In an intruiging article on VoxEU, David Audretsch, Oliver Falck, Maryann Feldman, and Stephan Heblich synthesize existing economic geography models to offer a theory of "regional lifecycles." I don't question their theory of regional lifecycles, but I do question the policy implication they draw from it. First, though, here are the four phases of the regional lifecycle they identify:

The initial entrepreneurial phase, during which Jacobs externalities and inter-industry startups prevail. ... The routinised phase, during which innovation takes place within top-performing incumbents. Once a dominant product is established, production becomes more specialised and shifts to industrial agglomerations where R&D effort becomes much more focused. ... A second entrepreneurial phase, which is characterised by Marshall-Arrow-Romer (MAR) externalities [i.e., intra-industry spillovers], leading to intra-industry startups in niche markets. An increasing routinisation eventually opens the door for niche producers providing custom-tailored sophisticated products and solutions. ... A second routinisation phase, which is a time of structural change during which no further innovation takes place. Existing knowledge is exploited in these regions but they lack a large enough or appropriate stock of regional knowledge that could act as the basis for a new, competitive industry.
Here's the main policy implication the authors draw from this:
For practitioners, these findings reinforce the need for differentiated regional policies and suggest each region needs policy tailored to its unique characteristics and its position along the regional lifecycle. It follows that such a policy can only be designed by those intimately acquainted with the region – in other words, at the regional level by regional politicians rather than instituted top-down by supra-national institutions. Regional policymakers need to act as entrepreneurial designers of their own regional policy.
I see one major problem with this conclusion. The success of each of the four types of regions will differ, sometimes dramatically. The fourth type of region ("the second routinsation phase"), for example, will undoubtedly be less successful economically than the first two regions, and will probably also be less successful than the third region. Regional politicians in the fourth region will not be content with their region's lagging economic success. They will adopt policies aimed at changing their region's classification, not at improving their region's efficiency within its existing classification. If the first type of region is the most economically successful region, then regional politicians in the fourth region will want emulate the first region. They won't adopt policies aimed at making the region a better fourth-region, because not only will that fail to lead to large welfare gains, it's also bad politics). So if we give control to regional politicians, the result will be perpetually inefficient fourth-regions. The authors assume that regional politicians will be satisfied with their region's place in the regional lifecycle, but that's a very pollyannaish view of regional politicians.

Shankar Vedantam, writing in the Washington Post, says yes. I say no. First, Vedentam:

The fault line in this dilemma -- the interests of a candidate pitted against the collective interest of his or her party -- shows up in many economic and political domains and is sometimes called the "tragedy of the commons." ... Pulling out of the race means giving up your dream -- when you think you are the better choice. Staying in risks collective disaster.
The Democratic primary may share some of the same characteristics as a tragedy of the commons, but it's fundamentally not a tragedy of the commons. For a tragedy of the commons to occur, there must be unrestricted access to a finite resource. In this case, the finite resource is the Democratic nomination. It follows that if either Hillary or Obama's access to the nomination can be restricted, then the primary is not a tragedy of the commons. Can Hillary or Obama's access to the nomination be restricted? Yes. The superdelegates -- who by definition represent the party's interests -- can restrict either candidate's access to the nomination. At this point, neither candidate can realistically win enough pledged delegates to secure the nomination before the convention. But the superdelegates can hand the nomination to Obama today. To clinch the nomination, you need 2,024 delegates. Obama currently has 1,729 delegates, so he needs 295 more delegates to clinch the nomination. And it just so happens that there are currently 295 uncommitted superdelegates. (The superdelegates could also effectively hand the nomination to Hillary, but she'd still have to win a few more pledged delegates to make it official.) The superdelegates thus have control over access to the Democratic nomination. In fact, I suspect that the superdelegates' ability to hand one candidate the nomination and end the primary has kept Hillary and Obama's campaigns from being even more slash-and-burn than they've been already. Both campaigns are actively courting superdelegates, so neither campaign can do anything so damaging to the party that the superdelegates won't vote for them. I know it seems like the Democratic primary is so vicious that it's irreparably harming the party's chances in the fall, but just imagine how much worse it would be if neither campaign had to woo superdelegates who have a vested interest in the party's success.

Brad DeLong is not impressed with Roger Lowenstein's conclusion that the problem was the rating agenies' over-reliance on historical data:

The problem is not that the rating agencies' formulas look backward while life is lived forward. Rating agencies' business is to look backward: to say that this bond looks, historically, like that class of bonds which have in the past defaulted at such-and-such a rate.
DeLong believes the allocation of responsibilities between rating agencies and invetors should be:
The proper business of investment is to take the rating agencies' work as a guide and ask two of the three standard questions:
  • What is there in the situation that could make things different this time--that could generate "ahistorical behavioral modes"?
  • How much of the risk that things are different this time are we willing to bear?
  • If this is such a good deal for me to buy it at this price, why is the seller selling--why isn't it a equally good deal for the seller to hold on to it?
Essentially, DeLong's view is that rating agencies should be responsible for all backward-looking analysis, and investors should be responsible for all forward-looking analysis. I don't think it's nearly as cut-and-dry as DeLong suggests. A registered rating agency has a duty to issue credit ratings that reflect the agency's "opinion, as of a specific date, of the creditworthiness of a particular company, security, or obligation." Whether a credit rating must be purely backward-looking depends on how you define "creditworthiness." DeLong would define creditworthiness in purely historical terms: "Rating agencies' business is to look backward: to say that this bond looks, historically, like that class of bonds which have in the past defaulted at such-and-such a rate." But that's an inaccurate definition of "creditworthiness" by any standards. In assessing creditworthiness, lenders are concerned with the borrower's ability to pay in the future. A borrower's history of paying back loans is usually the best indicator of his future ability, but it's certainly not the only indicator. DeLong is confusing an indicator of creditworthiness with actual creditworthiness. A determination of the creditworthiness of a security is necessarily forward-looking. It may rely on historical data as indicators of creditworthiness, but to say that rating agencies' job is only to rely on historical data is to badly misstate their purpose (i.e., their legal duty as registered rating agencies). Should rating agencies be responsible for forward-looking analysis? Maybe not. But you simply can't say that investors were wrong to rely on credit ratings for forward-looking analysis at all. Investors clearly relied too much on credit ratings for forward-looking analysis, but that's a different issue. The fact credit ratings -- as assessments of creditworthiness -- necessarily include forward-looking analysis shifts at least some of the blame back on the rating agencies. Rating agencies are to blame for issuing bad credit ratings, and investors are to blame for relying too much on credit ratings for forward-looking analysis. Investors bear more of the blame because they should have known how much to rely on credit ratings for forward-looking analysis, based on the particular rating agency's methodology in issuing credit ratings. But make no mistake: rating agencies bear some of the blame.

Saturday, April 26, 2008

Role Reversal

The State Department is generally the one executive agency that consistently favors a greater international role for the United States. Farmers, on the other hand, have historically been more parochial in their concerns (not just U.S. farmers, but farmers in every country, and throughout history). In an op-ed in today's New York Times (via Mark Thoma), Norman Borlaug -- the father of the Green Revolution and Nobel Peace Prize winner -- describes the growing threat to global wheat production from Ug99, a new strain of the famous "stem rust" wheat disease that he helped fight in the 1950s. Borlaug notes that the Bush administration has recently scaled back its support for research to fight Ug99, but what struck me as odd was alignment of the executive agencies on this issue:

The Bush administration was initially quick to grasp Ug99’s threat to American wheat production. In 2005, Mike Johanns, then secretary of agriculture, instructed the federal agriculture research service to take the lead in developing an international strategy to deal with stem rust. In 2006, the Agency for International Development mobilized emergency financing to help African and Asian countries accelerate needed wheat research. But more recently, the administration has begun reversing direction. The State Department is recommending ending American support for the international agricultural research centers that helped start the Green Revolution, including all money for wheat research.
As the recent food price crisis has demonstrated, this is the kind of thing that disproportionately harms people in poor countries (i.e., the majority of the world's population). But it's the Department of Agriculture that took the international lead in fighting stem rust, and the State Department that's recommending scaling back our international role. Huh?

Friday, April 25, 2008

A (Small) Silver Lining

David Kurtz at TPM captures this screenshot from Fox News: Note the use of the word "ready." This is the argument that Hillary's campaign has been pushing for a while now: that Obama, while a talented politician, just isn't ready to shoulder the responsibilities of the presidency. Hillary's campaign largely concedes Obama's obvious talent. That's to be expected in a primary (yes, even a primary with the supposedly evil Clintons). But it's encouraging to see this particular argument against Obama spilling over into Republican talking points. Saying that Obama isn't "ready" for the presidency implies that he will be ready for the presidency in the future. It's a tacit admission that he possesses the tools necessary to be the President. This is, in my opinion, a mistake by the Republicans. Instead of arguing that Obama lacks the competence and the experience to be President, they're basically arguing that Obama lacks just the experience. I don't think the experience argument will be terribly effective. George W. Bush was less experienced than Al Gore, and Bill Clinton was less experienced than George H.W. Bush. Americans like wunderkinds. We like to unleash potential, and see what raw talent can really do. But most of all, we don't like to wait. If we're told that Obama has the raw talent necessary to be a good president in the future, then we won't want to defer those benefits for 4 or 8 years. We want it now. So in this case, I think Americans' aversion to deferring benefits is good for the Democrats.

Megan McArdle, in a debate about land use regulations, plays the libertarians' ultimate trump card:

[T]hen we got into noise pollution, and he demanded to know if I thought people should be allowed to play loud music in their houses, if you can hear it. Not deafening music, which I would be against; just loud. I pointed out that as long as the transaction costs for side deals are relatively low, which they should be in the kind of leafy, large suburb we were discussing, it didn't really matter whether he had the right to play music, or I have the right to enjoy silence; the Coase Theorem dictates that we will end up with preference maximization.
The Coase theorem "dictates"? Actually, the Coase theorem dictates absolutely nothing. The Coase theorem has made enormous contributions to economics, but its net contribution is diminished every time someone applies it to the real world. I literally cringed when I saw McArdle invoke the Coase theorem as the basis for her argument. It's a neat trick, and a lot of libertarians I know use it, but it betrays a fundamental misunderstanding of the Coase theorem. Not only should the Coase theorem never be applied to the real world, but it was not intended to ever be applied to the real world. In his seminal article establishing the Coase theorem (The Problem of Social Cost), Ronald Coase made this clear:
The argument has proceeded up to this point on the assumption that there were no costs involved in carrying out market transactions. This is, of course, a very unrealistic assumption.
Coase never argued that the results reached under the Coase theorem would have any relevance to the real world. After 20 years of people abusing his thoerem, Coase again stated in no uncertain terms that his theorem was not intended to, and should never, be applied to the real world and treated as determinative:
[W]hile considerations of what would happen in a world of zero transaction costs can give us valuable insights, these insights are, in my view, without value except as steps on the way to the analysis of the real world of positive transaction costs.
So if you invoke the Coase theorem as the basis for your argument, your argument is by definition wrong. Please, end the scourge of Coase Theorem Abuse! UPDATE: Megan McArdle responds in the comments:
I actually agree with you, sort of ish, but by that point in the argument, we were so far into theoretical la la land that you'll have to trust me that zero transactions costs were among the more realistic assumptions being made.
Okay, I trust you. And I should have noted that relying on Coasean bargaining is probably more realistic than relying on Tieboutian sorting, which your friend seemed to do. But some transaction costs are so distortionary that the Coase theorem is inapprorpiate even as a starting point. This is especially true for a lot of land use issues, where transaction costs are extremely high. Government capture is so widespread in land use that Coasean bargaining is the exception rather than the rule. In fact, last year I had a client tell me that she would have approached her neighbor about resolving their land use dispute privately, but she didn't think the contract would hold up in court! It's important to remember that homeowners don't make their decisions on land use issues based solely -- or even predominantly -- on their subjective valuations. Most homeowners care first and foremost about maintaining the resale value of their house, because the higher the market value of their house, the more equity they have to borrow against. So homeowners make land use decisions based on what they think prospective homebuyers' preferences are. Prospective homebuyers, in turn, also take the future resale value of houses into consideration when buying a house. And so on, and so on, in a self-reinforcing cycle. A much better starting point for modeling land use is probably an anticommons. As Ed Glaeser has noted, there has been a "dramatic increase" in the number of land use regulations over the past 30 years (though I would trace the rise of land use regulations further back than that, as William Fischel has done). The complex web of land use regulations has essentially given every resident de facto veto power over every other resident's land use. You can imagine how useful the Coase theorem is under that allocation of property rights.

Sen. Sherrod Brown (D-OH) has an op-ed in the Wall Street Journal with the title, "Don't Call Me a Protectionist." Based on the title, I expected Brown to make non-protectionist arguments against the Columbia Free Trade Agreement, and maybe other recent trade agreements as well. That's certainly possible, although I don't find those arguments very persuasive from an economic standpoint. But curiously, Brown spends the whole op-ed making arguments that are unquestionably protectionist, even under the most favorable definition of protectionism. There's more than a whiff of mercantilism in the op-ed too. Brown even defines "U.S. trade policy" in terms that are more-than-a-little protectionist:

[L]et us agree that U.S. trade policy – writing the rules of globalization to protect our national interests and our communities – is worthy of a vigorous national debate.
It's hard to argue that you're not a protectionist when the word "protect" is in your definition of "U.S. trade policy." I'm not immune to arguments against some trade deals, even though I've ultimately supported all our trade deals since about 1990. Not every trade deal with "Free Trade" in the title necessarily moves us towards freer trade. Details matter. But let's be honest: Sherrod Brown is protectionist.

I've found it extremely difficult to explain to people in just an email how subprime has wreaked such havoc the entire financial market. But CR over at Calculated Risk provides a great one-paragraph summary:

Homebuyers were speculating with no money down. Mortgage brokers didn't care because they would sell the loans immediately and collect their fees. Wall Street didn't care because they could package the loans and sell them to investors. Investors would have cared, except they trusted the rating agencies. And as this article describes, the rating agencies weren't evaluating the underlying loans - they were performing statistical analysis using models based on lenders that cared if the borrower would repay the loan. At the same time, regulators - despite numerous warnings - mostly ignored the problem, apparently for ideological reasons ("let the free market work"). What a mess.
The bottom line: nobody cared.

Tyler Cowen confuses "deregulation" with "getting rid of regulations affecting the energy industry." Cowen, commenting on Paul Krugman's energy pessimism, writes:

It's worth noting that if we had to build today's energy infrastructure working under the current regulatory and NIMBY burden, it probably could not be done. So it shouldn't be surprising that building a new energy infrastructure is proving so hard. There's a reason why many of us think deregulation is a big issue and it's not because we want to see people poisoned by Chinese botchagaloop.
Cowen is one of my favorite bloggers, but he clearly misunderstands the NIMBY issue. Deregulation would do absolutely nothing to solve the NIMBY problems that have helped stunt the growth of our energy infrastructure. The NIMBY problem occurs almost exclusively at the local level. Residents don't want coal-fired power plants, refineries, and pipelines in their community, so the local government uses land use regulations to block their contruction. The local government can simply rezone the property for non-commercial use, refuse to issue the proper building permits, etc. When a local government blocks a new power plant or waste-to-energy facility like this, it is not regulating the energy industry; rather, it is regulating the use of the land. So even if we completely "deregulated" the energy industry, Con Ed still wouldn't be able to build a new energy facility if the local government didn't want it. The federal government doesn't have the authority to force local communities to allow the construction of energy infrastructure. State governments can limit the ability of local governments to block construction with land use regulations (unless the state constitution provides otherwise, which is extremely unlikely). In fact, a lot of states have been forced to step in and exert some control over the siting of hazardous waste facilities, which also run into fierce NIMBY opposition. The NIMBY burden on the energy industry represents a classic free-rider problem. Everyone uses energy, but no one wants energy facilities to be in their community. Deregulation of the energy industry would do nothing to solve this free-rider problem. A small-scale deregulation of land use -- which I wholeheartedly endorse -- would ease the NIMBY burden, but that's a completely different issue.

The trio of economists at Capital Gains and Games offer a lengthy three-part review of McCain's economic plan. Andrew Samwick handles the economics of the plan. His conclusion: it's not bad, but it's also not much:

There are some parts of the McCain economic plan that are silly or irrelevant. There are some good points on microeconomics and international trade. But I would be surprised if these got any attention at all, given the enormous fiscal burden that this plan shifts to future generations.
Stan Collender tackles the budget aspects, and not surprisingly, he is very unimpressed:

The most glaring problem with the McCain plan is also the simplest to see: he is proposing more than $3 trillion in tax reductions (some estimates put it at $5 trillion or higher) with nothing close to offsetting spending cuts. ... The biggest problem with the McCain plan is that it continues to look to a part of the federal budget that simply isn't large enough to pay for the tax cuts he is proposing. Spending on nondefense domestic appropriations is about $500 billion. That means that a $200 billion annual reduction in revenues in each of the early years of the plan (I'm being conservative so we don't have to argue about the numbers) would require a 40 percent reduction in this spending. Unless McCain is talking about eliminating rather than just streamlining whole areas of federal activities, this can't happen. ... The McCain plan really isn't a budget plan anyway. There's no indication that he anticipates the government having to do anything during his administration beyond what it is currently doing...and we already know that even under the best of circumstances that's wrong. ... The plan is far too easy to dismiss as a bad idea poorly executed. My guess is that it won't be long before the McCain campaign stops talking about "the plan" and just focus on the individual pieces as his speaks with particular constituencies.

Finally, Pete Davis covers the tax aspects. He discusses the whole smorgasboard of tax cuts in the plan, and while the results are mixed, on balance he approves of more than he opposes:
Senator McCain's tax policy is much more pro-business than that offered by the Democratic candidates. Lowering the corporate tax rate, expensing equipment, and making the R&D credit permanent and simpler are all good ideas that would make America more competitive around the world. Expensing would be a badly needed reform of our antiquated depreciation system, although it has a steep up front revenue cost. ... Mr. McCain is also to be commended for what he didn't propose, a long list of new tax loopholes to reward special interest political supporters.
On the whole, here's what I took from their review: The economic and tax aspects are pretty good in isolation, but the awful consequences for the budget swallows any of those gains, making it a net negative. An excellent exercise from three very smart economists. I'm eagerly awaiting their review of Obama and Hillary's economic plans!

Monday, April 21, 2008

First-Year Law School Indoctrination

Mark Thoma points us to a very interesting study on the effect that law professors' different educational backgrounds have on their law students:

[W]e put 70 Yale Law students in a computer lab, and had them play a game that would reveal to us their views on fairness. (The study, which was coauthored with Shachar Kariv and Daniel Markovits, can be found here.) The students made 50 decisions about giving. In some cases students started with $10, and for each dollar they gave up, their (anonymous) partner in the game would get, say, $5. In this case, giving was "cheap." In others, giving was expensive (each dollar given up yielded only 20 cents for the partner). Someone who gives a lot when it's cheap and keeps most of the pie for himself when giving is expensive focuses on efficiency: He's making sure the maximum amount is paid out to him and his partner combined. Someone who keeps 80% of the pie when it would be cheap to give is more focused on equality. Someone who always keeps everything, regardless of the price of giving, is just plain selfish, the very embodiment of the rational, self-interested Homo economicus. It turns out that exposure to economics makes a big difference in how students split the pie, in terms of both efficiency and outright selfishness. Students assigned to classes taught by economists were more likely to give a lot when it was cheap to do so. But they were also much more likely to take the whole pie for themselves.
I can absolutely relate to this study. I went to law school after getting my MA in economics. I attended N.Y.U. Law, which at the time had very few professors with any sort of interest in economics. Certainly none of my first-year professors talked about economics. In our casebooks (law school textbooks), the notes after many cases would discuss the "law and economics" approach to that particular area of law, but none of my first-year professors would ever talk about those notes. I was stunned by the lack of basic economic literacy among my classmates. The most basic concepts in economics, like mutual gains from trade, were completely foreign to 90% of the people in my first-year section. When we discussed public policy considerations and I would make an argument based on efficiency, people looked at me like I was crazy. When I would criticize the law being applied in a case on efficiency grounds, many of my classmates were clearly shocked that I would have the audacity to think that I knew better than legislators. (Luckily I had a friend who had been an economics major at Harvard, so we could at least talk to each other about economics.) Moreover, this utter lack of economic literacy did not improve at all as students moved through law school. The school offered a 10-person Law & Economics seminar every other semester, but that was the only class that provided students any real exposure economics. I was still the only person talking about efficiency in my third year. So the fact that the Yale Law students whose first-year professors didn't emphasize economics focused on equality rather than efficiency doesn't surprise me at all. In fact, I'm quite sure that those students were puzzled as to why anyone wouldn't focus on equality!

Paul Krugman wonders why commodity prices are so high:

Broadly speaking, there are three competing views.

The first is that it’s mainly speculation — that investors, looking for high returns at a time of low interest rates, have piled into commodity futures, driving up prices. On this view, someday soon the bubble will burst and high resource prices will go the way of Pets.com.

The second view is that soaring resource prices do, in fact, have a basis in fundamentals — especially rapidly growing demand from newly meat-eating, car-driving Chinese — but that given time we’ll drill more wells, plant more acres, and increased supply will push prices right back down again.

The third view is that the era of cheap resources is over for good — that we’re running out of oil, running out of land to expand food production and generally running out of planet to exploit.

I find myself somewhere between the second and third views.
Krugman attributes most of the run-up in commodities prices over the past few years to rising demand from China, while assigning a small (but he predicts growing) role to dwindling natural resources.

However, while Krugman cited the IMF's 2008 World Economic Outlook (WEO) on his blog for evidence that inventories haven't been increasing, he failed to see the most important finding on commodities in the WEO: that corn-based ethanol production has accounted for a huge share of the high commodities prices. The WEO finds:
Rising biofuel production in the United States and the European Union has boosted demand for corn, rapeseen oil, and other grains an edible oils. Although biofuels still account for only 1.5% of the global liquid fuels supply, they accounted for almost half the increase in the consumption of major food crops in 2006-07, mostly because of corn-based ethanol produced in the United States. Biofuel demand has propelled the prices not only for corn, but also for other grains, meat, poultry, and dairy through cost-push and crop and demand
substitution effects.
Here's a chart from the WEO showing corn production for ethanol as a share of major food crops:

Notice that the share of global demand coming from China and other emerging markets is falling from 2005 to 2008. So it's difficult to attribute the run-up in food prices mostly to China and India. The biggest change in the demand for major food crops has clearly been the huge increase in demand for corn for U.S. ethanol production. Demand for corn-based ethanol began to rise in 2003, and exploded in 2007-2008.

Now look at the commodity price aggregates, and note when the current run-up in prices began:


As you can see, the run-up in commodity prices began around 2003-2004 -- right around the time demand for corn for U.S. ethanol production started to increase. Most analysts acknowledge that U.S. ethanol policies are contributing to the increase in commodities prices, but they seem to assume that the demand for corn-based ethanol production isn't big enough to play a leading role in the high commodities prices. However, the 2008 World Economic Outlook shows that demand for corn-based ethanol production is not only big enough to play a leading role, but actually is playing the leading role.

Ethanol should figure prominently into any discussion of the high commodities prices.

Sunday, April 20, 2008

The Business "Cycle"

I want to correct one particularly glaring misperception that has been increasingly rearing its head in the debate over what the government should do, if anything, in response to the ongoing housing/credit crisis. A growing number of the "let the market be" advocates have been arguing that government action isn't required because this is just a "normal business cycle." For example:

What is scary is the degree to which the Fed assimilated the alarmism on the Street: “These guys are so afraid of an economic cycle,” a hedge-fund manager remarked.
Let's be clear: the business cycle is not a "cycle." Just because recessions are normally part of the business cycle doesn't mean that recessions are predetermined or predictable, and most importantly, a full recovery is not predetermined (see e.g., Japan, Great Depression). The "business cycle" is just the short-run fluctuations in economic activity. For those of you who don't have time to take a refresher Intro to Macroeconomics course, here's what you would have read in Greg Mankiw's basic Principles of Economics textbook:
"The term business cycle is somewhat misleading, however, because it seems to suggest that economic fluctuations follow a regular, predictable pattern. In fact, economic fluctuations are not at all regular, and they are almost impossible to predict with much accuracy." (pg. 724)
Aggregate demand doesn't always increase itself; most of the time, in fact, it requires monetary stimulus via Fed rate cuts, and other times it requires fiscal stimulus. Government intervention is thus part of the "normal business cycle" every bit as much as recessions. My intuition is that some Wall Streeters and hedge fund managers adopt the deterministic "this is just a business cycle" argument because it allows them to excuse their own malfeasance. That is, they can say to themselves, "It wasn't my actions that led to this recession, it was the unstoppable forces of the normal business cycle. I had no choice." I've always thought that the simple act of replacing the term "business cycle" with "fluctuations in economic activity" in economics textbooks would produce substantial social benefits in the long-run. I'm looking at you, Professor Mankiw!

Mark Thoma is angry with George Will, and for good reason. Will writes in his column today:

"The Fed's mission is to preserve the currency as a store of value by preventing inflation. . . . The Fed should not try to produce this or that rate of economic growth or unemployment."
This is false, as anyone with a passing knowledge of the banking system knows. The Fed has a dual mandate: (1) prevent inflation, and (2) achieve maximum employment. In fact, it's federal law; 12 U.S.C. § 225a states:
The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.
Thoma neatly eviscerates the rest of Will's god-awful column (which the Washington Post should be embarrassed for printing). It's ironic that morons like George Will who profess complete and total faith in "the market" know so little about markets. An efficient market economy needs governments to provide a myriad of services, and one of the most important things an efficient market economy needs is a central bank to manage monetary policy. One of the goals of monetary policy is to promote long-run economic growth. Will lacks the intellectual capacity to understand that not everything the Fed does is "government intervention" in the Glorious Free Market. George Will is the Herbert Hoover of our day.

I was looking something up on Wikipedia, and came across an entry for the book, The Politically Incorrect Guide to American History by Thomas E. Woods. The entry states:

"The book makes several challenges to modern notions of American history, asserting that, for example . . . FDR sent one million Russian POWs back to the USSR after WWII."
That would indeed be a surprising historical fact, as FDR died 6 months before WWII ended. Or maybe that's what the political-correctness-police want you to think!

Maybe my brain is still warming up, but I found this comparison in Greg Mankiw's latest New York Times column puzzling:

Over the last several decades, technology has kept up its pace, while educational advancement has slowed down. The numbers are striking. The cohort of workers born in 1950 had an average of 4.67 more years of schooling than the cohort born in 1900, representing an increase of 0.93 year in each decade. By contrast, the cohort born in 1975 had only 0.74 more years of schooling than that born in 1950, an increase of only 0.30 year a decade.
So workers born in 1950 have 4.67 more years of schooling than workers born in 1900, while workers born in 1975 have 5.41 more years of schooling than workers born in 1900. Why compare workers born in 1975 with workers born in 1950? His point is that the rate of educational attainment has slowed, and that's certainly true, but there are only so many years you can spend in school! Getting a college degree takes 4 years, so we can explain the difference between 1900 and 1950 by saying that the average worker born in 1900 had a high school degree or less, while the average worker born in 1950 had a college degree. If the rate of educational attainment kept up that pace, then workers born in 1975 would have roughly 2.33 more years of schooling than workers born in 1950 -- in other words, the average worker born in 1975 would have, or would be close to having, a Master's degree! Having a graduate degree is very helpful in some professions, but not all. (My 2 graduate degrees have been very helpful, but law is one of the most skill-intensive professions in the world.) Most workers, if not all, probably benefit from having a college degree. But do most workers benefit from having a graduate degree? I'd say no. Salesmen, for example, would probably benefit more from 2 years of work experience than from 2 years in grad school. So yes, the rate of educational attainment has slowed, but what's the optimal rate? Without knowing the optimal rate, just saying that the rate of educational attainment has slowed doesn't tell us anything.

Bob Herbert offers Obama some truly laughable political advice:

"The way for a candidate to eventually change the subject is to offer policy prescriptions so creative and compelling that they generate excitement among the electorate and can’t be ignored by the press."
There's a widely-held belief among political consultants in DC that most columnists at the major national newspapers are desperate to be considered political experts. The partners in the consulting firm I worked for always said this somewhat jokingly, but I knew many people at other consulting firms who were dead serious. (My firm didn't handle any really high-profile campaigns in the 2 election cycles I was there, so we didn't have a lot of contact with columnists at the major national newspapers.) Some columnists try relentlessly to informally "advise" candidates (and the party) on campaign strategy. By far the two most mocked columnists in this regard were George Will and Joe Klein, who would apparently all but beg high-profile candidates to hire him. Bob Herbert -- who has long held the title of Most Politically Naive Columnist -- has lately seemed a bit desperate to be an informal adviser to Obama. Herbert has clearly confused American voters with someone else if he thinks a majority of voters will get so "excited" over policy proposals that they'll force the press into writing about them. Columnists like Herbert live in a make-believe world where everyone votes based on the candidates' substantive policy positions, and everyone spends every minute of every day talking about the "big issues" (by which Herbert really just means the issues that matter to him the most). Thank god Obama isn't stupid enough listen to Herbert.

I'm surprised to see a line like this in the National Journal (for my money, the best weekly publication in the world):

"Wall Street investors and the major banks that finance deals have been the primary victims so far, but below them, smaller banks will inevitably be forced to sharply curtail their lending, raise interest rates, or both." (emphasis added)
I'm going to go out on a limb and say that both will happen if one happens. The demand curve in the loanable funds market still slopes down, no?

I'm a big Paul Krugman fan, and have been for many years, but I was quite unimpressed by his column today. He intended to rebut Obama's claim about religion in his famous "bitter" comment, but he ended up rebutting a series of claims about religion that Obama didn't actually make. Obama claimed that people in the Midwest have become bitter about the lack of jobs, and that this has led them cling to religion.

To rebut this claim, Krugman pointed out that poor people in Montana and Maine (two poor non-Midwestern states) go to church less than people in Connecticut. Okay, but that has nothing to do with the relationship between religion and economic circumstances in the Midwest. Obama didn't claim that people outside the Midwest weren't as religious as Midwesterners, so citing data from non-Midwestern states doesn't make any sense. Krugman also noted that while people in poor states go to church more than people in rich states, "this result largely reflects the fact that southern states are both church-going and poor." Again, this has nothing to do with whether people in Midwestern states have reacted to their worsening economic circumstances by clinging to religion.

Moreover, the graphs that Krugman provided to support his arguments only showed the relationship between church attendance and income for 2006. You have to look at the data on a time-series to see if worsening economic circumstances have led Midwesterners to cling to religion. Looking at the church attendance rates for just 2006 won't do any good, because you don't know whether the Midwest church attendance rates in 2006 are higher or lower than they were during good economic times.

To that end, I very quickly pulled up a couple of graphs from the National Opinion Research Center website, using data from the annual General Social Survey. These are very, very rough indicators, and I'm using them to make any positive claim; they do, however, paint a slightly different picture than Krugman did. I couldn't actually find a graph of median household income in the Midwest because the GSS database on the NORC website is absolutely awful, so I'll just use the one Krugman posted on his blog:


Next, here's the percentage of people in Midwestern states who attended church "every week":


As you can see, the percentage of regular church-goers in the Midwest isn't a perfect fit with Krugman's graph, but it does very roughly track median household incomes.

Finally, this graph shows the percentage of Midwesterners who said on the survey that their financial situation had been "getting worse" during the "last few years." This is probably a much better indicator of "bitterness" than household income, because people who have been poor for a long time are less likely to be bitter about their economic circumstances than people who have just recently become poor.


The percentage of people who feel their financial situation has been "getting worse" tracks the percentage of regular church-goers more closely than does the median household income. Also, notice the huge spikes in both regular church attendance and worsening financial situations around 2003. I don't really know what to make of that, but it's interesting.

Again, I'm not saying Obama is right that Midwesterners cling to religion because of their worsening economic circumstances. I'm just saying that it's probably not as cut-and-dry as Krugman seemed to imply. In fact, minus the part about religion, Harvard economist Benjamin Friedman made essentially the same argument as Obama in a meticulously researched book, The Moral Consequences of Economic Growth. Friedman broadly argued that during periods when real incomes across the board have been rising (e.g., the late '90s), people are significantly more open on social issues like immigration, affirmative action, trade, etc. So while I don't think Obama was 100% right (especially about religion), I'm willing to cut him some slack on this one.

Thursday, April 17, 2008

Paul Krugman Is A Brave Man

On his blog, Paul Krugman is already offering the supporting data for his column tomorrow. Based on the data, it appears that his column is going to tackle Obama's "bitter" comment. Specifically, it looks like Krugman is going to address the most controversial and politically explosive aspect of Obama's comments: that people who suffer hard times economically "cling" to religion. Just posting the chart that shows church attendance and income by state is guaranteed to stir up considerable controversy. If he does address the relationship between income and church attendance in his column, then no one will ever again be allowed to say that Krugman shies away from the tough issues. Of course, no one who remembers his Foreign Affairs article in the early '90s that called the "Asian miracle" a myth would say that anyway. UPDATE: Indeed, Krugman did address the relationship between income and religion. However, he took the less controversial route of saying that people in poor states don't go to church more because they're poor.

Jonathan Adler thinks that "Brian Leiter understands academic freedom." It's painfully obvious, however, that Leiter is unable to distinguish between "academic freedom" and "immunity for academics." How a law professor can be oblivious to such a critical distinction is beyond me. In the ongoing John Yoo debate (which Brad DeLong has been following meticulously, and makes for fascinating reading), Leiter thinks that Yoo shouldn't be fired because there is only "speculation that maybe what Yoo did (writing the torture memos) constitutes a crime or legal malpractice." Ipso facto, firing Yoo would infringe on academic freedom! Or so Leiter thinks:

"Tenure, and academic freedom, would mean nothing if every professor with views deemed morally reprehensible or every professor who produced a shoddy piece of work--while inside or outside the academy--could be fired. I find it almost unbelievable that a group calling itself "American Freedom Campaign" does not understand this."
Repeat after me: OLC memos are not academic scholarship. Firing John Yoo for authoring the Torture Memos would have zero effect on academics, because when you work at the OLC, you're not an "academic." Under Leiter's bizarre theory, firing Yoo before a court determines that authoring the Torture Memos constituted legal malpractice would infringe on academic freedom. What if Yoo is sued for malpractice, but settles before a court can render a decision? Even if it's clear that a court would have found Yoo liable for malpractice had he not settled, Leiter thinks this would infringe on academic freedom. Academics are free to endorse any and all viewpoints without fear of being fired, but that doesn't mean they're free to engage in unethical conduct without fear of being fired. And as I've noted before, Yoo engaged in unethical conduct:
[T]he consensus is that Yoo's conduct in authoring the Torture Memo was unethical because he failed to even address Youngstown Sheet & Tube Co. v. Sawyer (1952). Had the memo been submitted to a court, Yoo's failure to address the Youngstown case would have violated Rule 3.3(a)(2) of the Model Rules of Professional Conduct, which prohibits lawyers from "knowingly . . . fail[ing] to disclose to the tribunal legal authority in the controlling jurisdiction known to the lawyer to be directly adverse to the position of the client and not disclosed by opposing counsel."
OLC memos should be judged at the very least by Rule 3.3, because within the Executive Branch, OLC memos are the equivalent of court decisions. Firing Yoo wouldn't be punishing him for his ideas; it would be punishing him for engaging in egregiously unethical conduct. Just because Yoo expressed unpopular ideas doesn't mean that the act of expressing those ideas wasn't unethical. The ethicality of Yoo's conduct in authoring the Torture Memos has nothing to do with the the popularity of the ideas he expressed in the memos. Not everything an academic does, or has done in the past, implicates "academic freedom."

Ben Bernanke is Harvard's Class Day speaker this year, and the Harvard Crimson suggests 15 ways Bernanke can "get [their] attention" (h/t Mankiw). The best one:

"5) He will give everyone a free lunch just to stick it to [economics professor Greg] Mankiw."

One of the greatest failings of the Efficient Markets Hypothesis (of which there are many) is its failure to account for the phenomenon of herd behavior. Dartmouth professor Karin S. Thorburn has an article on VoxEU arguing that U.S. companies' failure to voluntarily reduce their carbon footprints (I hate that term) is the result of herd behavior among investors. Yves Smith gets at the heart of Thorburn's article:

Apparently, investors do not buy the idea that investing in greater energy efficiency in an era of of $115 a barrel oil is compelling (and note that despite all the brouhaha about alternative fuels, using less energy will have a far greater impact). How could investors be so ill informed? One possibility: socially responsible investing has gotten consistently bad press. It's generally depicted as a soft-headed way to guarantee inferior investment performance. Thus, being a skinflint about energy use, which like other types of cost-cutting is good for profits, is instead treated as naive do-gooderism and punished.
So yet again, the Efficient Markets Hypothesis becomes a self-fulfilling prophecy: investors think that investing in energy efficiency is bad for companies because that's what other investors think; when a company announces that it's investing in energy efficiency, investors flee the company's stock, and the stock price falls; investors then use the fall in the company's stock price as evidence that energy efficiency is bad a investment for companies. This is the main reason I think the massive global warming PR campaigns, while overly moralizing and extremely grating, are nevertheless beneficial in the long-run.

David Brooks writes:

"We may not like it, but issues like Jeremiah Wright, flag lapels and the Tuzla airport will be important in the fall. Remember how George H.W. Bush toured flag factories to expose Michael Dukakis."
Bush Sr. "exposed" Dukakis? Of what, exactly? Not being someone who wastes his time touring a flag factory? It's ironic that both Dukakis and Obama face(d) questions about their patriotism while running for President of the United States. How much more patriotic can you get?

The Vox Populi Act, which is currently before the Florida legislature, is already the frontrunner for Worst Bill of 2008 (State Level). According to an editorial in the St. Petersburg Times, the bill would give residents the right to "speak at local government meetings on both agenda and nonagenda items." Moreover, residents would be "invited to speak on any topic for at least 15 minutes at the start" of the meeting. I spent a semester in law school interning for a county attorney's office (not in Florida), and I've had to endure way too many county- and city-commission meetings in Florida as a lawyer, and I can tell you that this is an unequivocally awful idea. As anyone who has attended local government meetings knows, the residents who take advantage of the opportunity to speak at the meetings are usually certifiably insane. I once saw a woman lead her kids into a county commission meeting on dog leashes (the kids were crawling on all fours), and then spend her 15 minutes of allotted floor time reading from an obscure poetry book. But even aside from the circus atmosphere and excessive government waste that this bill would create, the rationale underlying this bill, as well as the St. Pete Times' support for it, is just awful. Rep. Dorothy Hukill, the bill's sponsor, says that she's just "responding to people who say they feel disenfranchised by local government." Disenfranchised? Disenfranchisement is the loss of the right to vote, so not being allowed to speak at local government meetings in no way disenfranchises local residents. The St. Pete Times argues that the bill is needed because "too many disrespected citizens hav[e] their concerns ruled out of order or disregarded." So now we're legislating in response to hurt feelings? That's smart. Every constituency has residents with competing interests, so legislators always seem like they're "disregarding" some of their constituents' concerns. Giving residents the right to speak at local government meetings won't change the fact that laws -- and especially local ordinances -- always hurt some residents' interests. You can't force local governments to do what the residents who speak at the meetings say. The only non-retarded argument the St. Pete Times offers still displays a bonecrushing naïveté:

"[The bill] would make local government officials more aware of concerns facing their communities, if not more accountable and responsive."
First of all, residents already have the ability to communicate their concerns to their representatives in numerous ways (e.g., scheduling an appointment with the representative, writing a letter, calling the representative's office). Second of all, any voter or voting bloc with enough sway to affect an official's vote on a particular issue is already able to communicate their concerns to local government officials; they don't need a special right to speak at local government meetings. Thus, local government officials won't adjust their behavior one iota in response to the bill. So ultimately, the bill will further frustrate the residents who speak at the meetings, and will waste a monumental amount of time. The boneheaded ideas that emanate from state legislatures in general, and the Florida legislature in particular, never ceases to amaze me.

Stan Collender posits that Republicans resist efforts to modernize the IRS because an awful tax-paying experience leads people to favor tax cuts:

Few Republicans in general (and expecially the Bush White House) want to do anything that will make the tax paying experience easier, simpler, and more pleasurable because IRS is more efficient. The result of all of the issues mentioned above is that paying taxes is more difficult, time-consuming, and infuriating. That decreases support for paying taxes and increases the likelihood that tax cuts will be seen by a larger group of people as preferable.
I don't think that's right. People still have to pay taxes after a tax cut. You obviously have to pay less in taxes after your taxes are cut, but you still have to go through the experience of paying taxes. One might argue that a tax cut reduces the time you have to spend paying taxes, but I'm not sure this argument holds water. The only real effect that a reduction in the income tax has on the tax-paying experience is to shuffle around the numbers on the IRS forms. It doesn't change your exposure to the tax-paying experience. Moreover, if people invest the extra money they gain from a tax cut, or use the extra money in any way that requires them to fill out additional IRS forms, then the tax cut will have actually increased their exposure to the tax-paying experience. I don't doubt that some people irrationally believe "lower taxes" means "less time spent paying taxes." But most people have gone through the tax-paying experience enough times to know better. Of course, there's always the possibility that it's the politicians opposing IRS modernization who irrationally believe that "lower taxes" equals "less time spent paying taxes." But that's a different story.

Yves Smith points to a scary story in the Wall Street Journal suggesting that banks aren't telling the truth about how high their short-term borrowing costs are. If true, this means that the LIBOR, and thus the TED spread (the difference between the 3-month LIBOR and Treasuries), are even higher than we think. And as Yves Smith points out, the official TED spread is already uncomfortably high:

So as we come to accept that the LIBOR doesn't measure banks' real short-term borrowing costs, it's important to remember that banks' balance sheets also don't represent their real financial condition, because the SEC has basically suspended mark-to-market rules for the most risky securities, telling firms:

"It is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale."
In other words, "mark to make believe": if you'd rather not report the actual market price of a security, you can just make up a price.

Combine the unreliability of both the LIBOR and banks' balance sheets, and we're now operating in a largely fictional world. What's worse, the TED spread is still very high, and banks are still taking huge write-downs. We can't even make up a world that isn't in a financial crisis!

Jim Lindgren of the Volokh Conspiracy thinks McCain's economic agenda is "ambitious," and is surprised by its "aggressiveness." Mark Thoma, on the other hand, sees a total "lack of action" on McCain's part: "If that's the best he can do, then he has clearly demonstrated his weakness on economic issues rather than countering any criticism." This one is a no-brainer: Thoma wins hands down. What is Lindgren smoking? There's nothing remotely "ambitious" in McCain's economic agenda. As I was reading the transcript of McCain's speech, I was half-expecting him to blurt out, "Belated April Fools'! Now in all seriousness, here are my real economic proposals." But sadly, these are actually his economic proposals:

  • Temporarily reduce the gas tax for the upcoming driving season. First of all, you're not the president yet. Second of all, if you want everyone to like you, why not just take the whole country out for an ice-cream cone?
  • Have the Education Department "work with" the states to support student loans. I'd actually like to see that happen, because then we'd get to hear 50 governors say "Go f*** yourself" in unison.
  • Cut the corporate tax rate to 25%. Whoa, watch out for this crazy guy! Seeing as all three remaining candidates have said that we should cut the corporate tax rate at one point during the campaign, that's about as controversial as Mother's Day.
  • Double the tax exemption for dependent children. This is not a bad idea, but as Mark Thoma notes, "if you have children, and if your tax rate is, say, 20%, this is only worth $700." Don't spend it all in one place.
  • Suspend all increases in discretionary spending for agencies other than those that cover the military and veterans for one year. Go ahead, deny Health and Human Services funding for expensive, yet potentially life-saving, medical research. I dare you. This isn't even a real proposal. It's just red meat for Republican campaign crowds.
If you've admitted that you don't know much about economics, then it's probably a good idea to come up with an economic agenda that won't make the vast majority of economists laugh. It's just a thought.

This seems like quite a reckless accusation from Bob Herbert:

"One of the main problems, of course, is that [Obama] hasn’t generated as much support as he’d like among white working-class voters. There is no mystery here. Except for people who have been hiding in caves or living in denial, it’s pretty widely understood that a substantial number of those voters — in Pennsylvania, Ohio, West Virginia and elsewhere — will not vote for a black candidate for president."
Essentially, Herbert is saying that most white working-class people who don't vote for Obama won't vote for a black president, and that Obama's race is the reason they haven't/won't vote for him. It's no secret that Obama has consistently lost the white working-class vote to Hillary. But here, Herbert ascribes a racist motive to "a substantial number of those voters," which is a direct reference to "white working-class voters." This assertion is wholly unsubstantiated, and incredibly reckless. Herbert relies on anecdotal evidence of racism from "Pennsylvanians themselves," and a two-month-old observation from Pennsylvania Gov. Ed Rendell that some white people might not vote for a black presidential candidate (which, but for his position as Governor, is hardly a remarkable statement). It's one thing to say that Obama has not done well among white working-class voters, and that there are white working-class voters who won't vote for a black presidential candidate; but it's another thing entirely to say that Obama has not done well among white working-class voters because "a substantial number" of them won't vote for a black presidential candidate. Herbert backtracks later in the column, admitting that it's "not racist to vote against" Obama. But that disclaimer rings hollow -- there's simply no getting around the fact that Herbert already ascribed a racist motive to "a substantial number of [white working-class] voters." Not Bob Herbert's finest hour.

In the least shocking development of the day, David Brooks jumps at the chance to condescendingly tut-tut Obama for hinting that his belief in the magical powers of "free trade" is anything less than absolute.

Needless to say, Brooks' analysis is embarrassingly simple-minded: he posits that the economic changes in America over the past 30 years are due to forces that are conveniently beyond our control, namely, "technological change" (that old blameless chestnut). It's convenient because it allows Brooks to dodge the evidence that the economic fortunes of Americans are fully within our control, but that Republicans really suck at improving Americans' economic fortunes!

Brooks also claims that "[f]or the first time in the nation’s history, workers retiring from the labor force are better educated than the ones coming in." Now, Brooks basically stole this line from Clive Crook, who in describing a new Peterson Institute study, wrote, "For the first time in decades, and probably ever, workers retiring from the US labor force will be better-educated on average ... than their much younger counterparts." But the problem is, that's not entirely true (and Crook offers a qualifier in his summary), as this chart from the Peterson Institute study shows:

As you can see, 31.8% of 30-34 year olds have a bachelor's degree or better, compared to only 27% of 60-64 year olds. Further, 28.4% of 25-29 year olds have a bachelor's degree or better, and the educational attainment of that age group is sure to improve as they get more time to actually finish their master's degrees. The only way you can say that the workers retiring are "more educated" than the workers entering the labor force is if you measure only master's degrees: 12% of 60-64 year olds have a master's degree or better, compared to only 9.8% of 30-34 year olds. So using the normal definition of an "educated worker" -- that is, having at least a bachelor's degree -- then the workers coming into the labor force are actually more educated than retiring workers. That's why you actually read the studies before parroting summaries of their findings, David. Try it sometime. It may make you sound -- gasp! -- less retarded.

Finally, at the end of the column, Brooks makes this rather odd assertion:

"American voters aren’t so stupid as to think their problems are caused by foreigners []."
No, David. As surveys have consistently shown, Americans do think their problems are created by foreigners. Fully 47% of Americans think that a "major reason" the economy is not doing better is that "there are too many immigrants." Additionally, 54% of Americans think that trade agreements have "cost the U.S. jobs." They're not right about foreigners hurting our economy, but they definitely believe that a lot of their problems are caused by foreigners.

(As an aside, apart from the tangible policy differences between Republicans and Democrats, are the "forces transforming the American economy" really as hard to control as Brooks implies? Broadly, there are three factors that have driven our economic growth over the past 30 years: (1) human capital; (2) physical capital; and (3) technology. The pace and penetration of "technological change" is quite clearly a function of human capital: an uneducated society won't make many technological breakthroughs. Properly viewing technological change as a function of human capital, it becomes apparent that technological change is not some external force over which we can exercise no control. Human capital is absolutely something we can control. In fact, we can even affect the number of Americans who go to college through -- horror of horrors -- government policy!)

There is an interesting op-ed in the Financial Times today by John Coates, a former trader at Deutsche Bank who is currently a research fellow at Cambridge University. Coates monitored the testosterone and cortisol levels of a group of male traders in London, and reports some interesting (though unsurprising) findings. Testosterone, which increases confidence and risk-taking, "surges in males as they prepare for a competition, and continues to rise in the winner while falling in the loser." Cortisol, on the other hand, "promotes an anticipatory arousal" when reacting to challenges, particularly "under conditions of novelty and uncertainty." In short, testosterone leads to excessive risk-taking, and cortisol leads to excessive risk-aversion. Here are Coates' findings:

"We found that a trader’s daily testosterone levels were indeed higher when he made an above average profit. We also found that the higher a trader’s morning testosterone, the more money he made that day. This effect was most pronounced in experienced traders. ... We found that cortisol rose with the variance of the trader’s profits. It also rose in lockstep with implied volatility in the options market, raising the intriguing possibility of a biological substrate for the derivatives market. Cortisol was preparing traders for an impending market move; like testosterone, it was highest and most volatile in experienced traders. ... "If testosterone continued to rise it could, by fostering over-confidence and risk-seeking, lead traders to make irresponsible trades. Testosterone is likely to rise in a bull market, increase risk and exaggerate the rally. Chronic cortisol exposure, on the other hand, promotes feelings of anxiety, a selective recall of disturbing memories and a tendency to find danger where none exists. Cortisol is likely to rise in a crash, make traders dramatically and perhaps irrationally risk-averse, and exaggerate the sell-off."
Here's my question: Which way does the causation run? Do high testosterone levels cause traders to take excessive risks, or does excessive risk-taking cause high testosterone levels, which then take over and cause even more risk-taking? It's clear from the op-ed that high testosterone levels cause traders to take excessive risks, but the key question is what induces the high testosterone levels in the first place. If some traders simply have higher testosterone levels than others, then we could identify the irrationally risk-loving traders ex ante. The same goes for cortisol: if cortisol causes excessive risk-aversion, and some traders simply have higher cortisol levels than others, then we could identify the irrationally risk-averse traders ex ante. And here's another question: Does a trader who experiences high testosterone levels also experience high cortisol levels? Or are traders either risk-loving or risk-averse, with no in between? That traders are irrational is neither new nor surprising. But more information on the psychological aspect of asset bubbles is certainly welcome as we wade our way through the wreckage of a popped housing bubble.

Monday, April 14, 2008

On John Yoo and Berkeley

There has been quite a bit of discussion about whether UC-Berkeley should fire John Yoo for his role in authoring the infamous Torture Memo when he was working in the OLC. Brad DeLong (another Berkeley professor) has been tracking the discussion closely. To me, the discussion has been needlessly complex. There are two competing interests in this case: (1) the interest in protecting academic freedom; and (2) the interest in punishing unethical conduct. Academic freedom requires that law schools not punish all conduct that could be characterized as "unethical," so as not to deter professors from taking positions that stretch the limits of legal ethics, but that are nonetheless not technically unethical. The interest in punishing unethical conduct is mostly self-explanatory: punishing professors who have acted unethically is necessary to demonstrate to law students that unethical conduct is unacceptable. Thus, there are two issues: (1) whether Professor Yoo's conduct was unethical, and (2) if so, whether punishing that unethical conduct would deter legitimate academic discourse in the future. Regarding the first issue, the consensus is that Yoo's conduct in authoring the Torture Memo was unethical because he failed to even address Youngstown Sheet & Tube Co. v. Sawyer (1952). Had the memo been submitted to a court, Yoo's failure to address the Youngstown case would have violated Rule 3.3(a)(2) of the Model Rules of Professional Conduct, which prohibits lawyers from "knowingly . . . fail[ing] to disclose to the tribunal legal authority in the controlling jurisdiction known to the lawyer to be directly adverse to the position of the client and not disclosed by opposing counsel." Second, punishing Yoo for authoring a memo in which he failed to disclose legal authority directly adverse to the memo's conclusion would not deter legitimate academic discourse in the future. This is where the people discussing whether Berkeley should fire Yoo veer badly off track. Yoo was not writing a law review article; he was writing a memo on behalf of the OLC, which is treated as authoritative within the Executive Branch. It would be impossible to force professors to disclose all legal authority directly adverse to their positions in law review articles -- every article would probably be over 100 pages. Had Yoo been writing a law review article, then punishing him for failing to disclose legal authority directly adverse to his conclusion in the article would certainly deter legitimate academic discourse in the future. But that's not what Berkeley would be punishing Yoo for doing. Yoo failed to disclose directly adverse legal authority in an OLC memo that had easily foreseeable real-world consequences. That's not even close to the same thing as writing a law review article. Berkeley would be punishing Yoo for failing to disclose directly adverse legal authority in an OLC memo. As long as Berkeley made it clear that it was firing Yoo for unethical conduct in authoring an OLC memo as opposed to a law review article, or any writing that could be considered "academic scholarship," then firing Yoo would in no way deter legitimate academic discourse in the future. UPDATE: It occurs to me that after I discussed why I think Berkeley can fire Professor Yoo without infringing on academic freedom, I never addressed whether Berkeley should actually fire him. Yes, I think Berkeley should fire Professor Yoo. There has been considerable debate over whether Yoo's work on the Torture Memos amounted to "scholarly misconduct," but as I discussed above, this is the wrong standard. The Torture Memos cannot be considered works of "scholarship" any more than a memorandum of law can be considered a work of scholarship, and thus the Torture Memos should not be subject to the standard of "scholarly misconduct." Instead, the Torture Memos should be subject to the same standard as memoranda of law, motions, appellate briefs, etc.; that is, Rule 3.3 of the Model Rules of Professional Conduct. Again, the consensus is that if the Torture Memos had been submitted to a court, they would have violated Rule 3.3(a)(2) because they failed to acknowledge the existence of the Youngstown case. Because a violation of Rule 3.3(a)(2) is a "knowing" violation of an ethical standard, Professor Yoo's violation was a particularly serious ethical violation (that is, more serious than ethical violations that do not require mens rea). Therefore, Berkeley should fire Professor Yoo. Another way to think about this is to imagine that Berkeley had hired a famous lawyer, and that after hiring him, it was revealed that the lawyer lied in the appellate brief that made him famous, in violation of Rule 3.3(a)(2). Berkeley would waste no time in (rightly) firing the lawyer from its faculty. So too should Berkeley fire John Yoo.

Sunday, April 13, 2008

Come On Clive, Don't Sugar-Coat It

Clive Crook does not mince words:

"Mr Bush has done the cause of fiscal moderation grave harm. He presided over an unwarranted surge in spending and he pushed for tax cuts that were so politically ill-conceived that, in the view of many Americans, merely undoing them is all the tax reform the country needs. The issue is not so much that he moved the structural budget balance from surplus to deficit – though he did and that was a great pity – but that he spared the country until further notice the effort of examining its priorities and mending its failing fiscal machinery. In this election year, control of entitlements and far-reaching reform of the tax system are not even being discussed. Before too long, both will be unavoidable fiscal necessities. Cancelling Mr Bush is not enough."
When highly-respected, normally non-partisan Financial Times columnists like Clive Crook (or Martin Wolf) start sounding like Democratic partisans, you know Bush has really gone over the edge. There really is no defending Bush's fiscal record.

Ed Glaeser -- the Harvard economics professor and preeminent urban economist -- has a new paper with Joshua Gottlieb, called "The Economics of Place-Making Policies," which was released today as part of the Spring 2008 Brookings Papers on Economic Activity. The bulk of the paper addresses whether the federal government should undertake policies aimed at strengthening specific places -- for instance, whether the government should try to resuscitate a dying city like Detroit. This is not a new topic for Glaeser, and he again expresses a preference for policies that focus on people rather than places. But the final section of Glaeser and Gottlieb's paper addresses the impact of land use regulations on housing prices, and since I've taken it upon myself to make the case that restrictive land use regulations probably contributed to the housing bubble, I thought I'd highlight what Glaeser and Gottlieb have to say about land use regulations. They present a couple interesting graphs, which I will discuss, but first, here is the crux of their argument with respect to land use regulations:

"If we believe that the most productive areas of the country have restricted construction through extensive land use controls and that these controls are not justified on the basis of other externalities, then it may be welfare-enhancing for the federal government to consider policies that could reduce the barriers to building in highly productive areas."
In other words, the most productive cities (i.e., those with agglomeration economies and lots of skilled workers) are using land use regulations to restrict the supply of new housing, thereby blocking other people from moving in. The most interesting graph (in my opinion) that Glaeser and Gottlieb present is also the simplest. This graph examines the relationship between housing prices and the Wharton Land Use Index (which measures the restrictiveness of a metropolitan area's land use regulations):
This shows that restrictive land use regulations are correlated with high housing prices. This is nothing new, and obviously individual housing markets vary widely, but it's interesting to see on a graph at least. It also rebuts the argument that restrictive land use regulations have no effect on housing prices. They do; this is fact. If they don't, then 30+ years of economic studies on land use regulations are wrong. Anyway, to support the argument that productive cities are using land use regulations to restrict the supply of new housing, Glaeser and Gottlieb examine the link between housing prices and the growth in each metropolitan area's housing stock between 2000 and 2005:
This graph shows that "the most expensive places have little building and the places with the most building are not particularly expensive." In previous posts, I argued that in the face of a demand shock, restrictive land use regulations cause higher and longer housing price appreciation, which contributes to the psychology that drives speculative housing bubbles (i.e., "housing prices always go up!"). Glaeser and Gottlieb provide one possible source for such a demand shock: the rapid rise in demand for housing in the most productive cities. So it's worth seeing whether the most prominent bubble cities are also among the most productive. If we measure productivity by Gross Metropolitan Product (admittedly a crude measure), here's how the bubble cities rank:

Los Angeles: #2 Miami: #11 Phoenix: #14 San Diego: #16 Inland Empire: #17 Denver: #19 San Jose: #23 Las Vegas: #29
So productivity as the source of demand shocks isn't a panacea, but you could certainly make the case that high productivity contributed to bubble formation in the most prominent bubble cities. The fact that the major bubble cities all ranked in the top 30 for GMP out of 316 metropolitan areas is certainly suggestive, though I'm not sure of what just yet.

It's odd that the biggest hedge fund cheerleader in the press, Sebastian Mallaby, knows so little about hedge funds (and financial markets in general, for that matter). Honestly, the thing that bothers me most about Mallaby's cheerleading isn't his painfully obvious ignorance of financial markets, it's that he accuses anyone who criticizes hedge funds of not understanding how international financial markets work! Unlike noted financial economist Sebastian Mallaby, of course. Last year he defended hedge funds in a Foreign Affairs article that read more like a hedge fund prospectus than a scholarly article. Mallaby started the article with some of his trademark condescension, assuring all those pathetic souls who don't understand hedge funds that "the fear of hedge funds is overblown, [and is] based on a misunderstanding of their role in the international financial system." Oh Sebastian, won't you please explain it to us? In the entire 12-page article, the word "leverage" appears a total of one time, and the word "liquidity" doesn't appear at all. This from an article allegedly about hedge funds. In one of his Washington Post columns, Mallaby had the gall to write, "the critics of the funds should at least understand their contribution." Then in a later column, he called hedge funds "the purest apostles of market forces." I kid you not. This man still has a job. Now Mallaby has another article in Foreign Affairs defending hedge funds, and it's even more detached from reality than his previous article, if that's even possible. He writes:

"Hedge funds, for the most part, have weathered the storm remarkably well. Their occasional failures have stemmed mainly from errors that were not of their own making. Because banks have mismanaged themselves so thoroughly, they have had to mobilize capital by calling in loans to hedge funds, forcing the funds to sell off positions precipitously."
If only those unscrupulous banks hadn't made such bad investments in subprime-backed assets, hedge funds would still be riding high! This is false on so many levels that I don't even know where to start. The most obvious thing that Mallaby fails to get his mind around is that the margin calls were the result of hedge funds' diminished creditworthiness. Also, if the hedge funds hadn't been so highly leveraged in the first place, then they wouldn't have needed to dump assets into illiquid markets to meet the margin calls. If most hedge funds aren't dangerously levereaged, as Mallaby claims, then why did they need to dump assets to meet margin calls? Mallaby's next fantasy borders on efficient-markets lunacy:
"When the subprime bubble was inflating, several hedge funds, notably an outfit called Paulson and Co., bet that it would pop. These funds not only made astronomical profits, they also prevented the bubble from growing even bigger than it did. Now that the bubble has burst, hedge funds will likely serve as opportunistic buyers of distressed assets, putting a floor under their value."
First of all, hedge funds are not even close to big enough to put a floor under the value of subprime-backed assets. This is reminiscent of Ben Stein's bizarre claim that hedge funds can manipulate stock prices for fun. Second, Goldman also bet that the subprime bubble would pop when it was inflating, and Goldman is much bigger than any hedge fund, so his claim that it was hedge funds that "prevented the bubble from growing even bigger" just doesn't make sense. Finally, Mallaby displays a shocking naïveté about the broader role of hedge funds:
"[S]tarving well-managed hedge funds of credit is likely to reduce the efficiency of markets; most funds earn their keep by moving prices quickly to the level that reflects the underlying value of assets, ensuring that the world's stock of savings is allocated productively."
Obviously, Mallaby has never met a trader in his life. But aside from his faith in the inner goodness of hedge fund managers, does Mallaby get all his economic knowledge from a Principles of Economics textbook? Does he really believe that stock prices aggregate information, and represent the true value of a company? Sebastian, here's a term you might want to look up: liquidity. It's liquidity that drives both the equity and bond markets, especially during credit contractions. To think that hedge funds are buying assets based on their underlying value right now, you'd have to be mindblowingly naïve. Sebastian: Please stop holding yourself out as an authority on anything remotely related to finance; you're embarrassing yourself.

Monday, April 7, 2008

"Carrots and Sticks"

One of my biggest pet peeves is when people suggest that the government use "carrots and sticks" to achieve some objective, without specifying what particular "carrots" or "sticks" the government should use. A perfect example comes from Jason Furman's article on reducing the budget deficit, in which Furman suggests that the next administration control health spending by, among other things:

[Using] a combination of better clinical guidelines, carrots, and sticks to reduce Medicare spending in high-spending areas.
I think you'd be hard-pressed to find a policymaker or economist who doesn't think we need to control health spending in general, and Medicare spending specifically. But the question is, how do we do it? Saying we need to use "carrots and sticks," without more, is like saying we need to use "public policy." It's completely useless.

With the link between land use regulations and housing prices being the topic du jour for me, I thought I'd post a link this recent paper by University of Washington economist Theo Eicher, titled Municipal and Statewide Land Use Regulations and Housing Prices Across 250 Major US Cities (2008). Table 3 (pp. 28-32) presents "Estimated Contributions to Change in Housing Prices 1989-2006" for a variety of factors, including different levels of regulation, across 250 cities. However, PLEASE NOTE that I'm not wild about the methodology of some of the Subindices in the underlying Wharton Regulatory Index that Eicher uses, and I'm even less wild about Eicher's decision to group some of the Subindices together. As a lawyer who has handled many land use cases, I know that many of the land use regulations, both at different levels (i.e., state vs. region-wide vs. local) and on the same level, are duplicative. For this and (many) other reasons, I think Eicher's estimates of the contributions of "regulation" to the change in housing prices are way too high. That said, it's very interesting from an econometrics standpoint.

Sunday, April 6, 2008

Hackonomics: George Will Edition

George Will is quite possibly the dumbest commentator alive. His column in the Washington Post today confirms this fact yet again. In an amazing feat of irony, he condescendingly chides the Democrats for not understanding "the market," while simultaneously displaying a complete ignorance of market economics:

"The market, which bewilders and annoys liberals by correcting excesses without the supervision of liberals, is doing that as housing prices fall far enough to stimulate demand. Witness this recent Financial Times headline: 'Property sales pick up as prices plummet.' The story began: 'Sales of previously owned homes in the U.S. rose for the first time in seven months in February, while sale prices fell by their most in at least 40 years.' By golly, the Gershwins were right: The age of miracles hasn't passed."
Memo to George Will: Existing home sales aren't measured month-to-month, they're measured year-over-year. And year-over-year, February existing home sales are down 23.8%. Touting the February existing home sales as evidence that the market is "correcting excesses" or that the housing market is rebounding is not an argument that is subject to debate, it's blatant misrepresentation. Why does the Washington Post mislead its readers by printing this kind of garbage by hacks like George Will?