Friday, May 30, 2008

Own-to-Rent with a Twist

I've been tossing this post around in my head for a while, and true to form as a lawyer, I didn't want to post anything until I had a fully developed view of the proposals. But I've decided to put my economist hat back on, throw out my impressions of the proposal, and then let other people tell me how wrong/stupid my impressions are. Ralph Liu, who apparently created the first yuan-denominated interest-rate swap for Chinese banks, is promoting a financial product called SwapRent to help with the foreclosure crisis. In a SwapRent contract, homeowners facing foreclosure would sell a percentage of the future housing price appreciation to investors in exchange for a monthly subsidy sufficient to keep the homeowner out of default. A homeowner who entered into a SwapRent contract would essentially become a renter, but without giving up legal ownership. The investors would essentially be betting that the value of the house will rise. It's a variation on the shared-appreciation mortgage idea. Housing prices would be determined by a price index, such as the MSA level of the OFHEO HPI. The duration of the SwapRent contract would vary (e.g. 1, 2, 5, or 10 years), as would the percentage of the price appreciation the investor gets. SwapRent contracts would also work the other way: homeowners could protect against declining housing prices by paying an investor a fixed amount to take on the downside risk. This Business Week article provides a nice summary of the SwapRent proposal (read the comments too, as Liu provides lengthy responses to some good questions). For a one-page summary, see here; for a Los Angeles Times article on Liu's proposal, see here. Residential real estate futures and options markets are not new ideas, but they've never been able to attract enough buyers and sellers to get off the ground. SwapRent, however, already has at least one large class of potential buyers: investors holding mortgage-backed assets. If SwapRent could attract enough liquidity, it would not only reduce the number of foreclosures, but would also help stabilize the housing market in the future. If there had been a real estate futures market 10 years ago, the housing bubble probably wouldn't be wreaking as much havoc on the economy as it is today. Ultimately, I'm not sure there are enough homeowners and investors in a position to use SwapRent for the proposal to have a huge impact on the foreclosure crisis. Assume housing prices have to fall another 15% nationally to reach the bottom (a generous assumption, given the most recent data). To make a significant impact on the foreclosure crisis, SwapRent needs investors who are willing to bet on price appreciation. But if housing prices still need to fall 15% to fully correct, then there won't be sufficient price appreciation to attract enough investors for a while. SwapRent would be very beneficial in communities where housing prices have reached the bottom in terms of supply and demand, but are in danger of falling too far due to foreclosures. If investors think housing prices are declining largely because of foreclosures, then using SwapRent to avoid foreclosures would not only stop housing prices from declining further, but would also increase the chance of future housing price appreciation (and thus profit). I could be wrong about the number of buyers and sellers in a position to use SwapRent, and feel free to correct me if I am indeed wrong. I do, however, think SwapRent could provide significant benefits beyond the foreclosure crisis. In the next post, I'll discuss the positive externalities generated by separating the legal and economic ownership of housing.

Somehow, when I was writing the post about whether oil producers are keeping oil in the ground rather than storing it in inventories, I missed this story in the WSJ:

The world's top oil producers are proving unable to put more barrels on thirsty world markets despite sky-high prices, a shift that defies traditional market logic and looks set to continue. Fresh data from the U.S. Department of Energy show the amount of petroleum products shipped by the world's top oil exporters fell 2.5% last year, despite a 57% increase in prices, a trend that appears to be holding true this year as well. There are several reasons behind the net-export decline. Soaring profits from high-price crude have fueled a boom in oil demand in Saudi Arabia and across the Middle East, leaving less oil for export. At the same time, aging fields and sluggish investments have caused exports to drop significantly in Mexico, Norway and, most recently, Russia. The Organization of Petroleum Exporting Countries also cut production early last year and didn't move to boost supplies again until last fall. In all, according to the Energy Department figures, net exports by the world's top 15 suppliers, which account for 45% of all production, fell by nearly a million barrels to 38.7 million barrels a day last year. The drop would have been steeper if not for heightened output in less-developed countries such as Angola and Libya, whose economies have yet to become big energy consumers.
The Fed has been cutting interest rates for 9 months now, so a year-over-year drop in oil production comports with Jeff Frankel's theory that interest rates are driving up oil prices by encouraging producers to keep oil in the ground. The drop in production does prove Frankel's theory, but it's a good data point. The WSJ story also has this great chart:
UPDATE: I praised The Economist earlier today, but this week's cover story on oil prices is a clunker. Among other mistakes and omissions, it fails to recognize that keeping oil in the ground can be the same as hoarding oil in inventories:
The oil price is set in a market. For Shell, Exxon et al to hoard oil underground would be to leave billions of dollars of investment languishing unused.
This is true only if the price of oil isn't exptected to rise. If, however, the price of oil is expected to rise, then oil companies would hoard oil underground because they could extract it and sell it for a higher price later. I personally don't think this is happening on a large enough scale to affect oil prices, but I wish The Economist would make sure the author understands the argument before dismissing it in a cover story.

I generally like my analysis without the heavy doses of naiveté and bias, even if I agree with the overall analysis. Alex Tabarrok highlights such a double-dosing in The Nation:

Christopher Hayes writing in The Nation.
The vast majority of interest groups in Washington, from the Sierra Club to the AFL-CIO to Planned Parenthood, are pursuing what Edsall calls "substantive reform"--attempting to push legislation and enact policies that will provide public goods, protect citizens from harm and redistribute benefits, rights and privileges away from the powerful and toward middle-class citizens and disenfranchised minorities.
And if you believe that, might I mention that if you act quickly I have some land in Florida just ripe for development.
That's why I limit my regular reading to the Financial Times, National Journal, The Economist, CQ Weekly, etc.

Thursday, May 29, 2008

I Got Your Oil Inventories Right Here

Jeff Frankel defends his argument that the high oil prices are primarily attributable to low interest rates. According to Frankel's theory, low interest rates lead to an expectation of rising oil prices, which provides an incentive to build up oil inventories (because the stored oil can be sold later at a higher price). Frankel admits that inventory levels haven't risen enough support his theory, but notes that storing oil isn't the only way oil producers respond to interest rates:

Stocks of oil held in deposits underground dwarf those held in inventories aboveground, and the decision how much to produce is subject to the same calculations trading off interest rates against expected future appreciation that apply to inventories. (The classic reference is Hotelling’s Rule.) Apparently the Saudis have decided to leave theirs in the ground. "King Abdullah, the country’s ruler, put it more bluntly: 'I keep no secret from you that, when there were some new finds, I told them, 'No, leave it in the ground, with grace from God, our children need it'.'" (Financial Times 19 May).
In other words, instead of extracting oil and storing it in inventories, oil producers are just keeping the oil in the ground. This is certainly a plausible explanation for the case of the missing oil inventories. Paul Krugman has challenged the people who believe there's an oil bubble: "Tell me where you think the excess supply of crude is going." If Frankel is right, the answer would be: Nowhere—it's staying in the ground. Now, I'm not sure if Frankel actually is right, but it's certainly possible that oil producers are leaving oil in the ground instead of storing it in inventories. As a recent research note from the Dallas Fed notes: "So far, new supplies haven’t materialized quickly enough to keep up with growth in world demand." The most popular explanation for the high oil prices is that world demand is rising while supply is stagnating. But suppose that Frankel is right, and that oil producers really are leaving oil in the ground because of the low interest rates. That would mean that some of the apparent stagnation in the supply of oil is just an illusion: oil producers could be keeping up with the rising demand, but the low interest rates are inducing them to keep more oil in the ground, thereby creating the appearance of stagnating oil supply. I'm still not ready to fully buy into Frankel's argument, but it's definitely the explanation I'm rooting for!

Wednesday, May 28, 2008

McCain, Gramm, and UBS

Josh Marshall flagged a story about how McCain's top economics advisor, Phil Gramm, was advising McCain on his response to the housing crisis while he was simultaneously a registered lobbyist for UBS. Marshall is continuing to push this story pretty hard, but I think he's overplaying his hand a bit. While it's true that UBS has been one of the banks hardest hit by the subprime crisis, Marshall goes a little far when he writes:

According to Forbes, UBS has some $37 billion in write-downs on assets tied to bad US mortgages. In other words, the bank's very life appears to be on the line in how the US government chooses to handle the matter.
UBS's "very life appears to be on the line"? UBS certainly has a significant interest in whether the US government bails out the housing market, but in no way does UBS's existence depend on a government bailout. Let's assume that UBS takes another $37 billion in write-downs due to the deteriorating housing market. Now, $37 billion in write-downs sounds like a lot (and it is), but when you consider that UBS has roughly $2.2 trillion in assets, it becomes clear that another $37 billion in write-downs won't mean the end of UBS. Also, UBS is not Bear Stearns. In terms of market capitalization, UBS is over 30 times bigger than Bear Stearns was before it collapsed. Don't get me wrong, I think it was completely inappropriate that McCain had a UBS lobbyist advising him on his response to the housing crisis. It's inexcusable for a candidate who portrays himself as a crusader against lobbyists and special interests. This should end Gramm's role as a McCain advisor. But it's not like UBS needed the US government to bail out the housing market in order to remain in existence. I greatly respect Marshall, but I fear that by overstating UBS's interest in a government bailout, he'll take the legs out from under his argument.

Tuesday, May 27, 2008

Own-to-rent, Part II

Megan McArdle offers a number of objections to the "own-to-rent" plan, which I defended earlier. Her opposition seems to be mostly to the particulars of the plan, whereas I like own-to-rent as an idea (I think it gets the incentives right). I agree with some of her objections, but I think she gets a couple things wrong (which I'll address below). First, here are her objections:

1) What is the "fair market rent" to be determined by an "independent appraiser" on a 90% empty exurban development without the legal minimum sales to form a homeowner's association? 2) The tenants may be willing to invest in upkeep, but who fixes the plumbing when it breaks? The servicers are not rental agents. Moreover, they have no legal ability to become rental agents under their contracts. There is no entity in the position to take the role of landlord to these people. This is seen as the biggest--nay, insurmountable--obstacle. The only way this would work is if the government took possession of the homes, i.e. gigantic government bailouts. 3) There will be considerable political pressure on the "independent appraisers" to keep the fair market rental value down, handing the banks a loss. 4) Most of the people with the really problematic loans probably can't afford to rent their house, either. 5) To the extent that they could afford the rents--i.e. that houses were massively overvalued--you're putting a big capital loss on the bank's balance sheet and keeping it there, year after year, rather than writing it off. 6) The worst hit homes are in "developing areas" that are now rapidly "undeveloping", meaning that there aren't adequate services there. Encouraging people to stay in those areas is not, in the long run, a good idea. It also isn't a good idea to make people less mobile during an economic downturn. 7) Some of the worst hit homes are in areas where the tax base will not support the cost of basic services to the developments that the government is encouraging people to stay in. 8) Who gets to vote on the board of the homeowner's association? Are various servicers supposed to send people to represent their interests? Who pays the property taxes? You're sticking banks with a long term asset that neither they nor the servicers are set up to handle at all. 9) Keeping bad assets on bank books for years and years was, many argue, the main factor that made Japan's economy so festive in the 1990s. We should probably not repeat their error.
I certainly agree with item 4 -- many people who can't afford the mortgage payments also can't afford the rent -- but I don't think that's a reason to oppose the own-to-rent plan. It just means that the plan will have a limited impact. If a homeowner won't be able to afford the rent, then he won't petition the judge to allow him to stay as a renter. The majority of homeowners who actually file a petition under the own-to-rent plan will be able to afford the rent. If only a few homeowners can afford the rent, then only a few homeowners will file an own-to-rent petition. I also agree with some of item 8 -- banks/servicers shouldn't bear all the costs of transitioning from a mortgagor-mortgagee relationship to a landlord-tenant relationship. (e.g., hiring a rental property manager). The costs should either be shared by both parties, or borne entirely by the homeowner. I disagree, however, with the following: Item 1: Determining the fair market rent of a house in a 90% empty subdivision is obviously difficult, but there's a reason for that. If state law requires a minimum number of sales to create a homeowners' association (most states don't), and there haven't been enough sales, then the appraiser will determine the fair market rent under the assumption that the restrictive covenants aren't applicable to the unsold houses. In other words, the appraisal will be made with the assumption that the house isn't part of a homeowners association. Item 2: I don't understand why McArdle thinks this problem is so insurmountable. Servicers could easily be required to hire rental property managers to serve as landlords. As I stated above, I'd have no problem with forcing the homeowners to bear some of these costs. As for the legality of servicers becoming rental agents, that's a purely contractual issue. Contracts can be altered. Homeowners also have no legal ability to become renters under their contracts, but the whole point of the own-to-rent plan is to allow judges to alter their contracts. The own-to-rent plan could just require judges to also alter the terms of the contract to allow mortgage services to become rental agents. Item 3: Yes, there will be considerable political pressure on the independent appraisers to screw the banks, but that's why they're independent appraisers. Items 6 & 7: If an area truly doesn't have adequate services (or the tax base to support adequate services), then homeowners in that area won't petition the judge to let him stay there as renters. The "undeveloping" areas will thus be allowed to undevelop. The government wouldn't be encouraging peope to do the wrong thing -- allowing homeowners to stay in undeveloping areas isn't the same thing as encouraging them to stay there. The government also wouldn't be "making" people less mobile; people would be choosing to become less mobile. As I noted at the outset, I think rent-to-own is a good idea, in the sense that it gets the incentives right. It's possible that there are problems with implementation that are big enough to make the whole plan not worth it. But I haven't seen a problem that's a deal-breaker just yet.

The main Opinion section page on has the following summary of David Brooks' column today:

A presidential candidate should be selecting a vice president on the basis of who can help him govern successfully and get him re-elected.
Let me get this straight: A vice presidential candidate should help the presidential candidate govern and win elections? That's cutting-edge analysis!

Inflation is apparently the cool topic to write about right now (I know what you're thinking: when isn't writing about inflation cool?).

Of course, anyone who pays even the slightest attention to the global economy is aware that inflation is back in emerging economies, so I'm not really sure what they were going for with that cover. Maybe they thought that because everyone knows inflation is bad in emerging economies, people would guess they were talking about inflation in developed economies, and then readers would be surprised to learn that No, the cover actually was referring to inflation in emerging economies after all. The rare double fake-out! Anyway, there's a long article on inflation in emerging economies. It's somewhat rambling and and disorganized, but it makes some interesting points along the way:
The synchronised jump in global food prices suggests that there is more to the story than disruptions to supply. Prices are also rising partly because loose monetary conditions in emerging economies have boosted domestic demand. These economies have accounted for over 90% of the increase in global consumption of oil and metals since 2002 and for 80% of the rise in demand for grain. This partly reflects long-term structural forces, but it is also the product of a money-fuelled cyclical boom. ... [T]he initial shock to food prices may have come from the supply side, but the strength of income and money growth helps to validate higher prices. Were monetary conditions tighter, rises in food prices might be offset by declines elsewhere, keeping inflation under control. ... Analysis by Goldman Sachs, for 1990-2007, confirms that in emerging markets, higher food prices did seem to push up other prices. In most developed economies the link from food to non-food inflation was statistically insignificant. Besides the larger share of food, this has two causes: central banks' credibility is weaker in most emerging economies, so that inflation expectations are less firmly anchored; and real wages tend to be less flexible. Both increase the risk of a price-wage spiral. ...
Inflationary expectations are rising and workers clamouring for pay increases. In a survey of inflation expectations in Argentina, the average reply for the next 12 months was 36%. Russian wages are rising at an annual rate of almost 30%. ... The broad money supply has grown by an average of 20% over the past year in emerging economies, almost three times the pace in the developed world (see chart 4). Russia's money supply has swelled by fully 42%.
This last part, however, doesn't make sense to me:
China has helped to hold down inflation in developed economies because its goods are much cheaper and they are gaining market share, replacing more costly goods. This will remain true for many years. Competition from China also forces local producers to cut their prices and it curbs wage demands in rich countries. As China moves up the value chain it will pull down the prices of a wider range of products. In other words, China will continue to help hold down global prices—although possibly by less than in the past.
If China will pull down the prices of more products in the future, then why would it be holding down global prices "less than in the past"? You could argue that as China moves up the value chain, the products it will make are less likely to be included in the CPI (or other baskets), and thus the prices China will be holding down won't show up in inflation. But I don't think that's what the author was arguing. Am I missing something here?

Yves Smith defends Rep. Raúl Grijalva's (D-AZ) "own-to-rent" proposal (see text of the bill here). The proposal would allow homeowners whose mortgages have been foreclosed to petition a judge to allow them to stay in the home as renters, paying a fair market rent, for a period of up to 20 years. Dean Baker originally proposed an "own-to-rent" plan as a solution to the housing crisis; in fact, conservative economist Andrew Samwick has since promoted the plan with Baker. Rep. Grijalva's bill is substantially similar to Baker's proposal. I must admit, when I first read Baker's proposal, it struck me as a gross interference with property rights to give tenants the right to rent the property for so long (especially after foreclosure). But the more I thought about it, the more comfortable I became with it. Yves Smith, in defending the proposal against Ken Bunnell's charge that it will degrade communities because renters tend to make bad neighbors, captures it perfectly: "Give people property rights, and they act like they have property rights." Since Smith bases her claim about renters on anecdotal evidence and personal experience, I thought I'd provide some empirical support. In a 1999 paper, "Incentives and Social Capital: Are Homeowners Better Citizens?", Denise DiPasquale and Ed Glaeser found:

[A] large portion of the effect of homeownership [in social capital] comes from lower mobility rates for homeowners. ... The most important effect of homeownership may be its role in increasing community tenure. The results confirm that homeownership works both directly and indirectly through lowering the probability of changing residence. Between 4 and 92 percent of the effect of homeownership on citizenship is operating primarily because homeownership is associated with lower mobility rates. This finding suggests that policies that act to limit mobility would end up having similar effects to homeownership-enhancing policies on increasing the level of investment in local amenities and social capital.
In an earlier paper, Richard Green and Michelle White examined the benefit that homeownership has on children. Comparing renters and homeowners, they found:
The length of tenure and the homeowning variables interact with each other, so that longer tenure mitigates the adverse effect of renting on the probability that youths stay in school.
The average tenure of homeowners is roughly 11 years, so giving renters the right to rent the property for up to 20 years essentially allows them to stay in the community for just as long as homeowners. And if the renters under Grijalva's plan are equivalent to homeowners in terms of tenure, then communities will receive most of the same benefits from the renters that they would have received if the renters were homeowners. In other words, the own-to-rent plan would preserve most of the vaunted benefits of homeownership for the surrounding community.

Joseph Stiglitz thinks inflation targeting is a bad idea. Megan McArdle thinks inflation targeting isn't such a bad idea. Stiglitz argues that inflation targeting is especially inappropriate for developing countries because most of their inflation is imported:

Developing countries currently face higher rates of inflation not because of poorer macro-management, but because oil and food prices are soaring, and these items represent a much larger share of the average household budget than in rich countries.
McArdle counters by noting that higher food and energy prices don't always lead to higher inflation:
[I]nflation in the general price level is a result of there being more money than demand for money. Sudden scarcity--which is what higher food and energy prices represent--results in a shift in the relative value of everything in the economy.
The problem with this argument is that higher food and energy prices aren't always the result of sudden scarcity. Higher food and energy prices are sometimes the result of inflation, and sometimes the result of sudden scarcity. It's true that the Fed pays more attention to core inflation -- which excludes food and energy prices -- than headline inflation, but the Fed also hasn't adopted strict inflation targeting. Ultimately, I think Stiglitz and McArdle are probably both right in a sense. Stiglitz is right that inflation targeting is inappropriate as a one-size-fits-all rule, and is especially inappropriate for developing countries. Firms with sufficient market power can raise prices above marginal cost, and firms are much more likely to have sufficient market power in developing countries (because markets in developing countries tend to be thin). When higher prices are the result of this kind of mark-up, then the price level and the output gap are moving in opposite directions. In this scenario, inflation targeting would prevent the central bank from achieving a stable output gap. However, McArdle is right that inflation targeting isn't always and everywhere a bad idea. As always, context is king.

Ilya Somin over at The Volokh Conspiracy shares a form email from the editors of the Bluebook soliciting advice for their latest update (the Bluebook is the main citation guide used in the legal world). Professor Somin's advice is to abolish the Bluebook. Law professor Daniel Solove offers some less drastic suggestions for reform. Both Somin and Solove are clearly frustrated with the Bluebook. To be sure, the Bluebook has countless terrible and/or needless rules, and desperately needs reforming. But when it comes to law review articles, the problem isn't the Bluebook, it's that student editors on law review are the ones who apply the rules in the Bluebook. I was an articles editor on the law review when I was in law school, so I have some first-hand experience. Solove couldn't have picked two better examples when he noted that the two worst rules in the Bluebook are: (1) the rule dealing with parentheticals; and (2) the rule dealing with when a footnote is required. The Bluebook doesn't actually require that a parenthetical containing descriptive text follow every citation, but that's essentially the way law review editors interpret the rule. I can't tell you how many arguments I had with other editors about this point. When I sent an article I had edited to the Editor-in-Chief and Executive Editor for the final review, they sent it back every single time demanding a parenthetical after every citation with a signal (see, cf., see also, etc.). They saw it as a hard-and-fast rule: every citation with a signal had to have a parenthetical, regardless of whether it was actually necessary within the context of the article. I would point out to them that the Bluebook allows for some discretion in using parentheticals, and they would reply, "this is the way we do things." I would tell them that adding more parentheticals would actually detract from the quality of the article, and they would reply, "this is the way we do things." I had similarly surreal arguments about which propositions needed footnotes. As Professor Solove noted, "law review editors want footnotes for nearly every proposition in the article." One time the Editor-in-Chief actually made me insert a footnote to support the proposition that the founding fathers signed the Declaration of Independence in 1776. If an author had written that 2 + 2 = 4, the editors probably would have required a footnote with a citation to a math textbook. I kid you not. This was at a top 10 law school. The problem is that student editors aren't capable of properly editing law reviews. They're not familiar enough with law review articles to determine which citations really need parentheticals and which don't. For the vast majority of students on law review, their first encounter with law review-style articles is the write-on competition. It's not surprising, then, that they shy away from exercising any discretion in editing law professors' articles. They cling to inflexible rules because they don't know what they're doing. Abolishing the Bluebook won't solve the problem. Law review editors will just find another source to give them hard-and-fast rules. If you want to improve the publication process, make law reviews faculty-edited.

Bloomberg reports that the fundamentals don't seem to justify the lastest tip of the run-up in oil prices (or so says The Market):

Crude oil fell more than $2 a barrel on signs that a 15 percent increase in prices this month isn't justified by stockpiles and demand. Consumption averaged 20.3 million barrels a day in the past four weeks, down 1.3 percent from a year earlier, the Energy Department said yesterday. Prices climbed above $135 a barrel today as OPEC ministers said they could do nothing to prevent higher prices because they are pumping at capacity. "The fundamentals justify a price between $80 and $100," said Sarah Emerson, managing director of Energy Security Analysis Inc., a consulting firm in Wakefield, Massachusetts. "The run-up in prices has more to do with institutional investors coming into the market. There's nothing to discourage them from doing so because the returns have been so high." ... "Even a bull market has to consolidate at some point and it looks like that's what's happening today," said Addison Armstrong, director of market research at TFS Energy LLC in Stamford, Connecticut.
Here's how I see it now: 1. Supply and demand could justify high oil prices, in that China and India are definitely consuming more oil, and supply has stalled because there have been fewer major oil discoveries. 2. The measure we usually use to determine whether there's a bubble in a commodity (inventories) doesn't point to an oil bubble. To me, that doesn't warrant the conclusion that there isn't an oil bubble. Remember, there's not conclusive evidence that fundamentals are driving oil prices either, there's just a plausible story that could explain the high oil prices. Moreover, the fact that a very basic measure suggests that there isn't an oil bubble doesn't prove that there isn't actually an oil bubble. The absence of conclusive evidence for a proposition doesn't disprove the proposition. It just means there isn't sufficient evidence to prove the proposition. Frankly I think most of the debate boils down to different definitions of what constitutes a "bubble." Those who argue that there is an oil bubble tend to take a short-run view of bubbles -- they ask whether today's price of crude oil is justified by supply and demand. Conversely, those who argue that there isn't an oil bubble tend to take a long-run view of bubbles -- they ask whether high oil prices in general are justified by supply and demand, and are less concerned with day-to-day oil prices. The two sides may just be talking past each other.

Alex Tabarrok at Marginal Revolution points us to an incredible yet thoroughly unsurprising story. The U.S. imposed import tariffs on wire hangers from China after several American producers accused Chinese producers of dumping. Brandon Fuller at the Aplia Econ Blog calculated how much it's costing us to protect the jobs in the U.S. wire hanger manufacturing business, and the numbers are astounding:

According to the NPR story, there are roughly 30,000 dry cleaners in the U.S., and on average, each pays an additional $4,000 per year due to the hanger tariff. This indicates an average annual cost of 30,000 firms x $4,000 per firm = $120 million. According to the U.S. International Trade Commission's report, U.S. employment in wire hanger manufacturing was 564 workers in 2004 and fell to 236 workers by 2006. Let's assume that employment in this sector would have fallen to zero in the absence of the tariff, and that with the tariff, employment will recover to 2004 levels. In other words, assume the tariff "saves" 564 jobs. Dividing the cost of the tariff to U.S. dry cleaners ($120 million year) by the number of jobs saved (564 jobs) indicates that each job saved costs about $212,765 per year. Keep in mind that the typical full-time worker in this sector earns about $30,000 per year. Even if we assume that industry employment doubles, the cost of the tariff is still roughly $120,000 per job.
That's right, we're paying $212,765 per year to save $30,000 per year jobs. Incredible. But what may be even more incredible is that an industry with only 236 workers was able to wield enough influence to secure such an expensive tariff. I know public choice theory is particularly applicable when it comes to the U.S. tariff schedule, but jeebus! 236 workers!

Kevin O'Rourke, a first-rate economic historian, observes that freer trade was achieved by giving parochial interests domestic concessions:

As an economic historian, I cannot but think back to the origins of the welfare state, which occurred at the end of the first great globalization of 1840-1914. In several recent articles, Michael Huberman has convincingly shown that if anything trade and government intervention were positively related during the late 19th and early 20th centuries. For example, a range of labour market regulations was introduced across Europe, prohibiting night work for women and children, prohibiting child labour below certain ages, and introducing factory inspections. The period also saw the widespread introduction of old age, sickness and unemployment insurance schemes. Crucially, this "labour compact" as Huberman calls it was more advanced in those countries which were more open to trade. There is no evidence of a race to the bottom here: rather, governments in Belgium and elsewhere used the introduction of such reforms to secure the support of workers for free trade.
The problem I have with this argument as it's applied today -- that we should secure support from unions for freer trade by giving them domestic concessions -- is that the trade-off may not be worth it anymore. Some level of government intervention is efficient; even Martin Feldstein supports the existence of mandatory Unemployment Insurance. Establishing a UI system in exchange for freer trade is thus a win-win from an efficiency standpoint. But what if unions demand a massive and ultimately inefficient expansion of the UI system in exchange for supporting marginally more liberalised trade with China? Then the argument becomes quantitative: are the gains from more trade with China greater than the costs of a bloated UI system? It's no longer a win-win. The current version of this argument seems to assume either that the domestic concessions are efficient standing alone, or that their inefficiencies are tiny compared to the efficiency gains from freer trade. That won't always be the case. The efficiency gains from freer trade are subject to diminishing returns -- as world trade slowly becomes more free, the efficiency gains from further trade liberalisation become progressively smaller. The domestic concessions used to secure support for freer trade are not subject to diminishing returns. Unless politicians progressively scale down the size of these domestic concessions (highly unlikely), then using domestic concessions to secure support for freer trade may well prevent the world from getting to a state of free trade. The inefficiencies of the domestic concessions will eventually outweigh the efficiency gains of further trade liberalisation. To be clear: I'm not arguing that we're in this position now. Not even close. I'd support significantly more transition assistance for displaced workers, among other reforms. But I'm wary of the argument that the ticket to a state of free trade is domestic concessions.

Monday, May 19, 2008

Healthcare and Budget Deficits

CBO Director Peter Orszag cuts to the chase: healthcare is the overriding issue:

The United States faces serious long-run budgetary challenges. If action is not taken to curb the projected growth of budget deficits in coming decades, the economy will eventually suffer serious damage. The issue facing policymakers is not whether to address rising deficits, but when and how to address them. At some point, policymakers will have to increase taxes, reduce spending, or both. Much of the pressure on the budget stems from the fast growth of federal costs on health care. So constraining that growth seems a key component of reducing deficits over the next several decades. A variety of evidence suggests that opportunities exist to constrain health care costs both in the public programs and in the health care system overall without adverse health consequences.
Fixing healthcare is clearly the answer to Mark Thoma's question about what you would do with one wish. A close runner-up would be wholesale adoption of school vouchers. Well, maybe not wholesale adoption of school vouchers, but some sort of market-based overhaul of the public education system. No other issue even comes close to healthcare and education in terms of overall importance.

Charles Engel wonders whether there's an oil bubble (via Econbrowser):

One possible explanation is that the market has kept learning about the strength of demand and the weakness of supply over the years. It is consistently being surprised, in other words. That may be right, but it is a shaky argument: why is the market always being surprised in the same direction – that excess demand is greater than we thought? Another story that I think makes some sense is the one that Jeffrey Frankel and Jim Hamilton have promoted – that Fed monetary policy has played a role. [A] drop in real interest rates should cause commodity prices to rise. But here again, the decline would also have to be unanticipated to explain the continual increase in the price. I think there is a lot of truth to the view that markets keep getting surprised in the direction that makes oil prices higher. ... The problem for economists is that the market for oil is so complicated that we cannot very accurately calculate what the price of oil “should be” if there is no bubble. We have to read the entrails to figure out whether the price is really reflecting market fundamentals – demand, supply, real interest rates – or has a bubble component. As I look at the rising price, I wonder which story is most plausible: (1) the markets have been surprised over and over about demand by end users and production capabilities; (2) markets have been surprised over and over about how low real interest rates are; (3) there is a bubble. These stories may go together, in fact.
The story about the market consistently being surprised is more believable if you think about it not in terms of the market being surprised over and over again in one direction, but rather the market being surprised in one direction more often than it's being surprised in the other direction. Look at the price of crude oil over the past 6 months:
Clearly, the market has been "surprised" in both directions over the past 6 months -- it's just been surprised in the direction of higher prices more than it's been surprised in the direction of lower prices. I'd be willing to buy this story as the explanation for increasing oil prices (rather than a speculative bubble). But just as intraday movement in stock prices reflect liquidity concerns rather than information being priced in, I'm not sure that most of the movements in oil prices don't reflect major liquidity issues -- especially as the credit crunch has made liquidity such a dominant issue. As far as I'm concerned, there's probably a bubble in agricultural commodities, but the jury is still out on whether there's an oil bubble. Oil is a unique beast, and cannot be lumped together with all of the other commodities. The debate over whether there's an oil bubble is fascinating, and is taking place at a considerably higher level than the debate over whether there was a housing bubble. (I'm just waiting until the hysteria and irrationality kicks into the oil bubble debate, because you know it will eventually.)

David Post at the Volokh Conspiracy reports on an experiment he conducted in his Intellectual Property classes. Instead of giving his students casebooks with pre-edited judicial opinions, he gave his students unedited judicial opinions, so that they could practice identifying the important portions of the cases. In Post's words:

My idea was pretty simple. Being able to read a judicial opinion from start to finish and to figure out what it means, or even what it might mean, even though there’s a lot of confusing junk in it, is an indispensable skill for any lawyer.
At the end of the post, he offers this observation, which I think highlights one of law school's most glaring deficiencies:
All of that I kind of expected. But there was an unexpected benefit as well. One thing I was nervous about was the obvious need to reduce the total number of cases the class would be reading. I tried to select cases that don’t have too much “confusing junk” in them, but even so it’s hard work for them to get through the opinions, and I can only assign one or two per class. I was worried that their understanding of the substantive subject matter – the nuts and bolts of IP law – would suffer as a result. But I think the opposite may well be true. Casebooks edit out not only the “confusing stuff” but also the repetitive stuff; because the American Geophysical Union v Texaco case is in the “fair use” section of the Casebook, the court’s discussion of copyright ownership, or the scope of the reproduction right, will probably be omitted as having been covered elsewhere in the book. But it turns out – somewhat to my surprise – that the repetitive stuff is enormously helpful. It’s one thing to read, in the section on “copyright infringement,” that the plaintiff has to prove “copying” and “substantial similarity in protected material” in order to prevail, and to try to understand what that means. It’s quite another thing to read that in every case, over and over again, the same basic formulation of the elements of the copyright claim. And to notice that while the basic formulation stays pretty much the same, different courts, in different cases, might articulate the rule somewhat differently – hmmm, what’s up with that? I could be wrong, but I think my students understand the copyright infringement “test” more thoroughly for having encountered it so many times than they did when we focused on it just for a couple of classes.
I think Professor Post is right, but for a reason he does not mention here. In casebooks, there is generally space for only one or two cases on each legal concept. Consequently, casebook authors choose cases with facts that are right on the edge -- in other words, in applying the legal rule to the facts in that case, the court could go one way or the other. The point of choosing these cases is to demonstrate where the outer limits of a particular legal rule are. The downside to this method is that students don't get any sense of what facts definitely do or definitely don't fall within a particular legal rule. Giving students unedited judicial opinions lets them see situations where courts make a routine application of a particular rule to a set of facts -- no legal debate about the applicability of the rule, or the outcome when the rule is applied. The "repetitive stuff" allows students to see what a routine application of a legal rule looks like. This is important because in practice, it's very rare to come across a set of facts that are right on the edge of a legal rule. The answer is usually pretty definitive one way or the other, based on existing statutory material, case law, etc. Professor Post is right that the ability to quickly parse an unedited judicial opinion is an invaluable skill. He's doing his students a big favor by teaching them this skill.

Friday, May 16, 2008

Emerging Markets

I've always thought that a very positive development for third-world countries was when investors started to refer to them as "emerging markets" rather than "third-world countries," "poor countries," or the like. As best I can tell (which is to say, based on LEXIS research), the earliest mention of "emerging markets" came from the Latin America Commodities Report on December 10, 1976, when it said:

"If nothing else, the deal illustrated the kind of competition Argentina is likely to come up against this season in emerging markets like Egypt."
The fact that the earliest mention I can find comes from an industry newsletter suggests that analysts were using the term already. But without any evidence that this term was being used before December 10, 1976, then I say, thank you Latin America Commodities Report! UPDATE: I knew I should have extended my search all the way back to the '60s! Now I see that the earliest mention came from Infovest21, another industry newsletter, on December 31, 1969, when it said:
"Hedge fund strategies currently in favor with European investors are at opposite ends of the return/risk spectrum, notably emerging markets are on one end and market neutral equity strategies at the other end."
This is the earliest mention in the LEXIS database. So thank you, Infovest21!

There has been quite a bit of discussion of asset bubbles and how to deal with them in the past few days, with front-page stories in both the Financial Times and the Wall Street Journal, and other follow-up pieces as well (see also an editorial in the FT, "The Great Asset Price Controversy"). I can hardly offer any great wisdom to this debate, never having set foot inside a central bank in my life. But let me offer one small piece of advice: when talking about how central banks should deal with asset bubbles, maybe we should drop the "bubble" metaphor. Bubbles can be burst with just a prick. This gives the impression that central banks can fight asset bubbles with something akin to a prick, and might cause central banks to look too hard such a policy tool, which may or may not exist. Exhibit A is this picture, which accompanied an article on asset bubbles in today's FT:

The most compelling argument against using interest rates to fight asset bubbles (i.e., leaning against the wind), is that interest rates are too blunt an instrument. According to Fed Governor Frederic Mishkin, it is "inappropriate to use the blunt instrument of interest-rate increases to prick bubbles." Or as Ben Bernanke put it, "One might as well try to perform brain surgery with a sledgehammer." But maybe popping asset bubbles isn't brain surgery; maybe it requires more than just a "prick." As the article in today's Wall Street Journal emphasized, asset bubbles are very hard to pop:
Manias can persist even though many smart people suspect a bubble, because no one of them has the firepower to successfully attack it. Only when skeptical investors act simultaneously -- a moment impossible to predict -- does the bubble pop. ... [I]nvestors who spot the bubble attack only if each is confident that other skeptics are on board. In work done with Mr. Abreu, Mr. Brunnermeier concluded that if all the rational investors could agree to bet against the bubble, they could make big profits. But if they can't coordinate, it's risky for any one of them to bet against a bubble. So it makes sense to ride it up and then get out quickly as soon as the bubble's existence becomes common knowledge.
Using the bubble metaphor may well be fostering a false illusion that central banks can pop asset bubbles with a policy tool akin to a prick, when in reality central banks need to bring out the blunt instruments. Personally, I think we need to be very, very careful in allowing the Fed to intervene in markets based solely on the Fed's perception of asset prices. That's a very dangerous proposition, and not one that I'm immediately head-over-heels in love with. Hindsight is 20/20, and in the aftermath of a bubble it's easy to say that central banks should have seen it coming. Witness the healthy debate over whether the current run-up in commodities is a bubble. What if it turns out to be a bubble, and we're already past the point where central banks needed to intervene? Think about that before you sign-off on giving central banks broad authority to pop asset bubbles.

Yves Smith sends us to a three-part series on the "financialization of commodities" by Michael Frankfurter, a commodities industry analyst. The series is quite long (as articles go) and it gets a bit technical in the second article, but it's worth the effort. Frankfurter ultimately argues:

Rising prices and a widespread bull market in commodities should indicate that there is a growing scarcity of hard assets. However, traditional forces of supply and demand cannot fully account for recent prices. To be precise, the normal price-inventory relationship has been altered. This is the assertion of an expanding list of bona fide hedgers, commodity professionals and economists. Specifically, dynamics have changed because securitized commodity-linked instruments are now considered an investment rather than risk management tools. Of late, this has been causing a self-perpetuating feedback loop of ever higher prices.
Essentially, Frankfurter's argument is that the commodities market has been slowly "financialized" (that is, made to look like the equity and bond markets), and that this has allowed excessive amounts of money to pour into commodities futures, which increases volatility, induces speculation, etc. It's a bit like "hot money" for commodities:
In a slowing global economy hit by a major credit crisis and reeling from a falling dollar, it is likely that money flows seeking safe haven in hard assets is the key driver of recent volatility.
His argument is much more complex and I can't really do it justice, so I won't try to summarize the entire thing. But I do want to highlight Frankfurther's reminder that commodities futures are unique instruments, and are not equities or bonds (to be honest, I probably needed this reminder myself):
Futures and forward contracts are intrinsically different instruments than securities which are derived from the capital markets (e.g., fixed income or equities). This is underappreciated. Derivatives are risk management tools, a “zero-sum game,” fundamentally different from the “rising tide raises all ships” concept of the capital formation markets. While there is an established theoretical basis and considerable empirical evidence that link investment in capital market assets to positive expected returns over time, notwithstanding the recent surge in commodity prices, the same cannot be said about commodities. As noted by Greer (1997), the inherent problem is that commodities are not capital assets but instead consumable, transformable and perishable assets with unique attributes. Hence, speculative trading, by definition any commodity trading facilitated for financial rather than commercial reasons, likely results in “zero systematic risk.” The conundrum is that for every buyer of a futures contract there is a seller—sine qua non, there is no intrinsic value in futures/forward contracts—they are simply agreements which commit a seller to deliver an asset to a buyer at some place/point in time.
On the whole, I found Frankfurter's argument pretty persuasive. While I don't think the "financialization" of commodities is the sole driver of the commodities boom by any stretch of the imagination, I'm ready to assign it a decent role.

On Thursday, I wrote a post about how much of this year's U.S. corn crop will be consumed by ethanol (answer: 31%, according to the IMF's World Economic Outlook). An article on the front page of the weekend Financial Times states:

The US Department of Agriculture revealed on Friday that the US biofuel industry would consume one third of the country’s corn crop in the 2008-09 season – or 4bn bushels – up from about 22 per cent a year earlier – or 3bn bushels.
I spent 2 incredibly frustrating hours late Wednesday night trying to find a good estimate of how much ethanol will consume this year's U.S. corn crop -- including about 45 minutes on the Department of Agriculture's website -- and the Department of Agriculture reveals its estimate 2 days later? Wow. Not funny. At all. On Wednesday, I had to go to footnote 16 in Appendix 1.2 of the IMF's 2008 World Economic Outlook to find the answer. On Saturday, the answer is on the front page of the FT. I really hate the Department of Agriculture.

Brad DeLong pits Megan McArdle against Greg Clark. Clark argued that it would only take incomes 3 years to recover from a permanent doubling of food and energy prices. Clark based his claim on income trends "[a]t current rates of economic growth," so he evidently thinks a permanent doubling of food and energy prices wouldn't lower the rate of economic growth. McArdle agrees with me that a permanent doubling of food and energy prices would lower the rate of economic growth, and thus that incomes would take longer than 3 years to recover. DeLong's conclusion: "I call this one for Greg Clark. I am a utopian neoliberal optimist." Huh? Now, DeLong is a very smart economist and I hold him in high regard, but that's just silly. He equates McArdle with Thomas Malthus, so he clearly thinks the dispute is about the long-run effects of a doubling of food and energy prices. Precisely the opposite: the dispute is about the short-run effects. (Note the irony of a Keynes admirer ignoring the short-run.) A cursory look at the short-run vs. long-run price elasticity of demand for gasoline illustrates why Clark's claim is so ridiculous. As Paul Krugman noted: "In the long run, the best estimate of the price elasticity of demand for auto fuel seems to be -0.7. That is, a 10 percent rise in prices will reduce gas consumption by 7 percent." In the most recent issue of Energy Journal, three of Greg Clark's own colleagues at UC-Davis published a paper titled, "Evidence of a Shift in the Short-Run Price Elasticity of Gasoline Demand." They concluded: "For the period from 2001 to 2006, our estimates of price elasticity range from -0.034 to -0.077." In other words, a 10% increase in gas prices will reduce gas consumption in the short-run by only 0.34% to 0.77%. That means a doubling of gas prices would barely reduce gas consumption in the short-run at all (from 3.4% to 7.7%). The short-run price elasticity for electricity and natural gas is around -0.2, which is a bit better, but not much. So if energy currently accounts for 7% of U.S. consumption, then a doubling of energy prices would push the share of consumption devoted to energy up to around 12% in the short-run. The extra money being devoted to energy would have to come from somewhere -- that is, a doubling of energy prices would be like a 5% decline in overall consumption. How does that usually affect economic growth? In the long-run, we'd reduce our energy and food consumption more, find newer and cheaper sources of energy and food production, etc., etc. But even in the rosiest scenario, that would only come after a rough period of slower economic growth. And if incomes would take 3 years to recover at current rates of economic growth, then they would take longer than 3 years to recover at slower rates of economic growth. Long-run optimism and short-run pessimism aren't incompatible. Ignore the short-run at your own peril. (Aside: Clark stated in his op-ed that "the share of modern U.S. consumption devoted to raw food...purchases is small: 1.4% for food raw materials... ." Higher prices for "food raw materials" would be passed on to consumers, so doubling the price of raw food materials would significantly increase the price of food. And seeing as the share of personal consumption devoted to food (as opposed to just "food raw materials") is 13%, a doubling of the price of raw food materials would significantly reduce personal consumption. Again, how does that usually affect economic growth? Badly.) UPDATE: Gary Becker notes the difference between the short-run and long-run effects of high oil prices:

Of course, even with energy's smaller role in the production of output, any rise in oil prices to over $200 a barrel in the next few years would have serious disruptive effects on the world economy. To many persons who have commented on this prospect, such a high oil price seems plausible, given the expected continuation of the rapid growth in the GDP of China, India, Brazil, and other major developing countries. For the evidence is rather strong that the short run response of both the supply of and the demand for oil to price increases is rather small. The small elasticity of both the supply and demand for oil explains why the moderate reductions in world oil supply during the earlier price spikes, and the moderate increase in world demand during the current price boom, produced such large increases in price. However, the long run response to price increases of both the demand and supply for oil and other energy inputs is considerable. For example, given enough time to adjust, families react to much higher gasoline prices by purchasing cars, such as hybrids and compacts, that use less gasoline per mile driven. They also substitute trains and other public transportation for driving to work and for leisure purposes. High energy prices, and hence the opportunity for large profits, induce entrepreneurs to work more aggressively to find fuel-efficient technologies, including the use of batteries as a replacement for the internal combustion engine.

Gregory Clark, in an otherwise sensible op-ed in today's LA Times (via Mark Thoma), makes this odd claim at the end:

Given that we can easily reduce consumption when costs go up, a permanent doubling of the prices of food and energy would reduce income by less than 6%. At current rates of economic growth, incomes would recover from such a shock in less than three years.
Call me crazy, but I think a permanent doubling of food and energy prices would slow our rate of economic growth pretty significantly. How long it would take incomes to recover "at current rates of economic growth" is irrelevant when the doubling of food and energy prices would lower the rate of economic growth.

Andrew Biggs tries his best to mislead his readers on the Wall Street Journal op-ed page this morning (via Mankiw):

If the tax cuts expire, income-tax revenues by 2018 will rise to 10.8% of the total economy from 8.7% today – an increase of 24%. Compared to the average over the last 50 years, allowing the rates to rise would increase tax revenues by 32%. Believe it or not, income taxes will rise even if the tax cuts remain in place, because the revenue-increasing effects of bracket creep more than offset the lower rates. With the lower rates, total income-tax revenues will increase to 9.3% of GDP by 2018. This level is 7% higher than today, and 13% above the 1957-2007 average.
For the first 3 sentences, Biggs (correctly) discusses income tax revenues in terms of percentage-of-GDP. When you talk in terms of percentage-of-GDP, small changes in percent represent big differences, since we have a GDP of over $13 trillion. So in the last sentence Biggs quietly switches to income tax revenue level, so he can use bigger -- and more impressive -- numbers. Using Biggs' own numbers, income tax revenues are currently 8.7% of GDP. If we extend the Bush tax cuts, income tax revenues will be 9.3% of GDP. If the Bush tax cuts expire, income tax revenues will be 10.8% of GDP. Thus, if we extend the Bush tax cuts, income tax revenues will increase 0.6% (from 8.7% to 9.3%). But because a 0.6% increase won't impress many people, Biggs says that it's a 7% higher level than today (since 0.6 is roughly 7% of 8.7). Wow, our budget problems will solve themselves, even if we extend the Bush tax cuts! We can have our cake and eat it too! In reality, however, the CBO projects that we'll be running a $450 billion budget deficit in 2010. Using Biggs' own numbers again, extending the Bush tax cuts results in $83 billion more in annual income tax revenues. Letting the Bush tax cuts expire results in $291 billion more in annual income tax revenues. So the difference between extending the Bush tax cuts and letting them expire is $208 billion a year. When we're running a $450 billion budget deficit, that's no small matter.

Thursday, May 8, 2008

Corn Production and Ethanol

An article in yesterday's Financial Times reported:

Mr Glauber [chief economist for the Department of Agriculture] said that ethanol was likely to consume 24 per cent of the maize harvest.
That struck me as remarkable, so I looked into it a bit further. According to the IMF's 2008 World Economic Outlook, ethanol will actually consume 31% of the entire U.S. corn crop in 2008 (see Appendix 1.2, fn. 16). If the U.S. meets its mandate to quintuple ethanol production by 2022, then by 2015 ethanol will consume roughly 50% of the U.S. corn crop. The U.S. is far and away the biggest corn producer in the world. According to the Department of Agriculture, the U.S. will produce 332 million metric tons of corn in 2008. If 31% of the U.S. corn crop is being used for ethanol, that means ethanol will consume roughly 103 million metric tons of corn. World corn production in 2008 is estimated to be roughly 772 million metric tons. Thus, U.S. ethanol is consuming roughly 13% of the corn produced in the world. Ponder that for a second: U.S. ethanol is consuming roughly 13% of the corn produced in the world. How much would food prices go down if there was a 13% increase in the supply of corn used for non-ethanol purposes? I don't know. But I imagine it wouldn't be an insignificant price reduction -- especially for poor countries. Now, some of the 103 million tons of corn being used for ethanol wouldn't have been produced without the ethanol subsidies, so it's a bit unfair to fail to control for that factor. On the other hand, the increased corn production also puts upward pressure on other commodity prices. From the 2008 World Economic Outlook (pg. 60):
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.
On balance, then, it's probably fair to say that in the absence of U.S. ethanol, the supply of corn used for non-ethanol purposes would increase by less than 13%, and that such an increase would lower prices across a wide range of commodities. The WEO also has these great charts on commodities:

Of all the financial reform proposals out there right now, not one seriously addresses the overriding problem with the current financial model. This problem is, of course, the famous Musical Chairs Problem described by then-Citigroup CEO Chuck Prince:

"[A]s long as the music is playing, you’ve got to get up and dance. We’re still dancing,” he said in an interview with the FT in Japan.
Financial houses, even at the highest levels, knew that subprime mortgage bonds were bad investments. They're not (that) stupid. In fact, they knew that subprime would cost them -- and not just naive investors they peddled subprime to -- substantial sums of money. Financial houses were forced to hold the worst tranches of subprime mortgage bonds, because even they couldn't unload that crap onto unwitting investors. As Jon Danielsson noted in an article on VoxEU today:
Unfortunately, the quality of SIV ratings differs from the quality of ratings of regular corporations. A AAA for a SIV is not the same as a AAA for Microsoft. And the market was not fooled. After all, why would a AAA-rated SIV earn 200 basis points above a AAA-rated corporate bond? One cannot escape the feeling that many players understood what was going on but happily went along.
So why did they keep going? Because the music was still playing, and "as long as the music is playing, you’ve got to get up and dance." When you see other firms generating huge fees by originating more and more crappy mortgage bonds, you have to keep pace, lest you be seen as less successful, and lose valuable market share. The same thing happened in the tech bubble: remember the beating Warren Buffett took for not investing in internet stocks when the bubble was inflating? Essentially, the problem boils down to this: The payoffs from maintaining short-term competitiveness are greater than the payoffs from sound, long-term investing. Until we break the link between the short-term competitiveness of a financial firm (which, as we've seen, is often illusory) and the overall success of the firm, we have not learned our lesson from the subprime crisis. It's a big task that requires fundamental changes, but it's a task well worth undertaking. Unfortunately, no financial reform proposal I've seen seriously addresses this issue. (Alan Blinder proposed forcing firms to keep a slice of a mortgage bond, but Yves Smith quickly tore down that simplistic solution.)

Wednesday, May 7, 2008


From a New York Times article about Barney Frank's housing bill:

Mr. Frank’s bill is part of a package that also includes two major housing measures that the White House has been demanding for months: an overhaul of the Federal Housing Administration and tighter regulation for the government-sponsored lenders Fannie Mae and Freddie Mac. In its statement of opposition, the administration said it viewed the inclusion of those provisions as “largely symbolic” and called on Congress to pass those bills as independent measures.
OK, I'll bite: If the provisions overhauling the FHA and the GSEs are just "symbolic," then why would you want Congress to pass them as independent measures? Calling for provisions of a bill to be passed as independent measures is supposed to signal support for those provisions. But the provisions overhauling the FHA and the GSEs would still be "symbolic" as independent measures. So why disparage provisions and simultaneously call for them to be passed as independent measures?

Tuesday, May 6, 2008

Simplistic Simplifications

Greg Mankiw, commenting on international tax competition, writes:

This issue goes well beyond economics to questions of political economy and political philosophy. If you think it is the job of government to take from Peter to pay Paul, and if Peter can move around the globe, then you need international tax cooperation. Otherwise, some countries will become nations of Peters, leaving all the Pauls to fend for themselves. On the other hand, if you think that the main job of government is to facilitate voluntary exchange by protecting property rights, rather than re-slicing the economic pie as it sees fit, then tax competition is a good check against excessive interventionism. In other words, are you more worried about too little government or too much?
Or maybe you think it's the job of the government to not only facilitate voluntary exchange by protecting property rights, but to do other stuff too (like, say, provide for a national defense, or put murderers in prisons). And maybe, just maybe, the government needs money to do some of that other stuff. Now I don't want to get too crazy here, but maybe the best way to collect the money -- dare I say the most efficient way? -- is through a system of progressive taxation. Of course, then the government would be protecting property rights and "tak[ing] from Peter to pay Paul." What a weird world that would be! Luckily, we don't have to worry about the implications of international tax competition in such a world, because that world obviously doesn't exist. But pretend for a moment that such a world does exist: that governments both protect property rights and take from Peter to pay Paul. Then some countries would still become nations of Peters, leaving all the Pauls to fend for themselves (because the Peters would leave any country that slices the economic pie). That would make it impossible for countries of Pauls to have an efficient system of progressive taxation, seeing as they would lose all vertical efficiency in their tax codes. Is it possible, then, that all-out international tax competition might not be such a hot idea? Nah. We better stick with the "slicing-the-economic-pie vs. growing-the-economic-pie" example. It's much more realistic that way.

...communism caused the subprime crisis! So goes the logic of Gerald O'Driscoll, in an essay for Reason magazine.

The pricing of these financial products was the product of complex economic models, not the outcome of market transactions. As the value of the underlying homes and mortgages declined, pricing of the financial exotica became nearly impossible. ... There is a wonderful parallel here to the collapse of the Soviet Union. As the great Austrian economist Ludwig von Mises argued almost 100 years ago, central planning inevitably fails because there are no market prices to allocate resources. Market prices can only be the outcome of actual market transactions among buyers and sellers. Planners used mathematical formulas to value resources, especially capital. Now Wall Street wizards have imported Soviet thinking to allocate financial capital. Is it any wonder that it failed?
You see? The problem was not enough market forces! I do have one question for O'Driscoll though: Why didn't the competitive forces of the market on Wall Street -- which were absent in the Soviet Union -- result in accurate economic models to price these financial products? O'Driscoll also tries to place some of the blame for the subprime crisis on the Community Reinvestment Act (CRA):
The second factor contributing to the housing market collapse was the federal government’s commitment to “affordable housing.” Lenders, especially Fannie Mae and Freddie Mac, were pressured into promoting housing to low-income groups that could not qualify for normal loans. That policy is predicated on the belief that there is an underserved group of people who, but for economic discrimination or some other market failure, would be homeowners.
The CRA was enacted in 1977. So how did the CRA not cause a subprime crisis for 25+ years, and then suddenly cause one in 2006? Keep in mind that the CRA doesn't actually require banks to lend to low-income or minority groups, and that it was significantly weakened in 2005. Believe it or not, not every bad thing is caused by "government interference" in the market. I swear, it's true.

Sunday, May 4, 2008

George Will: Logically Challenged

Behold, the awesome logic of George Will. First, Will notes that the "unitary executive" theory has been "intensified by the current president in the context of 'the long war' against terrorists." Will then writes:

[D]isoriented by their reverence for Reagan and sedated by Republican victories in seven of the past 10 presidential elections, many conservatives have not just become comfortable with the idea of a strong president, they have embraced the theory of the "unitary executive." This theory, refined during the Reagan administration, is that where the Constitution vests power in the executive, especially power over foreign affairs and war, the president, as chief executive, is rightfully immune to legislative abridgements of his autonomy. Judicial abridgements are another matter. When in 1952 Truman, to forestall a strike, cited his "inherent" presidential powers during wartime to seize the steel mills, the Supreme Court rebuked him. In a letter here that he evidently never sent to Justice William Douglas, Truman said, "I don't see how a Court made up of so-called 'liberals' could do what that Court did to me." Attention, conservatives: Truman correctly identified a grandiose presidency with the theory and practice of liberalism. (emphasis added)
OK, so here's the tally: A liberal president (if you can define Truman as "liberal") asserted the unitary executive theory, and a liberal Supreme Court immediately rejected said theory. A conservative president (Reagan) then asserted the unitary executive theory for eight years. Finally, George W. Bush "intensified" the unitary executive theory. Will's conclusion: The unitary executive is a liberal theory. Makes sense. If there was a Special Olympics for Columnists, Will would be standing on a podium right now.

I came across a blog called The Antiplanner (evidently maintained by Randal O'Toole of the Cato Institute), which had a post titled, "Yes, Smart Growth Caused the Mortgage Meltdown." Now, I've argued before that land use regulations probably played a role in the housing bubble, but I would never go so far as to say that they "caused" the subprime crisis, or even the housing bubble. Nevertheless, I was intruiged, because the role of land use regulations is an area where I very much agree with libertarians (although I prefer to use an anticommons model rather than a Coasean framework). The Antiplanner post links to a Heritage Foundation paper by Wendell Cox, in which Cox argues that "if price-escalating smart growth policies had not been adopted in state capitals, county courthouses and local planning commissions, the financial risk in the current crisis would be at least $4 trillion less." As you can probably imagine, the reasoning that led to such a sweeping statement was, shall we say, strained. It's well-established that land use regulations can artificially constrain the supply of housing, thus raising housing prices above their equilibrium level, but the problem lies in connecting general housing price increases to the housing bubble. Cox cannot connect the two, and instead relies on bald assertion:

Between 2000 and 2007, house prices increased an average of more than $275,000 compared to incomes (house price to household income ratios) in the 10 markets with the greatest price escalation or the greatest affordability loss. Among the second 10 markets with the greatest affordability loss, prices rose $135,000 relative to incomes. By contrast, in the markets with the least affordability loss, house prices increased only $5,000. What the 20 markets that have lost the most affordability have in common is excessive land use regulation.
The first paragraph amounts to saying: housing prices are higher in the 20 markets where housing prices grew the most, and lower in the 10 markets where housing prices grew the least. Alert the press! Cox then makes the connection to the housing bubble by simply asserting that the 20 markets that have lost the most affordability all have "excessive land use regulation." Cox doesn't define "excessive land use regulation," nor does he even identify the 20 markets he's referring to. Instead, he provides the URL for another paper of his that supposedly establishes that the 20 markets he's referring to all have "excessive land use regulation." Table 3 of that paper lists the 20 markets that have lost the most affordability. I immediately noticed that Cox lists Las Vegas, Baltimore, and Virginia Beach -- 3 cities I know don't have particularly restrictive land use regulations -- among the 20 markets that he claims have "excessive land use regulations." The Wharton Residential Land Use Regulations Index is the only comprehensive database that measures the restrictiveness of land use regulations across the country. I have some minor issues with its methodology, but it remains the gold standard in urban economics. According to the Wharton Index, Las Vegas has the 1,547th most restrictive of land use regulations in the country (out of 2,730 cities). Baltimore comes in at #1,719. Virginia Beach is #1,835. To say that these cities have "excessive land use regulations" is to bend the truth. I honestly think land use regulations played a role in the housing bubble (though I certainly don't think they "caused" the housing bubble), but I don't have a dog in this fight ideologically. The Heritage Foundation does, and it shows in this incredibly sloppy paper. (If you're interested in my theory of how land use regulations could have contributed to the housing bubble -- and I know you are -- see here, here, and here. In a nutshell, empirical research has shown that a demand shock in metropolitan areas with more restrictive land use regulations leads to much higher and much longer housing price appreciation. The length of the housing price appreciation assures people of the stability of the upward trend, and gives realtors and homebuyers the impression that (stop me if you've heard this one already) "housing prices always go up!" The perceived stability of this upward trend would then induce people to borrow over their means to buy a house.)

Tim Harford thinks local currencies are a bad idea. Tyler Cowen thinks they're not that bad. I'm with Harford on this one. Cowen gives two reasons for his favorable disposition on local currencies, but I want to focus on his first reason:

First, local currencies blossom when the nominal money supply is too low and wages and prices are sticky downwards. A boost in the real money supply is needed and the private sector will do it -- albeit at high transactions costs -- even if the government will not. That's why so many of these local currencies blossomed in the 1930s but then disappeared. They did good but then they were stamped out or ceased to be necessary.
It's true that a boost in the real money supply is needed when the nominal money supply is too low and wages and prices are sticky downwards, but should that boost come in the form of local currencies or the government currency (i.e. dollars)? Cowen believes the government will be too slow in boosting the real money supply -- the community might need a boost in its real money supply now, but it'll take around 6 months for a cut in the Fed funds rate to reach the community. A local currency could fill in for dollars while the community waits for the Fed's rate cut to take effect. But how much of the local currency should be printed? It's impossible to know ex ante how much a Fed funds rate cut will increase the money supply in a specific community, because the money has to work its way through the money multiplier. Presumably the community would forecast how much a Fed funds rate cut would increase its money supply, and price its local currency accordingly. But do we really trust local communities to accurately predict the amount that a Fed funds rate cut will increase the community's real money supply? There's a good chance the community will overshoot in one direction or the other, and I think the costs of overshooting will outweigh any benefits accruing to the community from an immediate boost in the money supply. Also, how will the community know when the local currency has ceased to be necessary? The process of fazing out a local currency would necessarily be governed by guesswork and intuition (not to mention currency arbitrage), and the inefficiency of such a process would also reduce the net efficiency of the local currency. On balance, I don't think the marginal benefit of an immediate boost in the community's real money supply would outweigh the real administrative costs.

Friday, May 2, 2008

Globalization ≠ Outsourcing

David Brooks is confused about all that "globalization" mumbo-jumbo people are always talking about. Apparently he thinks globalization is the same thing as outsourcing, and that by showing that there's less outsourcing than is commonly believed, he has disproved the "globalization paradigm." From his column today:

Globalization is real and important. It’s just not the central force driving economic change. Some Americans have seen their jobs shipped overseas, but global competition has accounted for a small share of job creation and destruction over the past few decades. Capital does indeed flow around the world. But as Pankaj Ghemawat of the Harvard Business School has observed, 90 percent of fixed investment around the world is domestic. Companies open plants overseas, but that’s mainly so their production facilities can be close to local markets.
Repeat after me: globalization ≠ outsourcing. An American company doesn't have to move to another country for America to lose jobs due to globalization. Just imagine a company that would have located in America but for a trade deal. To prove his argument about globalization's irrelevance, Brooks cites U.S. manufacturing of all industries:
Nor is the globalization paradigm even accurate when applied to manufacturing. Instead of fleeing to Asia, U.S. manufacturing output is up over recent decades. As Thomas Duesterberg of Manufacturers Alliance/MAPI, a research firm, has pointed out, the U.S.’s share of global manufacturing output has actually increased slightly since 1980.
Even under the dubious assumption that "share of global output" is the proper way to measure the impact of globalization, the fact that the U.S.'s share of global manufacturing output has increased proves absolutely nothing about globalization. The proper question would be whether the U.S.'s current share of global manufacturing output is higher or lower than it would have been in the absence of globalization. If it's lower, then the U.S. has lost jobs due to globalization. This is a bit like the supply-siders' argument that the Bush tax cuts paid for themselves because tax revenues are higher now than they were before the tax cuts. That also proves nothing, as the proper question is whether tax revenues are higher now than they would have been in the absence of the tax cuts. David Brooks doesn't understand this. And yet some people consider him a "thinking" Republican. That makes me sad.