money, your borrower is demonstrating to you that his default risk is increasing. What Citigroup and JPMorgan did is no different. If your borrower can't put up more collateral and you cut off his loans forcing him to drastically cut back on his extravagant spending habits, this is better for everyone involved (you are no longer throwing good money after bad, and the borrower is forced to reform his behavior).

This financial crisis has really brought the concept of failure in the marketplace to the forefront. It is vital that we understand the importance failure serves in a properly functioning economy, and cease ostracizing institutions or individuals that cause failure to happen.

Tuesday, March 9, 2010

Is two that much greater than one or zero?

I have been a little behind on my pleasure reading, but this fact wasn't as apparent as it became when I saw an article in New York Magazine about Scott Brown's recent election victory in Massachusetts and if/how Democrats might be able to win his support on some initiatives. That upset victory in Massachusetts now seems like ages ago but here is my post regardless...

It was informative for me to learn how, despite Brown's previous characterization as a "right wing nut" (who apparently exemplifies right wing nuttyness by posing nude in Cosmopolitan), he might turn out to be nothing of the sort (I didn't know much about his background). John Heilemann who authored the New York Magazine article, writes "For all the tea-party atmospherics around the Massachusetts race, there are plenty of indications that Brown is hardly a right-wing loony, and even some signs that he might be - wait for it - an honest-to-goodness northeastern moderate right out of the old school." Considering how wide the political spectrum is (taking into account all types of extreme or non-moderate views), the chances that someone actually elected to political office turns out to be moderate... seems to be reasonably high.

After intellectually digesting that, my mind entered a somewhat theoretical realm and considered how if most elected officials are moderate, we could essentially consider them to be identical (to an extent). In which case, what is the point of elections? I then brought my mind back from the theoretical and considered that, practically speaking, each election does involve a contest between two individuals who are at least somewhat different from each other. I am sure I read/heard the soon to be revealed insight somewhere, so apologies to the person that brought it to my attention, but here is the problem: we criticize societies that either have no option to elect someone or only "one option" to elect someone. Do we really live in such an improved society because we get to pick from two (instead of... one or zero!), when each of the two barely differs from the other?

Monday, March 8, 2010

Endangered Shoes

I recently heard the phrase "endangered species," and after thinking about it, realized that those two words always go together, but rarely is the first word following by anything else. Why is it that it seems like species, referring to animals or presumably plants as well, are the only things to be endangered (by endangered I am assuming it is meant there are too few of them)?

The economic word that reflects the observation of there being too few of anything, is scarcity. The way that we typically deal with the quantity of most goods in the marketplace like shoes or services in the marketplace like massages, is to have a market determined price and quantity. If and when shoes were to become scarce, the price would rise significantly and shoe manufacturers would have an added incentive to produce more shoes. We don't need an agency to make this happen. We do however need shoes to be an exchangeable commodity with a price.

Animals and plants that are considered endangered, on the other hand, are not treated like normal goods and services. The purported methodology for dealing with this problem is entirely different. Wikipedia tells us the following:
"Another way to help preserve endangered species is to create a new professional society dedicated to ecological ethics... One final way in which one can conserve endangered species is through federal agency investments and protection enacted by the federal government."
Could you imagine having an ethics course explaining why we need to have a sufficient quantity of shoes in the economy? Or what about having a federal agency invest and protect the quantity of shoes? These ideas are preposterous because we recognize that the best way to have any object remain in society is to make it privately owned, put a price on it, and let it trade in the market. The above-quoted solutions are no more viable for animals than they are for anything else.

Now that we know endangered species should be treated like any other good or service, the next question is how to make it happen. There is something specific to endangered species that requires one more step in the analysis. Where are the endangered species located? Since the endangered species are likely to be located in the wild, that is, land either vaguely owned publicly or specifically owned by the government, it isn't enough to just say "privatize the species" when their area of habitation is entirely unprivatized. In fact, that these species are living on public land and disappearing should be no surprise in the first place; that is what we would expect to happen.

If we value endangered species enough, we should not only encourage them to be traded like any other good or service, but we should also privatize all the land upon which they might currently reside. The best way, after all, to get an individual to maintain and protect an animal so that it (and its progeny) never disappears from the earth, is to have him know that it is his animal, on his land, and worth a lot of money. In contrast, what would you expect to happen if an animal is scarce and located on land that nobody owns?

Saturday, March 6, 2010

Illogical Derivatives

Ever since the financial crisis began in 2007, we have heard just about every component of the economy targeted at least once by someone as the cause of our problems. Most of those targeted components however, hardly ever include the right one, but among them is often found these "very scary" insurance-like contracts known as credit-default swaps. The most recent example of public sentiment towards this specific derivative is found in German Chancellor Angela Merkel, who said, "Credit-default swaps, where you insure your neighbor’s house just to destroy it and make money from it, that’s exactly what we have to curb."

It is probably helpful to continue using Chancellor Merkel's "neighbor's house" metaphor, in order to prove her sentiment is without merit. A credit-default swap is a type of derivative that, as she says, is a form of insurance, just like any other. Where Chancellor Merkel goes astray is in making the statement that first you bought the derivative, and then you burned your neighbor's house down. This is in stark contrast to the more reasonable scenario of first knowing that maybe your neighbors play with fire all day and then thinking it wise to buy insurance on their house. What is the equivalent of Merkel's event causation (first buy insurance, then force disaster) when it comes to Greece? Many institutions did indeed purchase insurance against Greece defaulting on its debt, but how did those same institutions also make Greece potentially default on its debt? Do banks and speculators now determine the level of government spending and tax policy in Greece?

The missing element here is by what process does Greece's level of indebtedness get determined. As revolutionary as it might sound, the answer is straightforward. It is not an institution like a bank, whose assets might be in Greece and whose concerns therefore might include Greece's level of indebtedness, that determines how indebted Greece is; rather, it is the Greek government, which controls Greek fiscal policy, that controls the level of Greek indebtedness. Rest assured, if Greece's fiscal situation were not as bad as it is, nobody would be interested in buying these derivatives on Greek debt. Similarly, if you live in an area extremely prone to flooding, you are not making yourself more likely to get hit with a flood by buying lots of flood insurance. The level of flooding is determined by something else called the weather. And if a place is not very prone to flooding, rest assured there won't be many people buying flood insurance on their homes.

The Greek government's fiscal irresponsibility is responsible for Greece's debt problem, not the institutions who were concerned about what they saw happening and who were acting accordingly to protect themselves against it.

Wednesday, March 3, 2010

Truth-in-Prosecution Law

I found out today that New York City has something called a "Truth-In-Pricing Law" (scroll to the middle of the page after clicking the link). The law is described as follows:
Truth-In-Pricing Law
Businesses are free to charge what they like, and consumers are free to look elsewhere for a better price. When businesses give false information about an item, consumers get burned. That’s why the truth-in-pricing law requires that price displays provide adequate information to the consumer. Violators will be fined.
Upon reading the first sentence in the explanation, I was delighted to see just how well lawmakers have the potential to understand the workings of the free market. In a free market, all association and transactions are done on a voluntary basis. Someone might be mean, but you don't have to interact with him. Someone might try to rip you off, but you don't have to buy what he is selling. When individuals engage each other on a voluntary basis, everyone is better off because each person is allowed to make decisions he deems best (not necessarily the "right" decision, but the decision made is always the person's best available option determined however he chooses to determine it). When interactions take place under force, someone is always worse off at the expense of someone else (the one who is forced is worse off at the expense of the one doing the forcing).

I then read the second sentence of the law and became puzzled because I thought I understood what the first sentence said (the two sentences contradict each other). Isn't giving false information about an item potentially (but most likely rarely) part of the bargaining process between two individuals, and therefore should be left up to the two individuals to decide? Isn't it true that if a seller engages in giving false information to customers long enough, word will spread about his lies and he will lose business? Doesn't it therefore mean that when businesses give false information about an item, businesses too get burned? Why do we assume that a lawmaker, or the government agency enforcing this law, will be more adept than a customer at determining what is and is not false information? Isn't it at least remotely possible that this law could be used to prosecute more harshly some businesses that are specifically targeted by the enforcement agency, while ignoring other businesses, for any number of reasons (friendships, connections, bribes, etc)? Why is the government agency presumed to act better than the business?

This law is just one of many examples of legislation that is useless at best and dangerously tyrannical at worst. Look at it this way: do you think you should be more concerned about a business lying to you knowing the business would probably like to maintain a good reputation (otherwise it loses customers), or do you think you should be more concerned about individuals at a government agency promising to protect your interactions when those government agents are not necessarily likely to be any different from a lying business-owner but have the force of law behind them unlike the business-owner? Laws passed by the government are not necessarily good just because the government passes them, and individuals who enforce government laws are not necessarily brilliant or selfless just because they work for the government.

Monday, March 1, 2010

Enforcing Contracts Without a Contract

After giving this post the title that I did, I realized it made it seem like the post would be more interesting than it probably is. So if you expected a fancy expose about how the laws of economics could make contract-like outcomes take place without any actual contracts... you won't find it here.

What I actually wanted to post on is the idea that one of the basic purposes of the government through the Constitution is to enforce contracts. The assumption is that without contract enforcement we would not have functioning markets and society would be worse off than with contract enforcement.

So here is my question: for all the talk of contracts being vital and the basis of society's cohesive glue, has anyone alive today signed the contract known as the U.S. Constitution?

Sunday, February 28, 2010

Insider Trading, also known as Trading

Anyone who makes an investment is automatically assuming that to at least some extent, he knows something that the market does not know. After all, if the market already knew what the individual knows, then there would be no profit to be made for the individual as the market price would already reflect what the individual knows. This means that markets function precisely because of imperfect information, and a healthy functioning market means that it is always moving in the direction of digesting all of that imperfect information (it never actually reaches a "perfect information endpoint" since information is constantly changing, but it is constantly moving in that direction). If you want to easily understand how critical imperfect information is, imagine for a moment that every entrepreneurial idea that has ever been successful, was at the time it was thought of, also thought of by literally every other person on the planet. What would be the incentive to act on that insight if everybody else already knew it? We benefit from the insights others have that we do not (the entrepreneur went ahead with his project because he knew we did not know how to do what he wanted to do, and as a result we can now use whatever it is that he created). We benefit from imperfect information.

The reason why insider trading is called insider trading is because there is presumed to be something harmful about a single person or group of individuals knowing something about a company that all other investors do not know (as if it is even possible to make sure all investors have the same information). As a result, the individuals that have the inside information about the company might be able to profit significantly from this knowledge. But doesn't each person in the world have completely different information, about just about everything, from everyone else? And doesn't each person always try to better his own life using information he hopes nobody else has? If we don't punish the already infinite number of instances in which people differ in the knowledge they possess, why do we make this special exception when it comes to investing? Once we understand how a healthy market should function, it becomes clear that people profiting from information as soon as it is available is precisely what we should want.

Let's assume publicly traded Company X has very good news that is going to be released in a few days. Scenario A is such that all the good information about the company is effectively kept secret; this information is released only after those few days go by and investors only act on this information after those few days have gone by. Scenario B is such that some individuals inside Company X begin aggressively buying the stock in anticipation of the good news and leak the information to other individuals in the marketplace who also begin aggressively buying the stock so that the price of the stock goes up well in advance of those originally intended few days. Let's now compare the two scenarios. The purpose of a market is to efficiently allocate resources given all available current and future information. If Company X has good news to deliver in a few days, it is far more efficient for the price of Company X to have capital move in its direction now thus making its price rise now (Scenario B) rather than all of this happening in a few days (Scenario A). Why should we, as market participants, accept a few days of inefficient resource allocation when we don't have to? Don't we want good companies to get rewarded as soon as possible and bad companies to get punished as soon as possible? The benefits to the marketplace of these things happening at all are much greater than worrying about who pocketed a few extra dollars in the process! A market works most efficiently when it reacts immediately to all information. Keeping inside information forcibly secret by punishing its premature release is actually harmful to a healthy functioning market, and therefore harmful to society.

Once this concern over small groups of individuals profiting from information before many other people (as if this is the only way for profits to be made) is properly understood, it becomes apparent that the support for laws against insider trading, at its most fundamental level, is actually about nothing more than what I would call "information welfare." Information welfare is the concept of trying to provide everyone with as much equal information as possible so that somehow everyone can profit from this information at the same time (as if everyone having equal information will somehow allow everyone to benefit simultaneously). It is literally an attempt to create intellectual equality that hopefully leads to financial equality. But if, as we saw above, everyone were to actually possess the same information, what would be the incentive for acting on this information if everyone else had it as well? Similarly, in a theoretically perfect socialist system, what would be the incentive for people to produce more than average if they will immediately have the surplus taken away and redistributed? Both welfare in money and information welfare might be a result of having laudable goals in mind, but implementing them is disastrous to everyone involved.

There should exist no insider trading laws whatsoever, specifically for the benefit of everyone in society. Let all insiders trade on information as soon as it becomes available. This means faster exposure of corrupt businesses as well as faster exposure of successful businesses. The sooner capital flows away from where it shouldn't be and towards where it should be, the better. Don't we want to know which companies are succeeding and which are failing as soon as possible? Do you really care if someone gets rewarded while revealing a company like Enron is a fraud? Don't you care more about knowing the company is a fraud, than if a group of individuals inside the company made money exposing to you and the rest of society that the company is operating in a fraudulent manner (and allowing you to avoid ever unknowingly subjecting yourself to the harmful ramifications of doing business with this fraudulent company)?

Rather than vilifying and punishing inside traders, we should be thanking them for the critical and irreplaceable function they serve in the market.

Friday, February 26, 2010

Friedman refutes... himself

Milton Friedman, both prior to and after his passing, was one of the 20th century's most influential economists. Friedman was the leader of the Chicago School of Economics which generally posits that the free market is the ideal economic system to pursue, except when it comes to money (Friedman helped create the withholding tax, contrary to free market principles, but I am giving him and the Chicago School the benefit of the doubt by saying they still tend to support free markets even though they deviate enough from the free market that my benefit of the doubt might be unwarranted!). I would like to focus here on Friedman's support of a central bank, because I consider it most ironic that an individual who really was so often a supporter of the free market, found one glaring part of economic theory in which he supported intervention in the market.

One of the reasons why Friedman defended having a central bank that controls the currency, against proponents of a gold standard, was because he saw in the gold standard a significant cost to the market in utilizing it. There are extraction costs, for instance, to take the gold out of the ground. Friedman concluded that if under a gold standard the quantity of gold will grow by approximately 3% per annum, there is no reason why we could not have something grow by a similar 3% per annum at a lower cost (like paper currency) without the gold at all.

In a 1986 paper in the Journal of Political Economy called "The Resource Cost of Irredeemable Paper Money," Friedman writes:
In earlier discussions, other monetary economists and I took it for granted that the real resource cost of producing irredeemable paper money was negligible, consisting only of the cost of paper and printing.
In this manner, Friedman admits that when determining the cost of a paper standard in contrast to a commodity standard, his analysis of cost was based on solely the cost of creating the money (and in fact he is correct that printing paper is cheaper than mining gold). But what Friedman overlooked, and admits as much, were the other costs to society of using the paper rather than using the gold (this error that he made is a basic economic fallacy first explained by the economist Frederic Bastiat, called "the seen vs. the unseen"). He continues:
Experience under a universal irredeemable paper money standard makes it crystal clear that such an assumption, while it may be correct with respect to the direct cost to the government of issuing fiat outside money, is false for society as a whole and is likely to remain so unless and until a monetary structure emerges under an irredeemable paper standard that provides a high degree of long-run price-level predictability.
Friedman is saying that our experience with a paper money standard has shown that the price level is far from stable and/or predictable, the way that it was for decades in the 19th century under the gold standard. As a result of this instability and unpredictability, there are costs to the economy that he did not originally consider. And since the costs to the economy of a paper money standard might be greater than those of a commodity standard, one of the main reasons why Friedman originally supported the paper money standard, vanishes.

Unlike Keynes whose refutation of his own work was never explicit, Friedman eventually realized the error of his ways. It is true that Friedman still adamantly opposed returning to a gold standard (I believe mostly for practical reasons), but at least he came to some sort of realization that the free market alternative is beneficial in ways that are not even apparent at first glance (something I might arrogantly argue he, of all people, should have realized at the outset). To that extent one could say that by the end of his career, Milton Friedman truly had a better grasp of how the free market functions than he did during the majority of his career. If only this could be said of all economists, some of whom unfortunately reveal that they can't tell the difference between a free market and a managed economy, blaming the former for a crisis that occurred as a result of the latter.

Thursday, February 25, 2010

Lord of the Housing Market

I came home, opened Bloomberg to see the latest financial news, and found out that, President Obama might ban foreclosures. I was more humored by reading this than shocked, the latter being the likely reaction of the average person who might instinctively just be surprised at the blatant exercise of power (and rightfully so).

The reason I found this to be so funny is because banning foreclosures it not very different from setting a price floor on the price of houses. In economics, we know that price fixing of any kind (price ceilings or price floors) always fails. The reason is because there is a market-clearing price for every good and service, so if you artificially set a price that is either above or below the market-clearing price, you end up with either shortages or surpluses. Price floors lead to surpluses.

In this instant, the surplus we are talking about is in individuals who will want to sell their houses at artificially higher prices. The problem is that buyers will not want to buy the houses at artificially higher prices. They would want to buy them at the lower market price, which is of course why this ban is being instituted in the first place (foreclosures would bring housing prices down).

There is not a single episode in history when price fixing has worked. The most recent glaring example (aside from rent control which exists to this day and causes shortages in housing) were the price ceilings on oil during the 1970s. Not surprisingly, this caused oil shortages all over the country. There is no reason to believe that President Obama will be the first individual in the history of mankind to institute price fixing and have it work.

Market prices exist for a reason, which is to efficiently allocate resources throughout the economy. When prices are manipulated because you don't like where they are, it doesn't mean that your manipulation will be a success (unless resource dislocation is defined as successful). If we do actually end up with a ban on foreclosures we can expect it to take longer for the housing market to recover (which will happen only if and when the price fixing is ceased and the market can clear). Not only will buyers be unwilling to buy, banks will also be less willing to lend since they don't have the ability to foreclose (would you make a loan to someone if his default didn't give you the ability to take ownership of his collateral?). Considering what the administration is trying to achieve in this financial crisis (presumably, a resumption in house purchases and a resumption in bank lending) does this sound like the proper way of going about doing so?

Wednesday, February 24, 2010

How does one disprove an infinitely open-ended belief?

The argument that fiscal and monetary stimulus is guaranteed to stave off a recession at some adequate quantity, has made me start thinking about other similarly infinitely open-minded beliefs. For instance, the claim that if one were to jump hard enough, one could get 100 feet in the air. How does one disprove such a belief? The reason it is difficult is because the proponent can simply say "well if you aren't reaching 100 feet, then you aren't jumping hard enough which is the requirement."

In the financial realm right now we hear that if the current quantity of fiscal and monetary stimulus is not turning the economy around, it means that we need more. But does there come a point when we can say that fiscal and monetary stimulus, no matter how large, does not in fact turn an economy around?

We know that during Japan's lost decade its government made it the most indebted nation in the world. In addition, its monetary authorities pumped incalculable quantities of money into their economy but that did not work either. In the United States right now the government has already passed the largest stimulus plan in history and the Federal Reserve has pumped trillions of dollars into the banks. But we have not yet recovered.

When will it be safe to say that there is something fundamentally flawed about the theory of fiscal and monetary stimulus being able to turn around an economy? Is it possible that in the past, in less severe economic situations, it only appeared that the fiscal and monetary stimulus turned the economy around when in actuality it was something else?

Tuesday, February 23, 2010

What is the purpose of the U.S. Constitution? A Practical Inquiry

Strict constructionists believe that the U.S. Constitution should be interpreted exactly as it was written. Even if certain words found in the document have a meaning today that is different from the meaning at the time of ratification, the meaning at the time of ratification should be used. Based on this understanding, society today obviously does not reflect the society that the U.S. Constitution would support. In that case, the U.S. Constitution has failed to function in one of the two manners it could have been intended to function (strict vs. loose interpretation).

On the other hand, loose constructionists suggest that the interpretation of the U.S. Constitution can change over time. Theoretically, the manner in which it is interpreted today could be entirely different from the way it was interpreted yesterday. In that case, the U.S. Constitution is pointless. What is the point of having the Constitution beyond its functioning as a simple procedural tool (since any of the non-procedural sections of it can change at any time and therefore don't have much eternal meaning) whose otherwise grand function is to tell us how to re-interpret the document any which way we desire? That is, not to mention the fact that the procedural sections aren't always followed either. And what makes the procedures in the Constitution (assuming those are the only aspects of it left that remain static, given that all the substantive aspects can be re-interpreted) any better than a different set of procedures we might design today that could also allow us to re-interpret it (or another document for that matter) any which way we desire?

The U.S. Constitution has either failed to achieve its purpose of restricting the government or it has no meaning since it can always be re-interpreted. What is the purpose of the U.S. Constitution?

Monday, February 22, 2010

Can we ever do too much for our children?

While riding in an elevator today, I was made aware on a TV screen that pediatricians want hot dogs and candy to be redesigned to prevent children from choking. No, I'm not joking. This advice is straight from the American Academy of Pediatrics.

Dr. Lee Sanders, an associate professor at the University of Miami Miller School of Medicine, sums up the article by stating, "I think it's very reasonable to strengthen regulations to prevent choking injuries for children." I couldn't help but start thinking about all the other potential causes of accidents we see in society, and what it would take to try to prevent them all. There is always a cost.

If we pretend that, purely for the sake of argument, the cost of making these changes to hot dogs and candy amounts to approximately $100 zillion (a large amount of money), it should be easy to convince most people that the changes are probably not worth the cost. In fact, there are probably many other more pressing things that the $100 zillion could be used for. So just having parents be vigilant of what their children consume would be much more sensical. But if we can see that a cost so large would make these regulations irrational to enforce, however good-hearted they may be, then we should also say that if the marginal cost of these regulations is even a tiny bit above the marginal benefit of having them then enforcing them in such a scenario would also be foolish. After all, if the marginal cost were greater than the marginal benefit, this is by definition telling us that there are better uses of capital than spending it on modifying hot dogs and candy.

Well then who exactly did the analysis to determine these regulations are worthwhile? And how did they determine this? The answer obviously is that nobody bothered to calculate the costs since the benefits are automatically taken to be a good thing no matter what. Side note: this could actually describe the vast majority of legislation and regulation that comes out of the government, unfortunately. It is likely the case that modifying the shape of hot dogs and candy is going to cost far more than having parents take responsibility for what children consume. Therefore, these regulations should never be permitted to pass until someone even begins to do a cost-benefit analysis.

And by the way, the best entities to conduct these calculations are the businesses who produce hot dogs and candy, because they eat (yes, pun intended) the consequences of making food that could cause children to choke and therefore force the businesses to lose customers. The very fact that these businesses still exist in society profitably means that the public finds there to be more benefits than harm from the food that these businesses produce. Rest assured that if this children-eating-hot-dogs-or-candy-often-choke pandemic were really as bad as these doctors imply, the businesses would have gone the way of history long ago. After all, would you take your children to eat food that is widely known to cause other children to choke?

Sunday, February 21, 2010

Keynes refutes... himself

In response to the financial crisis, governments around the world have engaged in unprecedented fiscal and monetary measures to try to avert catastrophe. Since the bulk of these policies are generally deemed to be "Keynesian" in nature, I thought it might be interesting to re-evaluate what it is that Keynes actually prescribed for economic downturns. The Spring 1995, Volume 17, No. 3 issue of the Journal of Post Keynesian Economics, in a piece called "What Keynes Really Said About Deficit Spending," differentiates between the beliefs that have been ascribed to Keynes with that which Keynes actually advocated based on his writings. There is much wrong with Keynesian economics from a pure economic theory perspective (such as the supposed instability of the free market, the ability of extra-market institutions to improve upon the free market, etc.) but there is something more basic that is wrong about Keynesian economics that both economists and non-economists should understand. It is not enough to be an advocate of a certain policy on its own immediate merits, one must take into account the implementation aspects of that policy as well as the practical implications of its acceptance.

The authors summarize Keynes' policies for the capitalist economy when it appears unstable as follows.
1. As the normal circumstance of a capitalist system would result in insufficient private investment, where total investment is less than the amount of saving that would be generated at full employment, social investment would be necessary to maintain full employment. Further, since fluctuations in private investment are likely to occur, the investment plans of public and quasi-public entities should be designed so that they could be varied in a countercyclical pattern.
Throughout the article the authors emphasize that the misunderstanding people have about Keynesian economics is with its nuances, most of which people typically ignore. In the above summary, it is argued that far from advocating widespread and significant government investment in an economy during a downturn, Keynes specifically advocated social investment. The authors of the piece do not give examples of what they mean by social investment, but the idea is that it is investment in an industry that serves some type of general public benefit. Furthermore, government investment should vary in a counter-cyclical manner, meaning it should increase during a downturn and decrease during an upturn.

The non-economic problem with this admittedly more nuanced explanation of Keynes' beliefs is that from an implementation and practical perspective, those nuances mean almost nothing. A metaphor is now in order. Imagine a scientist comes up with the theory that if a man jumps off a building but flaps his arms fast enough, he will be able to fly rather than fall to his death. I guess it is theoretically plausible that if a man did flap his arms fast enough he might fly (though who knows exactly how fast that might have to be), but we can say very confidently that any man who tries to do this is going to fall to his death. So the nuance is that the scientist said the man has to flap his arms very fast, but practically speaking that isn't going to happen so the man will just fall to his death. What this means for Keynes is that his advocacy of only certain government investment at only certain times is irrelevant because the government as an institution is not built to differentiate between those distinctions.

We know the government differs from private business because it does not have a profit and loss mechanism. A private business makes money by offering a good to the public that the public in turn voluntarily purchases. If the public buys enough of the good, the business prospers. If the public does not buy enough of the good, the business might fail. The government on the other hand "makes money" through taxes, which means that the public is required to give up its money. There is no comparable voluntary component the way there is with a private business. If the government fails in a certain policy and runs a deficit, it need only increase taxes. Imagine a private business failing and then requiring that people hand over their money to keep it afloat!

As a result of these characteristics of the government, it will never come close to staying true to what Keynes might have said. Why just have social investment when you can have social and private investment, that way every interest group in society can benefit (and re-elect the individuals who enacted those "charitable" policies). Why increase social investment only during a downturn if you can increase social investment perpetually? Remember that the government bears little cost for these policies as a result of not being subject to the profit and loss mechanism that every other institution in society is subject to. If you didn't have to bear the cost of what you did, would you restrict yourself? Obviously not. So how can we (or more importantly Keynes, the 20th century's most admired economist) expect the government to do that?

Criticism of ubiquitous and perpetual government spending and deficits as an equivalent criticism of Keynesian economics might not be entirely fair given Keynes' nuanced thoughts on government spending and deficits, but at the same time Keynes does nothing more than refute himself by not thinking through the implementation and practical implications of what he suggested the government do in a downturn. It is therefore not unreasonable to consider modern day government policy as Keynesian, all those nuances notwithstanding.

Update from Taylor:

"you may wish to clarify that deficits dont occur when policies fail, but when expenditures outstrip tax revenues, and theyre made up for with borrowing, which is just future taxation"

Taylor is correct. I was making the assumption that a failed policy, similar to a "policy" that fails in a private business, is one that ends with a loss (in the case of government, one that ends with a deficit). Strictly speaking, a deficit occurs when expenditures outstrip tax revenues, whether or not one considers the policy to have failed. 

Thursday, February 18, 2010

Marshmallow Test

I recently read a fascinating article in New York Magazine by Jennifer Senior about the intense competition that 4 year olds face (or more likely their parents face) in New York City when it comes to both taking exams (yes, as 4 year olds) and getting accepted to the best schools (for kindergarten). While I have neither a degree in education nor a degree in child psychology, and therefore would not normally post on such a subject, there was one paragraph near the end of the article that really got me thinking because of its nuanced connection to the field of economics. After delineating in the article some of those different exams that 4 year olds are often expected to take, and the evaluation process associated with picking which children go to which school, the author ends with this tidbit:
But my money’s on the marshmallow test. It’s quite compelling and, apparently, quite famous—Shenk talks about it with great relish in The Genius in All of Us. In the sixties, a Stanford psychologist named Walter Mischel rounded up 653 young children and gave them a choice: They could eat one marshmallow at that very moment, or they could wait for an unspecified period of time and eat two. Most chose two, but in the end, only one third of the sample had the self-discipline to wait the fifteen or so minutes for them. Mischel then had the inspired idea to follow up on his young subjects, checking in with them as they were finishing high school. He discovered that the children who’d waited for that second marshmallow had scored, on average, 210 points higher on the SAT.
What immediately struck me after I read this was that the psychologist took the economic concept of time preference, which is the basis of the phenomenon known as the interest rate, and decided to observe it on a micro level in children to see if it correlates with success. Time preference is the idea that we would be willing to forgo consuming something right now, if we could have more of it at some point in the future. Obviously, if offered to have an equal quantity in one or the other time period, we might as well take it now.

Most interesting is how we typically see time preference play out in society: individuals who are more financially successful have a low level of time preference, which means that they are willing to defer consumption to the future. In contrast, less financially successful individuals have a higher time preference, which means that they are more inclined to consume today rather than wait until tomorrow. Keep in mind that financially successful individuals could have achieved their success through any of a number of different paths with any of a number of different character traits or skills, but they generally share in common the characteristic of low time preference. And while correlation does not imply causation, it seems reasonable to consider that at least some ability to look forward is required before an individual becomes successful, rather than becoming forward-looking after success has already been achieved.

While tests administered to children might evaluate various skills, it is not as though future successful individuals necessarily possess all of those evaluated skills or even some of those evaluated skills. It seems more likely, with successful individuals spanning the gamut in just about every way (type of success, method of success, personality, beliefs, etc.), that a better gauge of success is not something concretely tested on an exam like math or writing, but something that could vaguely be described more as the individual's "approach," "outlook," or "way of being" that, when combined with any of those concrete traits (or maybe even none of those concrete traits), will produce a successful individual. Is it therefore possible that this seemingly primitive marshmallow test, based on a theoretical economic precept, is superior to all those exams that evaluate how well a 4 year old puts blocks together because it actually tests for something that successful individuals generally share in common?

Wednesday, February 17, 2010

Growing Debt Paradigm (GDP)

The study of modern economics gets broken up into the macro and the micro. Of all the complex equations that one solves while studying macro and micro, one of the few that probably gets remembered is that of GDP, or gross domestic product. GDP is composed of consumption, investment, government expenditures, and net exports. Now that my studies in this field have long been completed, I can't help but wonder about the logic behind the premise that we measure growth in an economy through the four components listed above. If economic growth is desirable, doesn't it take no more than every consumer to take out as big a loan as possible and spend it in the economy to make GDP go up? And doesn't it also take no more than the government to decide on a few trillion dollar expenditures (or more) to make GDP go up? And doesn't it also take no more than the central bank to print the currency ad infinitum to weaken its exchange rate versus foreign currencies, and therefore make our exports and subsequently, GDP go up? There is something fundamentally wrong with each of these actions moving the supposed growth parameter upwards. In fact, based on the above descriptions and how consumers, government, and the central bank actually behave in reality, GDP is more of a measure of growth in debt than it is of legitimate economic growth. The next question then is: so what is an accurate measure of economic growth? I would argue that this is largely irrelevant given that what we are trying to do is measure the health of the economy. Let me elaborate.

The most important function of an economy is that it satisfies consumer wants; it is not important, necessarily, to produce and then consume as much as possible. Here is an example: imagine a small economy on an island whose inhabitants don't like to work very much. They produce very little and consume very little and this makes them perfectly happy. A modern economist would look at this situation and gasp that the economy might not even be growing year after year. But is this a problem? The inhabitants, by their actions, don't want the economy to grow. They are happy because the economy is satisfying their wants. The more accurate measure of the health of this economy is if there are no institutions that in some way hamper consumer demands from being satisfied, or even add a minor cost to the satisfaction of consumer demands. Would it be an improvement if we had a government-like entity on this island that took resources from the inhabitants and made them work longer hours so that it could "produce" and then "consume" more? Or what if this government-like entity borrowed in the inhabitants' names and then required that they work off these debts for years to come. These actions would make the island's GDP go up.

The GDP metric fails even for its stated purpose of calculating economic growth because it actually calculates growth in debt. But irrespective of this wish to determine the level of growth, we should be determining how free an economy is from artificial impediments so that we know whether or not consumer demands are being met to the fullest extent. We should not necessarily be concerned about how quickly or slowly an economy is growing, ignoring entirely these more vital questions.