Privatization vs. Competition

They are not the same thing.

Capper points us to the case of LogistiCare, a private contractor hired to arrange non-emergency rides for Medicaid patients.  The various failures by LogistiCare, he concludes, provide proof that privatization, "costs a lot more money and provides a lot less service," than the government systems that are supplanted by private entities.  Capper may be correct that he is looking at a case of too few services supplied at too high a price, but it is the monopoly power that is the problem, not the privatization.

Let's not get bogged down in the particulars of this case, maybe LogistiCare is totally incompetent, maybe not.  What I can say with confidence is that the LogistiCare case is just another example of how competition is what is important, not privatization.  That is a lesson that both the left and the right could stand to learn again.

For another example, look at the recent moves by school districts to save money on insurance, some by dropping WEA Trust and some by switching to WEA Trust.  When WEA Trust had to compete, sometimes they won and sometimes they lost, but school districts were able to insure they were getting a good price.  A great outcome for school districts and further proof of the power of competition to reduce costs.

Making a public monopoly private does nothing to reduce the inefficiencies associated with monopolies.  Competition is the key.

Socialism, Snow Removal, & Public Goods

The other day, I saw this on the Blogging Blue Twitter feed:

I say we do away with socialized snowplowing. Get the government out of my snowbanks!!!

I realize that socialism has been used as an epithet by those on the right, particularly during the healthcare debate, and that those on the left may feel the need to try and defuse some the word's power. The sentiment in this tweet may be designed to do exactly that, but both sides could benefit from some more clear-headed thinking when it comes to the use of the S word.

Socialism is typically defined in economics as "a centrally planned economy in which the government controls all means of production," a concept most of us can easily understand. As a means of administering an entire modern economy, this method has been thoroughly discredited by the example of the former Soviet Union. Obviously, there are current examples of specific countries or industries that resemble Socialism to greater or lesser degrees. For example, a healthcare system where a government only permits doctors in its employ to practice medicine would be described as having socialized medicine. (Note that this is distinct from allowing anyone who demonstrates minimum qualifications to offer medical services for sale.) Whether or not such a system is your preference, calling it socialized medicine is an accurate description, not a slander.

So is it accurate to say we have socialized snow removal?

While government entities are responsible for much of the snow removal that occurs, they certainly don't do it all. Many private enterprises offer snow removal services, though these services are generally limited to private homes and businesses rather than on public streets. The very existence of private snow removal services would seem to argue against snow removal being accurately described as socialized. At the same time, the primary role of government in providing this service is clear. So what, exactly, is going on here? Before we answer that we should think about another economic concept, public goods.

For a full discussion of public goods read this article, for our purposes, I will just focus on this aspect of the definition by Tyler Cowen:

Public goods have two distinct aspects: nonexcludability and...“Nonexcludability” means that the cost of keeping nonpayers from enjoying the benefits of the good or service is prohibitive. If an entrepreneur stages a fireworks show, for example, people can watch the show from their windows or backyards

Now I happen to live on a court, which is the name they give cul-de-sacs in areas with high property taxes, and, as such, my street is among the lowest priority for snow removal following a storm. Budding entrepreneur that I am say I hook a plow to my Chevy 1-ton van and start plowing my court ahead of the city after every storm. I would bet that my neighbors will appreciate this. It's not that far-fetched to think that some of them might even be willing to pay me for performing this service.

If the city gets wind of this and slaps me with a cease and desist, that would be pretty strong evidence that we are on the verge of a socialized snow removal regime. Supposing they don't and I am allowed to continue my small scale operation, would I?

It's doubtful that I could get all fifteen or so of the houses on my court to pay me for my quicker than the city snow removal, so what are my options? First, I could only plow in front of the houses that pay me, leaving a sort of patchwork quilt of unplowed street. This could quickly become a problem as my paying customers would rightly complain that paying for my service is only worth it to them if the entire street is plowed. If they still have to punch it in order to get through a drift every forty feet, why bother paying at all.

My response to this is likely to include plowing the entire street in order to keep my paying customers happy. This also means that everyone who didn't pay me gets to benefit from the plowed street. Unfortunately, this will quickly bring an end to my dreams of early retirement financed through snow removal efforts as my paying customers realize their neighbors are enjoying the benefit of the plowed street without paying. In economic jargon, the non-payers are free-riding. Once this is apparent, there is little incentive for anyone to pay and shortly after that there is no incentive for me to plow and all the residents of the court are left waiting for the city.

I hope this little illustration demonstrates the concept of nonexcludability and suggests that snow removal might meet at least this criteria of a public good. If so, that makes the means for producing snow removal on public streets easier to deal with. There is a broad consensus that public goods are most efficiently produced when financed by taxes and supplied by the government. So the real question is, which goods are public goods?

We won't always agree on the answer of course, but these days, I'm not sure if anyone is even asking the question.

To those on the right, I would suggest that we not cry "socialism!" at every government encroachment lest we end up like the boy who cried wolf and no one listens when we are confronted with the real thing. Additionally, there is a role for government to play beyond law and order, we should acknowledge those cases and endeavor to make government's operations there the best it can possibly be.

To those on the left I would remind you that not every outcome you don't like represents a market failure, begging for a government solution. Relative to other cultures, maybe the United States is more suited to a smaller government sector simply as a matter of temperament. And if some of us detect that some of your preferred solutions to our national woes may lead to government control over the means of production, we should be able to call that what it is, the road to socialism.

The Limits of the Yield Curve

I'm not an economist, I don't even play one on this blog, but I am able to read. Here's Paul Krugman from December of 2008:

...I see that economists at the Cleveland Fed are taking some comfort from the positive slope of the yield curve. Long-term interest rates are higher than short-term rates, which is usually a sign that the economy will expand.

Not this time, I’m afraid. It’s all about the zero lower bound....

... the Fed can’t cut rates from here, because they’re already zero. It can, however, raise rates. So the long-term rate has to be above the short-term rate,...

So sad to say, the yield curve doesn’t offer any comfort. It’s only telling us what we already know: that conventional monetary policy has literally hit bottom.

I've been critical of Krugman at times, but this seems like a reasonable idea. It also makes me wonder if there aren't other times when long run interest rates don't mean what they normally mean.

Specifically, maybe the low long run interest rates on US debt we are experiencing right now are not the result of a positive outlook on the future fiscal picture. Perhaps they are just the result of very high demand for US debt during a flight to safety.

Answering this question, or at least thinking about it, is important since the low rates are used as evidence in the case for additional deficit spending now. Here's Brad DeLong:

Confidence in the safety and soundness of U.S. Treasury bonds is greater than--well, greater than it has ever been in my lifetime.

To which I would add, "probably because they are the last best hope of earth," if I was feeling wistful. But what it comes down to is that maybe our debt has such low rates because, right now, everything else just seems a lot riskier.

The Left Still Doesn't Get Economics

Lakeshore Laments highlights a study showing that those identifying as liberal or progressive don't score well on questions of basic economics.

Nate Silver takes to his blog today to denounce the study as "junk science" for, among other things, poorly worded questions:

Finally, there are some questions about which there is considerable disagreement even within circles of academic economists -- as Klein should know, since he's commissioned several surveys of them. Economists are about evenly split, for instance, when it comes to the minimum wage. There is much closer to being a consensus on free trade, but there are an ample number of heterodox views [E.A.]

Far be it from me to quibble with Silver, whose reputation was made analyzing polling data. So let's stipulate that the survey is junk. Let's go further and just look at an area where even Silver acknowledges widespread agreement, free trade.

Here's economics professor Anthony Evans:

I think useful testing points are Greg Mankiw and Paul Krugman. Firstly, here's what Mankiw has said on this topic:

Few propositions command as much consensus among professional economists as that open world trade increases economic growth and raises living standards. Smith’s insights are now standard fare in Econ 101.

Finally, Paul Krugman - have a look at Pop Internationalism, or his essay on "Ricardo's Difficult Idea" (note: I don't think the principle of comparative advantage is difficult). Despite his more recent NYT columns, if you look at the body of Krugman's academic work you find someone who uses the basic principle of trade theory, and accepts it. When Mankiw and Krugman agree , I'd say that's pretty close to a definition of consensus.

I'd say that's a powerful argument for the existence of a consensus that free trade is on net a positive. But that's hardly what you will hear from liberals and progressives today.

Virginia Democratic Congressman Tom Perriello was profiled on NPR yesterday and apparently, he doesn't agree that free trade and low prices benefit his contsituents:

And when the congressman sits down to talk with the workers, jobs are what's on everyone's mind.

Rep. PERRIELLO: I mean, I think part of what got us into this mess was we said to people we're going to take your job away but we're going to give you really cheap stuff at Wal-Mart. It's going to work out great for you, and it doesn't. People need a job. They need to be able to support their family and...

He's right of course, people do need jobs, but there's not even a whiff of the consensus on free trade in that sound bite. It's as if he can't recognize that his constituents are not only wage earners, but consumers as well. Elsewhere, Perriello denounces demagoguery in relation to death panels, but apparently he has no qualms about engaging in the same when it comes to Wal-Mart.

While liberal economists may call for additional fiscal and monetary stimulus to reduce unemployment, it appears liberal members of congress and many self-described liberals would prefer to turn back the clock and live in a world that includes jobs, but fewer goods at higher prices. Those that do, exhibit a startling lack of economic knowledge on a topic that even Mr. Silver notes there is a broad consensus.

I realize this is just an anecdote, but if you polled people on whether or not they agree with Mr. Perriello, I suspect you would find liberals and progressives agreeing with him by wide margins. Whether this particular study was in fact junk science or not, Mr. Silver is going to have to do a lot better to convince me that the majority of self-identified liberals and progressives really do understand even widely held economic concepts.

The Economics of Packer Tickets

From the Press Gazette (H/T Fox Politics)

From a purely economic standpoint, the fact that the Packers have an 81,000-person season-ticket waiting list indicates tickets could be priced much higher.

"Obviously, they are priced below the market," said Stephen Happel, professor in the W.P. Carey College of Business at Arizona State University....

Happel attributes underpricing of tickets for professional sports to several factors. He said team owners like to create a sense of demand for their product, and in the Packers' case, "There is also a strong sense among Upper Midwesterners about fairness in pricing."

Fairness in pricing? I thought we were just trying to keep from filling Lambeau with people from Chicago who happen to have money. That's what Door County is for.

It's Hard Out Here for a Laureate

Nobel Laureate and NY Times blogger Paul Krugman, that is.

First, Scott Sumner at The Money Illusion argues that the tax reductions and move toward deregulation of the Reagan/Thatcher era were successful, and that Krugman's argument to the contrary is wrong:

Krugman makes the basic mistake of just looking at time series evidence, and only two data points: US growth before and after 1980. Growth has been slower, but that’s true almost everywhere. What is important is that the neoliberal reforms in America have helped arrest our relative decline.

Then Tyler Cowen at Marginal Revolution weighs in on the tort vs. regulation debate and points out that the current disaster in the Gulf of Mexico provides a case of regulatory failure that doesn't seem to register in Krugman's analysis (italics in original):

There is in fact an agency regulating off-shore drilling and in the case under question it totally failed. How can Lake Erie, an orthogonally related success, be cited but this very directly relevant failure not be mentioned?

Now, it's important to point out that both of these critiques are by professional economists and are arguments about the merits, rather than just some guy with a free blog picking on Krugman for the partisan nature of his analyses. Krugman is still the most popular and influential writer on economic matters in the public sphere, so don't' feel too bad for him.

Besides, DeLong has his back (Saltwaters Unite!) accusing Sumner of not being able to read!

Who knew the dismal science could generate such feisty blogging?

Krugman's Consistency Deficit

In the comments to my Greece post, J. Strupp and I had a little back and forth about economist Paul Krugman's attitude toward deficits. I want to assure Strupp that while unfounded assertions make up a large percentage of discourse on the internet, I try really hard not to traffic in them.

I accused Krugman of not having a problem with deficits, as long as they are being run by Democrats. My accusation was based on an article from Econ Journal Watch that I had recently read. From the abstract:

Economists affiliated or aligned with one of the parties may be suspected of changing their positions on budgets deficits to serve their favored party or win favor with its constituency. This paper investigates selected economists, to see whether their tune changes when the party holding the White House changes. Six economists are found to change their tune—Paul Krugman in a significant way...

And from the paper:

Upon the 2006 Democratic victory in Congress, Krugman reverted to favoring deficits. In a column entitled “Democrats and the Deficit” he wrote:

One of the biggest questions is whether the party should return to Rubinomics—the doctrine, associated with former Treasury Secretary Robert Rubin, that placed a very high priority on reducing the budget deficit. The answer, I believe, is no...And the lesson of the last six years is that the Democrats shouldn’t spend political capital trying to bring the deficit down. They should refrain from actions that make the deficit worse. But given a choice between cutting the deficit and spending more on good things like health care reform, they should choose the spending. (Krugman 2006)

So deficits are OK, as longs as they are for what Krugman perceives as the "good things". I think we really ought to expect more from someone who is cited with such authority on these matters.

The Wages of Nonsense

It's a sad state of affairs when liberal blogger Matthew Yglesias has to point out that some of what's printed in the Wall Street Journal doesn't comport with the realities of economics:

Financial advisor Mike Donahue whines in the WSJ: “I have more than most only because I’ve worked harder than most and because I am a saver.”

I find it literally shocking that people say things like this. And I always go back to the case of the Salvadoran guys who moved all my furniture into my current apartment. I certainly make more money than those guys. But whether or not I work longer hours than they do (which is definitely possible, I work pretty long hours), you’d have to be clinically insane to think that writing my blog entails working harder than they do. In the real world, the reason I earn more than Salvadoran movers is the same as the reason I work less hard—I have more valuable skills

To be fair, the original article was subscriber only, so I couldn't read the whole thing. But the notion that you earn more because you "worked harder" sounds more like aggrieved utopian nonsense than the principled free-market outlook that is associated with the WSJ.

Don't take my word for it, or Yglesias's for that matter. Here's Hayek from The Road to Serfdom:

In any system which for the distribution of men between the different trades and occupations relies on their own choice it is necessary that the remuneration in these trades should correspond to their usefulness to the other members of society, even if this should stand in no relation to subjective merits.

Standing athwart the baggage carousel yelling enough!

I'm beginning to wonder if Senator Charles Schumer (D-NY) has even a tenuous grasp on reality. Via Senatus:

Senator Chuck Schumer (D-NY) “said he would introduce legislation that would prevent airlines from charging a fee for carry-on bags,” Reuters reports.

Schumer, a New York Democrat, said he would press the Treasury Department to issue an administrative rule that would define carry-on bags as a "reasonable necessity" to prevent airlines from imposing such charges, calling them a "slap in the face to travelers."

Schumer said if the Treasury Department cannot close what he dubbed a loophole in the law, he will introduce legislation that would mandate carry-on bags as reasonably necessary for air travel.

If there was ever a phenomenon that cried out, "I am not a market failure requiring government intervention," the practice of charging for carry-on bags was it.

Despite what Southwest airlines keeps telling you, bags do not fly free; they never have. If you think that in the good ol' days prior to baggage fees you were somehow sneaking one past the airlines by having them transport your luggage for free, you're kidding yourself. The cost of transporting the bag was part of the cost of your ticket. Any airline that couldn't figure out how to make sure of that, wouldn't be in business very long.

It seems to me baggage fees do two things: 1)They make travelers aware of the cost of transporting a bag. A cost that was always there, but hard for the average traveler to identify. 2) They make travelers who impose higher costs by traveling with more bags, actually pay those higher costs.

While this second feature is bad for people who like to travel with a lot of luggage, it's good for people that do not. In fact, prior to this, people who traveled lightly were subsidizing the ticket price of those who packed a lot of clothes. Has our entitlement mentality ballooned to such a size as to now include reduced cost airfare for the more sartorially inclined traveling public?

The negotiation between airlines and passengers over costs, including the costs of transporting luggage is absolutely no place for the government to inject itself. I simply can't think of any compelling rationale for a government intervention over a carry-on bag fee.

Eliminating the cost of transporting luggage from one destination to another would require a repeal of the laws of physics. Outlawing the practice of charging baggage fees may make the fees disappear, but you can count on the fact that travelers will continue to pay them in the form of higher ticket prices. To pretend otherwise is either an outright lie or a denial of reality so troubling that it may disqualify one from holding public office.

Learning from Lehman

Even if there are never any criminal prosecutions or civil awards related the collapse of Lehman Brothers, one thing is clear from the recently released bankruptcy court examiner's report.

From Enron to Lehman, corporate financial reporting, accounting, and auditing has suffered what can only be called a lost decade in which the industry learned nothing from its own mistakes.

Real Time Economics is featuring excerpts of the report:

"Colorable claims exist that Ernst & Young did not meet professional standards, both in investigating Lee's allegations and in connection with its audit and review of Lehman's financial statements."

--From the report, executive summary, page 21

"[W]e are also dealing with a whistleblower letter, that is on its face pretty ugly and will take us a significant amount of time to get through. I am confident from what I have seen it shouldn't result in any significant issues around financial reporting, but again there is a lot of work to do yet. This combined with some very difficult accounting issues around off balance sheet items is adding stress to everyone." (From a June 8, 2008, email from William Schlich, a former lead partner on Ernst & Young's Lehman team)

--From the report: Volume 3, page 961

We're All Austrians Now...Or Not

When I linked the Keynes vs. Hayek rap video the other day, I mentioned that I wasn't convinced this was really an accurate description of the debate playing out in the country as a whole. In fact, I don't think this is an accurate description for the debate that is playing out in the United States Congress.

It is the case the Keynes has received a lot of attention lately due to the debate over the need for, and effectiveness of, fiscal stimulus in response to the economic crisis, but Hayek simply hasn't gotten the same visibility.

Freidrich August Hayek was an economist affiliated with what is now known as the Austrian School. Some of his major work was on business cycles, the booms and busts that economies experience. Here is a description of one of his insights (from the Library of Economics and Liberty):

One cause, he said, was increases in the money supply by the central bank. Such increases, he argued in Prices and Production, would drive down interest rates, making credit artificially cheap. Businessmen would then make capital investments that they would not have made had they understood that they were getting a distorted price signal from the credit market....he concluded, artificially low interest rates not only cause investment to be artificially high, but also cause “malinvestment”—too much investment in long-term projects relative to short-term ones, and the boom turns into a bust. Hayek saw the bust as a healthy and necessary readjustment. The way to avoid the busts, he argued, is to avoid the booms that cause them.

Sound familiar? You would think with an insight that so nearly describes our recent history, lawmakers, and everybody else, would be beating down the door to the Austrian School, and that this would show up in their decision making.

Well, the Senate recently had a chance to demonstrate whether or not they had made such a conversion with the confirmation vote on the guy who exerts an enormous amount of control on our money supply, Ben Bernanke. The result? Sean Scallon at the @TAC blog said it best:

Yes the two political parties may have bitter disagreements when it comes to abortion, or climate change, or health care reform, but when it comes to benefiting themselves and the establishment they serve they do know how to come together for a common purpose.

I mean you had Sen Thad Cochran, Republican of Mississippi and Charlie Schumer of New York, as different as two men can possibly be from two completely different places and backgrounds, and yet Ben Bernanke brought them together. Not only can he drop money from out of the sky, not only is he’s Time’s Man of the Year, he’s also a peacemaker as well. Perhaps he should nominated for a Nobel Peace Prize as well. Ain’t he swell?

So, rumors of a Hayekian awakening are, I fear, greatly exaggerated. We now return you to your regularly scheduled boom and bust cycle already in progress.

Keynes v. Hayek Video

Just in case this is the only blog you read that addresses economics, here is the Keynes vs. Hayek rap video that has been making the rounds this week.

I'm generally skeptical of these attempts to shoehorn important concepts into popular media formats, but this is really well done. Just don't let this be your only source of information. It's OK to put ketchup on your fries, just don't count it as a vegetable.



I'll say something more substantive about the debate in the future. While it's clear Keynes is getting a lot of discussion these days, I'm not convinced that the opposing argument in the popular discourse is Hayek's. (It's seems more like Hayek-lite.)

One nitpick with respect to the video. Near the beginning, Keynes calls Hayek on the phone and Hayek's body language seems to suggest he is not exactly sure what that strange ringing object is. Hayek died in 1992, so I don't think he would be surprised by a ringing telephone in a hotel room. Even one appointed in such a modern style.

Haystacks, needles, and networks.

Sometimes I wonder if our recent rapid technological changes haven't quite lived up to their potential.

Then I hear about how technology can be used to solve a problem:

In less than nine hours, a team from the Massachusetts Institute of Technology Media Lab scooped a $40,000 prize by cracking DARPA's Network Challenge. They found 10 red weather balloons, which the US military research agency had tethered in public locations across the US last Saturday.

How did the MIT group succeed so quickly? Team leader Riley Crane says their incentive programme helped.

To recruit people into their network of balloon spotters, the MIT team offered to split the prize money, so that if the team won, the person who correctly identified a balloon's location got $2000. Finder fees were also offered, so that whoever referred a successful spotter would be given $1000; $500 went to the referrer of the referrer, $250 to the referrer of the referrer of the referrer, and so on, with any remainder going to charity.

"In 48 hours, we went from a team of five to a team of 5000," says Crane

A trivial problem I realize, but one that demonstrates a fundamental, and fundamentally good, aspect of the new kinds of communication and networking that were previously unavailable.

This was a zero sum game to be sure, so a strategy that increased team size reduced the size of the winnings that an individual team member would get, but it also greatly increased the chance of winning.

The metaphor of a pie is often used when talking about economic growth. With the debate often coming down to a discussion of cutting the pieces of the pie so that they are the same or nearly the same size versus increasing the overall size of the pie so that everyone's piece is bigger, even when there is great variability in the size of the individual pieces. The collaborative competition used to win this game showed how a group might actually be able to bring a whole new set of the pies to the table. Pies that previously nobody ate because the cost of making them was simply too high for one person.

If this game required that only a single person locate the balloons there is a good chance that the prize money would never be claimed. $40,000 may not get you very far if you are trying to find ten balloons scattered randomly throughout the United States. By using technology to communicate with people around the country, the team was able to include people whose cost of finding a single balloon that just happened to be in their area was much much less than the $40,000.

This team combined the need for incentives to encourage collaboration with the recognition that there are diminishing marginal costs and won. The winning team was successful by increasing the number of payouts the game had. Literally changing the rules of the game. This is something that we often hear technology is capable of, it's encouraging to see that change in action.

Getting it wrong

Economist Paul Krugman has a New York Times Magazine article entitled How Did Economists Get It So Wrong? which has a nice description of the mainstream of economic thinking since the Great Depression.

He winds up arguing that the only way forward is a return to government spending as a response to business cycle downturns. He treats this as a far more settled conclusion than I believe it to be. Regardless, Krugman's walk through recent economic thinking has value even if you don't think we ought to double down on Keynesian spending the way Krugman does so you should go read the whole thing.

Of particular importance to understanding this crisis is understanding the role of finance:

By 1970 or so, however, the study of financial markets seemed to have been taken over by Voltaire’s Dr. Pangloss, who insisted that we live in the best of all possible worlds. Discussion of investor irrationality, of bubbles, of destructive speculation had virtually disappeared from academic discourse. The field was dominated by the “efficient-market hypothesis,” promulgated by Eugene Fama of the University of Chicago, which claims that financial markets price assets precisely at their intrinsic worth given all publicly available information. (The price of a company’s stock, for example, always accurately reflects the company’s value given the information available on the company’s earnings, its business prospects and so on.)

The notion that market actors are always rational and that market prices are always correct seems foolish regardless of where you fall on the political spectrum. To accept such a notion, one would have to accept a fundamental change in human nature.

If you are one who believes we live in a fallen world, there is absolutely no way, short of split personalities, that you can also believe in the perpetual accuracy of market prices. The flip side to this of course, is the fact that no amount of government intervention is going to permanently alleviate all human suffering whether caused by economic striving or not.

This is not to say we should do nothing. Nihilism is not an option. A measured approach to implementing prudential but substantial changes is my preferred course. It's possible, perhaps even likely, that the Obama approach will be one of highly publicized cosmetic changes and then business as usual on Wall St.

Economists that overturned the thinking of Keynes in the academy weren't right, and it's not at all clear that Keynes' approach still holds true. Given this state of affairs, without some new thinking when it comes to finance, we could find ourselves continuing to 'get it wrong' for a very long time.

*Economics In One Lesson*

Even though it first appeared in 1946, Economics in One Lesson: The Shortest and Surest Way to Understand Basic Economics by Henry Hazlitt has some fascinating things to say about events happening right now. I was particularly struck by this:

Government guaranteed mortgages, especially when a negligible down payment or no down payment whatsoever is required, inevitably mean more bad loans than otherwise....They encourage people to "buy" houses that they cannot really afford. They tend eventually to bring about an oversupply of houses as compared to other things. They temporarily overstimulate building, raise the cost of building for everybody (including the buyers of the homes with guaranteed mortgages), and may mislead the building industry into an eventually costly overexpansion. In brief, in the long run they do not increase overall national production but encourage malinvestment.

At first glance I thought this was incredibly prescient. But then I had second thoughts. After all, it isn't the government guaranteed loans that have gone bad in the latest crisis. Otherwise banks wouldn't have toxic assets. They would be made whole by government guarantees and it is the government that would have the toxic assets. (They do anyway, but that is a function of the response the current crisis.)

On the other hand, it's not that hard to argue that government guarantees distort the market; and it is these distortions that started us down the path of ruinous activity in the mortgage markets. Activity whose negative effects eventually spilled over into other parts of the economy.

In light of recent history though, Hazlitt is far too optimistic about the private market's ability to avoid the negative consequences outlined above, which he sees as the outcome of government intervention only. His confidence in the market seems thoroughly misplaced when he writes:

Most lenders, therefore, investigate any proposal carefully before they risk their own money in it.... The private money will be invested only where repayment with interest or profit is definitely expected.

He was right about the expected profit part; but lenders weren't counting on repayment in order to obtain their profit. It wasn't the government extending loans to people with no realistic chance of repayment, it was the private mortgage industry. It wasn't the government giving mortgages to people who provided no documentation as to income or credit history, it was the private mortgage industry.

The proliferation of liar loans and incredibly stupid behavior by so many involved in mortgage transactions however, does not mean that Hazlitt was wrong about the consequences of government intervention; but it is clear that his notions about the free market's ability to avoid such negative outcomes seems outdated.

What isn't diminished at all and is, in fact, reinforced by the latest economic crisis is what Hazlitt calls the single lesson that contains the whole of economics:

The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.

It is absolutely clear that many in the financial industry were either ignorant of or willfully disregarded this simple notion. It is demonstrable almost to the point of being indisputable that much of the financial activity in our recent past consisted of the pursuit of narrowly focused short term profit with little or no thought given to the "longer effects" or the consequences "not merely for one group but for all groups."

Finding a way to teach both our government and our industries Hazlitt's lesson, and getting them to put it into action, is essential to our future prosperity and our continued economic security.

Why Inflation Is Not The Threat Now

I've mentioned once before Economist Scott Sumner's blog. Sumner blogs on monetary issues. Like the popular New York Times columnist Paul Krugman, Sumner thinks that the main threat currently is deflation, not inflation. Unlike Krugman, Sumner argues that monetary policy is still effective and can address the current crisis alone, without government spending (fiscal policy).

Unlike almost all other economic commentators these days, Sumner argues that currently and last fall the Fed was pursuing a tight money strategy.

Two items from Sumner's FAQ section on his blog:

2. But weren’t interest rates cut to very low levels?

Interest rates are a very misleading indicator of monetary policy. Both in the early 1930s and late 2008, falling rates disguised a tight money policy. The rates were actually falling for two reasons. Expectation of recession led to less borrowing and thus lower real interest rates. And inflation expectations also fell sharply.

3. But didn’t the monetary base increase sharply?

Yes, but this is also misleading for two reasons. During periods of deflation and near-zero rates, there is a much higher demand for non-interest bearing cash and bank reserves. In addition, last October 6th the Fed began paying interest on reserves, which caused banks to hoard bank reserves.

So low interest rates don't necessarily indicate an a loose monetary policy and even if the Fed pursues a money creating strategy, increased demand for holding cash can thwart this.

The label contrarian gets thrown around so much these days it's lost most of its punch. But the notion that recent monetary policy has been tight seems to be one of the few current views truly worthy of the description. Fed Chairman Ben Bernanke however, is doing what he can to make the contrarian label outdated. Writing in a Wall Street Journal Op-Ed he notes:

When the Fed makes loans or acquires securities, the funds enter the banking system and ultimately appear in the reserve accounts held at the Fed by banks and other depository institutions. These reserve balances now total about $800 billion, much more than normal. And given the current economic conditions, banks have generally held their reserves as balances at the Fed.

Bernanke goes on to argue that one way to control inflation, if and when it becomes the major threat, is through the payment of interest on bank reserves, encouraging them to hold cash rather than lend it out. The use of interest on reserves as a tool of monetary policy has been one of the major ideas of Sumner's blog.

But Bernanke is still talking as if we are in a period of loose monetary policy; for example he mentions, "[w]hen the time comes to tighten." When the time comes? We may be tightening now and not even realize it.

So if Sumner is right, not only is inflation not the current threat, but recovery could in fact be slowed or prevented outright. What if what looks like an expansionary monetary policy is, in fact, the exact opposite. It is difficult enough to determine the best policy approach to economic recovery; overcoming the fact that a policy may be doing the exact opposite of everything we think it is doing may be an insurmountable obstacle to recovery.

What We Can Learn from the Breakdown in the Motor City

Are Michigan's woes a cautionary tale regarding international trade?

Trade between different states within the United States is not exactly analogous to international trade, but there may still be some valuable lessons in such a comparison. The key to understanding why international trade occurs and how countries benefit from it is a concept called comparative advantage.

Imagine two states, Wisconsin and Michigan, making two goods, cheese and cars. It may be the case that MI is actually able to produce both cheese and cars more cheaply than WI (I know, not possible, just go with me, it's a hypothetical), but this does not mean that MI doesn't stand to gain from trade. In this case MI and WI would each be better off if they produce the particular good that they can produce at a lower cost and then trade with each other.

Don't think of lower cost in terms of dollars and cents, but in terms of the other good. If MI is good at making cars relative to cheese, they may only give up a little bit of cheese if they decide to spend their time making cars, this lost cheese is the cost of making a car in MI. Over in WI, they may be better at making cheese relative to cars. This means that if they choose to make cars, they give up more cheese production than MI does. Since every car MI makes costs less in terms of cheese, trade theory tells us that MI should make cars, WI should make cheese, and then they should trade with each other. This way they both have more cheese and more cars than they would if they each made both goods themselves.

Since there is a benefit to trading, both MI and WI will likely do so. As time goes by each state will likely increase its specialization in its one good, meaning that its economy is highly concentrated one sector. An economy that is highly concentrated is obviously less capable of handling a shock to their particular sector. This is what we see in Michigan now.

Here is an item from the Chicago Fed's blog from 2005:

Michigan’s traditional heavy reliance on the domestic auto industry has been troubling its economy over the past five years....job losses are felt more keenly in Michigan since, even among the Midwest troika of auto states, Michigan is by far the most dependent on automotive. Michigan’s job base is 7 times more concentrated than the nation in automotive parts, versus 5 and 3 for Indiana and Ohio.

And that was in 2005, prior to the current recession. For April of 2009, Michigan's unemployment rate was at 12.9%. This is 4% higher than the nation as a whole.

It is definitely the case that the world benefits from international trade, but countries (and states) are weakened when their economies are highly concentrated in one particular sector. The concentration has a double effect in that it means a shock to the sector disproportionately affects the concentrated economy and the concentration is often difficult to dilute in response to the shock, making recovery harder and slower.

As I said though, Michigan's economy is not a microcosm of the U.S. economy. The national economy is enormous and incredibly diverse, right? Here is economist Simon Johnson writing in The Atlantic (E.A.):

From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent.

While concentrated profits is not exactly the kind of concentration found in Michigan and the auto sector, it is a type of concentration. This also makes it clear why a global financial crisis will have a great impact on the American economy.

A country as rich and highly developed as the United States will be better able to weather a crisis than less highly developed nations, even a crisis that affects a sector in which it specializes. But this dependence on financial sector profits may partially explain why a country like Canada would be less affected by a global financial crisis than the U.S.

While protectionism will never solve our economic problems, the U.S. would do well to remember Michigan's example and maintain a high degree of economic diversity.

Monetary policy & where the rubber meets the road

At this link you can check out a primer on Quantitative Easing. Quanti-what, you might ask. This is one of the more unusual tools that a central bank like the Fed can use when interest rates are already very low. Don't wory, the primer is a video with talking and graphics, no reading required. Just sit back and enjoy.

I wouldn't say that using QE means were in 'duck and cover' mode, but we certainly have crossed over into 'spare tire' territory.

Let's just hope it is a full size spare and not one of those bizarre miniature spare tires that seem to be the norm. It's bad enough when you are on the side of the road changing a flat that cars pass by at such incredible rates of speed you feel like you are part of a nascar pit crew, only you are wearing a tie and shoes that hurt your feet; but then when you get back in your car and on the road again, everyone can still tell you just had a flat because of the dinky spare that is causing your car to pull dangerously to one side. I mean, sure, you can white-knuckle it for a few miles, but at some point you consider lashing your hands to the wheel like some 19th century sailor at the helm of a ship headed straight into the gaping jaws of a storm at sea.

Anyway, those little spare tires are the automotive equivalent of a scarlett letter.

As an added bonus the QE video narrator has an English accent. I personally believe everything sounds better with an English accent. That is why I feel strongly that all announcements about the future national debt should be made by the actor Michael Caine, or if he is not available, the Geico lizard.
__________________
h/t on the QE primer to Mankiw. All the rambling about spare tires and English accents is mine.

Get Your Sticky Wages Off My Health Care.

When you have six kids encountering something sticky is a daily occurrence. But in economics the phenomenon of sticky wages (and prices) has very different implications.

Basically, when things are sticky, they can't adjust as quickly as the surrounding conditions. This results in periods of time when the real world doesn't quite match the charts that the graduate students spent all that time on. I would call this a time when things are out of whack. Professional economists call it a disequilibrium.

The confluence of sticky wages, health care costs, and the competitiveness (or lack thereof) of the US auto industry reared its head recently on the blog of Harvard professor Greg Mankiw.

Mankiw quotes representatives (and personal friends) from two different agencies from the federal alphabet soup as follows (the red text is Mankiw's):

NEC: Our ability to produce competitively in the United States will be enhanced if we contain healthcare costs

CBO: when firms provide health insurance, wages and other forms of compensation are lower (by a corresponding amount) than they otherwise would be. As a result, the costs of providing health insurance to their workers are not a competitive disadvantage for U.S.-based firms.

This debate is more than academic, especially in Michigan. Do health care costs put GM at a disadvantage? Mankiw answers no:

Ultimately, what matters to firms is the compensation they pay workers. The composition of compensation between cash wages and fringe benefits like healthcare does not matter for the firms' costs of production. In short run when cash wages are sticky, the cost of healthcare may affect competitiveness: Lower costs of fringe benefits would reduce compensation and thus reduce firms' cost of production. But in the long run, compensation is set by supply and demand in labor markets. If more compensation is paid in the form of fringe benefits like healthcare, less is paid in the form of cash. And if less is paid in fringes, more is paid in wages.

OK, I'll agree that total compensation is the critical factor, not the cost of a single component of compensation.

But Mankiw specifically mentions workers. Does the calculus change when thinking about retirees? I suppose pensions can be adjusted through negotiation, no different than cash wages. But what about the fact that these people are no longer producing anything.

As Americans live longer, GM pensioners live longer, so every Chevy now has to cover the cost of the men and women that are currently producing the cars, and the health care and pensions of the men and women that produced Chevy's that have long since found their way to the scrap heap.

What about the fact that, during their working years, the productivity of current retirees was limited to the technology that was then available; but the health care they consume today is limited by today's standards. That is to say they worked at 1965 productivity levels, but GM has to pay for health care at 2005 levels. (This is not to say GM doesn't owe this to the workers, I am just wondering if this is more of a problem than Mankiw's brief analysis allows.)

Admittedly, both of these items have to do with legacy costs, but there may be some problems that are driven by the here and now as well.

Mankiw notes that in the long run cash and fringes will vary in order to stabilize total compensation. But certainly there must be some bottom limit beyond which cash wages cannot fall or people won't work - even though the cost of the fringe benefits to the company represent a level of compensation at which people would otherwise choose to work. (I mean would people have to be hospitalized so that they could eat a meal which would then be covered by their employer provided health insurance?)

Finally, what if a firm faces a rapid and steep increase in the cost of compensation coupled with a rapid and steep decline in demand for the products it makes? This seems to be what we have now. In this case, maybe there is no long run during which wages and fringe benefits can recalibrate to keep the firm competitive. Basically a firm could go under for want of a long run, or for want of a loan to make it through the short run. (Anyone still think functioning credit markets aren't important?)

Anyway, no doubt someone of Mankiw's caliber could put all my questions to rest with a few professorial pronouncements. (If only it were that easy!).

His post, for me at least, raised more questions than it answered. As far as I can tell he doesn't have an email or comments on his blog, so I am posting this reaction here.

I suppose I could send him a letter, care of the ivory tower of course! (Now why did I do that, I just marred an otherwise thoughtful post with a silly populist jab. Shame on me. )

Shocking the Shockers OR Disaster Keynesianism

A comment to my last post triggered a thought about how I could be more succinct in my critique of the government response to the current economic situation, both at the Federal and State levels. In particular, I was reminded of this quote:

Only a crisis—actual or perceived––produces real change. When that crisis occurs, the actions that are taken depend on the ideas that are lying around. . . . Our basic function [is] to develop alternatives to existing policies, to keep them alive and available until the politically impossible becomes the politically inevitable.

This was free-market economist and Nobel Laureate Milton Friedman's insight. But the version of the quote I remembered wasn't Friedman's, it was from Naomi Klein's book The Shock Doctrine: The Rise of Disaster Capitalism.

In the book, Klein delivers a whirlwind tour of the late 20th century economic response to certain crises arising from natural disasters and political upheavals. If you want to read a recent history with an axe (a really big axe) to grind, I can't recommend The Shock Doctrine enough (here's a link to the google books version).

Klein spends the entire book trying to show that Friedman's prescriptions for a return to economic health were, well, disastrous. But she never refutes his assertion that only times of crisis produce change. I can't remember if she even tries.

Oh yeah, the succinct part:

Working from Friedman's insight, recent events can be seen in a whole new light. Democrats took Friedman's words to heart and have continued to keep alive those ideas that are dear to them, that have been dear to them at least since the New Deal. The collapse of the housing market, with the rest of the world economy in tow, did the rest.

If they are simply using the current crisis to enact the same old agenda, what chance does it have of succeeding? Some? Any?

If the current program succeeds, great, we will all be better off. But if it fails, I hope that thirty years from now we have recovered sufficiently for some hip right-winger to write a snappy critique of the early 21st century response to economic crisis and title it: The Stimulus Doctrine: The Rise of Disaster Keynesianism.