Kenneth Arrow on Behavioral Economics, etc.

A few weeks ago I blogged about Conor Clarke's insightful interview with Paul Samuelson. Well, Mr. Clarke is back at it, and he recently conducted an interview with Nobel prize-winning economist Kenneth Arrow (part one here, part two here, and part three here). Arrow is best known for his contributions to general equilibrium analysis, welfare economics, and Arrow's Impossibility Theorem. The interview addresses subjects such as healthcare reform, behavioral economics, and climate change. Here are a few things I found interesting (interview questions are bolded):

What do you think of behavioral economics?

Yes, there is a tendency to go to these psychological arguments. But my problem with these arguments is not that they are wrong -- though sometimes there are wrong -- but that they are not helpful.

Why?

They don't predict anything!

I agree that behavioral economics is only useful if it increases the accuracy of predictions made by economists (see here and here). Nevertheless, I wouldn't go so far as to say that behavioral economics doesn't "predict anything." Behavioral economics does a good job of predicting how people make retirement decisions (hint: they follow the status quo, so default rules are exceptionally important determinants of behavior).

Back to the interview - Arrow on the uncertainty surrounding climate change:

The treatment of uncertainty [with climate change] strikes me as one of the most confusing things about climate change. . . . But with climate change there is an awful lot at stake! And the time horizon is long, and you have the risk of these incredibly high cost but low probability events...

Well, the least that can occur still looks pretty bad, and I don't want to overdo the uncertainty question. I think that, even if you take a very conservative point of view, things are bad. 150 years from now, the average person will be a lot poorer then they would be otherwise be.

On health care costs:

The basic reason why health costs increased is that health care is a good thing! Because today there is a lot more you can do! Consider all these expenses that are diagnostic. Cat scans, X-rays, MRIs and now the proton-powered whatever-it-is. Something that is the size of a football field, cost $50 million, and has all sorts of diagnostic powers. A lot of these technologies clearly reveal things that would not be revealed otherwise. There's no question about it. Diagnostics have improved. Technology has improved. You know, sending things through your blood stream to help in operations, instead of cutting you open. It's incredible. But these things are costly. But for older people longevity is increasing by a month each year. Now, whether that creates other problems with retirement and social security is another question. But, nevertheless, preserving life is a good thing.

On the erosion of professional standards:

And if one explanation is the professional standards, why do you think the professional standards have changed?

Sometimes I think it's because of the Chicago School.

I'm not sure if the last one was a joke, but blaming the Chicago School for the decline in professional standards seems a bit over the top. Still, I would definitely recommend reading the entire interview.

Don't Text and Drive!

According to a Virginia Tech Transportation Institute study, texting while driving is 23 times more dangerous than driving while not distracted. By comparison, drunk driving is "only" seven times riskier. Unsurprisingly, the study's authors encourage regulators to ban texting while driving:

Texting should be banned in moving vehicles for all drivers.

I couldn't agree more (though I have been guilty on occasion). Talk about a massive negative externality!

Posner v. Thaler - Behavioral Economics

Richard Posner, one of my academic heroes (see here and here), recently criticized the Consumer Financial Protection Agency Act of 2009 in the Wall Street Journal. Although I don't know the details of this act, I was somewhat surprised that in his editorial, Posner went further and criticized behavioral economics and Richard Thaler, one of behavioral economics' strongest proponents:

The plan of the new agency reveals the influence of “behavioral economics,” which teaches that people, even when fully informed, often screw up because of various cognitive limitations. A leading behavioral economist, Richard Thaler of the University of Chicago Booth School of Business, wrote “Nudge: Improving
Decisions About Health, Wealth, and Happiness” last year with Cass Sunstein, who is President Barack Obama’s nominee for “regulatory czar.”

Mr. Thaler, whose views are taken seriously by the Obama administration, calls himself a “libertarian paternalist.” But that is an oxymoron. He is a paternalist with a velvet glove—as the agency will be. Through the use of carrot and stick, the agency will steer consumers to those financial products that it thinks best for them, whatever they naïvely think.

. . .

Behavioral economists are right to point to the limitations of human cognition. But if they have the same cognitive limitations as consumers, should they be designing systems of consumer protection?

Two things struck me about this argument. First, libertarian paternalism, at least as it is defined by Thaler and Nudge co-author Cass Sunstein, is not an oxymoron. They argue this point forcefully in an article called "Libertarian Paternalism Is Not an Oxymoron." This article is one of the forces that converted me to the importance of behavioral economics. Among other things, the article argues that regulators will inevitably influence behavior, since default rules (such as voluntary or mandatory enrollment in retirement plans) affect decisions.

Second, although it may have been tongue-in-cheek, I am surprised by Posner's claim that regulators, because they have cognitive limitations, cannot encourage people to make better decisions. This is a poor argument. Regulators have time to make considered decisions, many consumers do not. Regulators are specialists, most consumers aren't. I was pleased to read that Thaler, in a response to Posner, makes very similar points:

The premise of behavioral economics is that humans are not perfect decision-making machines. We are busy and distracted. We have fields that we know well, but are amateurs in most other domains. If our car breaks down, we go to a trained mechanic. Even the best mechanics will make some mistakes (they are human), but for most of us they still have a better chance of getting our cars to work than doing it ourselves.

Feasibility Analysis: Ambiguous and Diffused Costs

Many environmentalists are uncomfortable with cost-benefit analysis (CBA). CBA undeniably has a number of technical problems. I have argued, for example, that analysts should, in some cases, account for altruistic preferences; others have argued that analysts should ignore immoral preferences and existence values. One main reason many people oppose CBA, however, is that it often justifies allowing pollution and natural resource consumption, as long as the benefits of the risk-producing or consumption activity outweigh the costs.

Thus, a number of policy makers have proposed alternative decision procedures. Feasibility analysis is one that has recently gained traction. Feasibility analysis instructs policy makers to reduce specific pollutants within an industry to the minimum feasible levels, given technological and economic constraints.

University of Chicago law professors Eric Posner and Jonathan Masur recently provided a critique of feasibility analysis, criticizing its vagueness and its potential to cause disbursed harm to consumers:

The problem is there is considerably ambiguity throughout the process. . . . Feasibility analysis, as noted, tends to focus heavily on concentrated harms like plant closings. It pays little to no attention to the harms regulation may impose on consumers. From a welfarist standpoint, this blindspot in feasibility analysis is difficult to justify. That's an example of where feasibility analysis leads to overregulation compared to the socially optimal result, but Posner and Masur stress that feasibility analysis can lead to underregulation as well, particularly of smaller and/or less profitable companies or industries, which would face proportionally higher costs at complying with socially optimal regulation.

Posner and Masur further contend that, because of the ambiguity in feasibility analysis (for example, are automobiles and airplanes in the same industry?) agencies often resort to an informal CBA:

[A]gencies undertaking feasibility analysis seem to smuggle in some cost-benefit analysis on the side . . .

This result is unsurprising to me, since, on an intuitive level, CBA seems to correspond with how people make actual decisions. Before deciding to write this post, I did a quick determination of whether the benefits outweigh the costs. So if bureaucrats don't receive clear directions on how to choose among policy options, it seems likely that they will resort to CBA.

Economists and Binoculars

The Economist recently pointed the finger of blame for the financial crisis on economists. Many people, including Judge Richard Posner in A Failure of Capitalism, have blamed economists for the crisis, or at least for failing to predict it. Although some economists, such as Dean Baker, correctly foresaw the problem (according to the cited article, "Dr. Baker put his money where his mouth is by selling his downtown DC condominium in May of 2004"), few sounded the alarm, and even fewer economists listened to their associates who made dire predictions. According to The Economist:

There are three main critiques: that macro and financial economists helped cause the crisis, that they failed to spot it, and that they have no idea how to fix it.

I have two things to add. First, not all economists are macroeconomists, yet all economists are similarly maligned. Richard Posner has recognized this, but few others have. I almost feel embarassed to introduce myself as an economist, even though the work I do is not related to the crisis. Second, a failure of economists to predict better the crisis does not mean that economic theory failed. Looking back, economic theory could have perfectly predicted what happened, it just seems that macroeconomists were asleep at the helm. In my view, it's not that the binoculars failed, rather economists failed to look through the binoculars properly.

Heinzerling - Appointing an Atheist Dean of the Seminary

Although I disagree with a number of President Obama's policies, I appreciate many of his political appointment. I have a lot of respect for his future regulatory czar, Cass Sunstein, and I think Austen Goolsbee has been an excellent advisor. But Lisa Heinzerling's recent appointment as Associate Administrator for the Office of Policy, Economics, and Innovation in the Environmental Protection Agency is an odd and questionable move (HT: Volokh Conspiracy). (To be fair, I'm not sure whether President Obama or the Administrator of the EPA made this appointment.)

In her book Priceless (coauthored with Frank Ackerman) Heinzerling argues that EPA's reliance on cost-benefit analysis is dangerous because, among other things, the process of placing a monetary value on human life devalues it. Heinzerling therefore feels that economics should play a very limited role (if any) in EPA's policy making. She instead urges EPA to make decisions holistically, like the military. (Dean Revesz, a defender of cost-benefit analysis and author of Retaking Rationality, notes with a hint of irony that the decision-making process leading to the Iraq war is the one Heinzerling wants to apply to environmental decisions.)

Though I don't agree with Heinzerling's ideas, I respest her work on cost-benefit analysis. Her critique of CBA helped me to refine my personal views. Still, a few things bother me about this appointment:

First, her appointment seems to be at odds with the mission of Office of Policy, Economics, and Innovation. Thus appointing Heinzerling is the equivalent of choosing an atheist to be the dean of a seminary.

The second reason I feel that Heinzerling is a poor choice is that her views are at odds with regulatory czar Cass Sunstein, who will head the regulatory agency that has oversight over EPA's economic analyses.

It will be interesting to see what changes, if any, Heinzerling's appointment brings.

The Climate is Changing - Wanna Bet?

Over at FiveThirtyEight, whiz-kid statistician Nate Silver has issued a challenge to all climate change skeptics. Here's the first part of it:

For each day that the high temperature in your hometown is at least 1 degree Fahrenheit above average, as listed by Weather Underground, you owe me $25. For each day that it is at least 1 degree Fahrenheit below average, I owe you $25.

Although the challenge is interesting and has been getting a lot of blog coverage (see here, here, and here), there are two reasons I don't think the outcome is likely to prove anything. First, definitive global warming proof can be gathered only over long time periods (i.e., decades), and it seems unlikely that anyone will continue the challenge for decades. A few warm months does not climate change make.

The second reason this bet is inconsequential is that few people deny that global temperatures are rising. Anyone with the ability to interpret a simple graph can see that the earth is getting hotter (see the Wikipedia graph above). The debate for most climate change skeptics is whether humans are causing the warming, a question that Silver's bet does not address.

A bet that lasted decades, on the other hand - something like the Simon-Ehrlich wager - would be really interesting.

Amazon Kindle - Big Brother?

I've recently contemplated buying the Amazon Kindle. E-books are cheaper, easier to store, etc. Amazon's actions today, however, make me very hesitant. From a New York Times blog:

This morning, hundreds of Amazon Kindle owners awoke to discover that books by a certain famous author had mysteriously disappeared from their e-book readers. These were books that they had bought and paid for—thought they owned.

But no, apparently the publisher changed its mind about offering an electronic edition, and apparently Amazon, whose business lives and dies by publisher happiness, caved. It electronically deleted all books by this author from people’s Kindles and credited their accounts for the price.

Wow, I think I'll keep buying hard copies. At least I know where they'll be when I wake up. Plus I can sell them when I'm done or lend them to a friend. The most ironic part of Amazon's move? The books they deleted:

The author who was the victim of this Big Brotherish plot was none other than George Orwell. And the books were “1984” and “Animal Farm.”

Energy Efficiency Paradox

Image via Wikipedia

Whenever I hear government officials tout the benefits of programs that increase energy efficiency (such as better insulation and LED lights), I am reminded of a conversation I had with a city official while I was an undergraduate. The official, a mechanical engineer, came to our class and explained what the city was doing to reduce energy consumption. He claimed that geothermal heat pumps, which provide heating and air conditioning by pumping water to the earth's surface, could reduce energy consumption by 20 percent, since these pumps use 20 percent less electricity than standard climate control units.

At the end of the presentation, I asked whether these pumps would actually reduce energy consumption by 20 percent. After all, I reasoned, if someone installed a heat pump on her home and shortly thereafter noticed a drop in her electricity bill, she might be inclined to use her air conditioning more frequently. The city official quickly dismissed the issue I raised, but I was convinced I was on to something.

I began investigating, and I soon discovered that the point I brought up already had a name: the rebound effect. Estimates of the rebound effect are typically in the range of 10 to 40 percent. This means that if geothermal pumps are 20 percent more efficient, the resulting reduction in energy from using them would be only 12 to 18 percent.

This doesn't imply, of course, that efficiency improvements aren't worth pursuing. On the contrary, smart traffic systems and energy efficient light bulbs seem to be some of the low hanging fruits in the quest to reduce carbon emissions. Nevertheless, it is important for policymakers to account for the rebound effect when making decisions. Otherwise, they will not attain their energy reduction goals.

Interestingly, Stanley Jevons, a famous 20th century economist (pictured above), had contemplated the possibility of a greater than 100 percent rebound. Such a rebound is known as the Jevons paradox, which states that actions that improve energy efficiency may actually increase the amount of energy used. Although it is unlikely that a 100 percent rebound will be observed on a micro level, some economists have hypothesized that it might be observed by taking into account macro level economic growth. This implies that energy efficiency gains cannot lead to resource conservation!

The Moon: Past and Future

Today marks the 40 anniversary of the Apollo 11 launch, which rocketed Armstrong, Aldrin, and Collins to the moon. Ned Potter at ABC News.com has a great article on whether the public then felt and still feels that the flight to the moon was worthwhile:

In a July 1967 Harris poll, two years in advance of the first moon walk, 43 percent of Americans were in favor of the effort, 46 percent opposed -- hardly a rousing endorsement. And in 1970, a year after the landing, 56 percent said it had not been worth its allotted $4 billion a year for nine years.

. . .

Since 1979, the number of people saying the moon landings were worth the cost has risen from 41 percent to 65.

. . .

Polls have consistently shown about 60 percent of the American people support the space program -- though the number always drops into the 40s when people are asked about the cost.

Given my enthusiasm for space exploration, I was surprised by the low levels of support from the public. As the article points out, NASA expenditures are less than 0.5 percent of all government spending. There are worse ways to spend government money. Space exploration is a public good that likely wouldn't exist without government support. It has yielded huge scientific benefits and created jobs. Furthermore, just as Columbus couldn't have known he'd discover a new continent, we don't know what benefits future space exploration might precipitate.

I am thus excited about NASA's Constellation program, which has the goal of sending astronauts to the moon by 2020, and possibly later sending astronauts to Mars. The above video shows a computer-generated conceptualization of how the Constellation program will work. Two rockets will fly into earth's orbit, and parts from both will meet up and fly to the moon. Pretty cool stuff.

Coal vs. Nuclear - Environmental Ironies

Seed Magazine recently posted a discussion on the viability and drawbacks of nuclear and coal power. Some contributors argued that nuclear is the best option, some that we should pursue "clean coal" (is that an oxymoron?), and still others that we should only seriously consider other renewable energy sources while looking for ways to increase energy efficiency.

While I found the discussion interesting, it reminded me of the two biggest environmental policy ironies of the past forty years.

1) Around the time of the Three Mile Island and Chernobyl incidents, environmentalists began arguing that nuclear power was unsafe and should therefore be regulated. Partially because of environmentalists' opposition to nuclear power, a new U.S. nuclear power plant hasn't gone online since 1996. The effect of stringent nuclear power regulations, of course, has been that the U.S. has increasingly relied on coal power plants. Thus, environmentalists urged policies that led to higher greenhouse gas emissions. Ironically, now that they recognize the problem of global warming, many are clamoring for a return to nuclear power.

2) The second irony is a result of the Clean Air Act. The Clean Air Act was seen as a landmark environmental regulation when it first passed. Many coal companies accepted the Clean Air Act because they felt that the E.P.A.'s regulation of coal power would be less stringent than the regulations proposed by many state legislatures. To further encourage coal lobbies to accept the Clean Air Act, Congress grandfathered in the contemporaneous coal power plants, offering lower standards than those faced by newer plants. The thought was that the older power plants would be soon abandoned. The end result, however, was unintended.

The grandfather clause gave the old coal power plants a comparative advantage relative to newer power plants. Thus fewer new plants were built, and power companies continued to rely on older plants. Older power plants, of course, are much more pollution intensive. In the end, the Clean Air Act may have actually slowed natural declines in coal-related pollution that would have occurred if new plants were comparatively disadvantaged. (Although, as I pointed out in another post, part of the increase in average life expectancy is attributable to less air pollution.)Environmentalists' support for the Clean Air Act may have led to higher current levels of greenhouse gases.

Environmentalists, then, helped to worsen the problem of global warming by advocating policies that eventually led to higher carbon emissions. This is one of the reasons I am wary of attempts to combat global warming through carbon sequestration (burying carbon emissions deep below the earth's surface) and increasing sulphur dioxide emissions. There could be serious, unintended side-effects.

The Law of Demand

According to a recent University of Michigan transportation study, the average carbon emissions per vehicle decreased 3 percent from October 2007 to April 2009. How did we achieve this emissions reductions? Cap and trade? Command and control regulations? No, the reduction instead occurred as consumers responded rationally to higher gas prices.

As a result of higher gas prices last year, consumers bought vehicles with better fuel efficiency and drover fewer miles. Thus, on average, each driver emitted less carbon. This is exactly how a carbon tax would work. The government levies a Pigovian tax roughly equal to the social costs of pollution and lets the market take care of the rest. As gas prices rise, people drive less and choose fuel efficient cars.

Unfortunately, the current administration seems to think that byzantine fuel economy standards will do the trick. But such standards are much more amenable to rent-seeking behavior. This is clearly demonstrated by the fact that the announced standards are favorable to light trucks, which benefits American producers but hurts the environment.

How Far Should We Take Paternalism?

In a Wall Street Journal article, Todd Zywicki highlights an analogy made by Elizabeth Warren, a Harvard Law professor:

[C]onsumers cannot buy a toaster that has a one-in-five chance of exploding, but they can get a subprime mortgage that has a one-in-five chance of ending in foreclosure.

I see one big problem with this analogy. A toaster would explode because of shoddy manufacturing - unless, of course, you have a child who puts his toys in the toaster. It is the manufacturer's fault when the toaster explodes.

On the other hand, in almost all cases mortgages end in foreclosure because of consumers' mistakes. It is not the bank's fault that the mortgagee lost his or her job (speaking of any single bank), it's not the bank's fault the mortgagee used too many credit cards, it's not the bank's fault the home lost value, and it's not the bank's fault mortgagees bought multiple investment homes. Consumers lived on credit because government tax breaks and low interest rates gave them a strong incentive to live accordingly. A foreclosed mortgage is nothing like an exploding toaster.

To be fair, many mortgage brokers were disingenuous in how they presented loans. I'm thus in favor of behavioral economics-type disclosure regulations. But I don't think the government should, in this case, impede freedom of contract. As Zywicki writes:

Treating all consumers as hapless victims rather than recognizing that many consumers rationally respond to incentives is a recipe for unintended consequences. It can lead to counterproductive regulation that makes loans more expensive and harder to get.

More on Waxman-Markey

Over at the National Review, Stephen Spruiell and Kevin Williamson list their top 50 reasons for voting against the Waxman-Markey climate change bill (tip: Volokh Conspiracy). (I'm on a roll with global warming posts - earlier posts here and here.) I agree with much of what they write, but there's a number of points with which I disagree. Also, their first reason displays a stunning ignorance of economics:

1. The big doozy: Eighty-five percent of the carbon permits will not be sold at auction — they will be given away to utility companies, petroleum interests, refineries, and a coterie of politically connected businesses. If you’re wondering why Big Business supports cap-and-trade, that’s why. Free money for business, but higher energy prices for you.

There are two reasons this is bad economics. First, as the Coase Theorem points out, if there is an externality problem (say, excess pollution) and transaction costs are low, private parties will bargain to an efficient level of the externality. Furthermore, the end result is independent of the initial property right delineation - ignoring income effects. If polluters receive the right to pollute, pollution recipients will pay polluters to reduce their emissions, and if polluters do not have the right to pollute, they will pollution recipients to allow pollution. Either way, according to the Coase Theorem, the same level of pollution will result.

The Coase Theorem cannot solve the climate change problem, however, since transaction costs are too high (transaction costs are the costs of reaching an acceptable agreement). Thus cap-and-trade schemes are a way of lowering transaction costs. The government presumably sets the cap at pollution levels that recipients would bargain to, and, in theory, the scheme enables polluters to reduce emissions at the lowest possible cost.

Anyway, whether the government auctions off the permits or gives them away, the same amount of pollution will be eliminated. The only difference is that auctioning the permits grants the government a windfall revenue increase, and giving them away grants businesses a windfall. Given that we are in a recession, I don't think that granting businesses a windfall is such a bad thing.

The second display of poor economic reasoning is the claim that although Waxman-Markey will be "free money for business," it will lead to "higher energy prices for you." This sentence is not even internally consistent. If businesses actually made money by receiving permits, why would they charger higher energy prices? Businesses typically lower their prices when they are profitable.

Many commentators have said that Waxman-Markey will lead to higher energy prices. This will happen only as the government lowers the cap and forces businesses to buy permits or to implement pollution-reducing technology. And this probably won't happen for a few years. If the government made polluters buy permits, price increases would be more immediate.

Happy Belated 4th!

Although many of my posts deride bad government decisions, I was yesterday reminded of how grateful I am for our country. Many people are critical of America, but "our worst critics prefer to stay."

Thank you to all those who labor in service of our country. God bless America!

Coal Ash Regulation

Coal ash from power plants is often stored in local ponds. Although the polluted water becomes extremely dangerous (you want an ice cold glass of coal sludge?), power companies usually build sturdy walls around the sludge ponds to prevent seepage. In December of 2008, however, a Tennessee Valley Authority containment wall in eastern Tennessee broke, spilling 300 million gallons of sludge and flooding 15 homes. The image above shows one of the homes (photo courtesy of the Freakonomics blog and Dorothy Griffith).

The Environmental Protection Agency recently announced that it would begin monitoring coal ash disposal sites. It identified 44 high hazard potential sites, places that are most likely to experience a similar spill. Although this is a great first step, EPA needs to clearly outline its plans for regulating coal ash. According to Stephen Smith:

It’s still unclear to me what the E.P.A.’s ultimate goal here is to do. Are they really going to aggressively regulate this material like they need to, or are they taking more of a hands-off approach?

It will be interesting to see how the EPA handles this issue in the coming months.

Why I Don't Like Politics...

I recently blogged about why I think the Waxman-Markley climate-change bill is a bad idea. (The House, by the way, approved the bill last Friday.) As I mentioned in the previous post, I don't think that climate-change regulation is undesirable per se. I instead think that (a) the costs of this ill-conceived cap-and-trade scheme will outweigh the benefits and that (b) a carbon tax is far preferable.

Anyway, the breakdown of how members of the House voted on this bill reminded me of the vote on the stimulus package. No Republicans voted for the stimulus bill, while only eight Republicans voted for Waxman-Markey. These outcomes are stark examples of why I hate politics.

I find it very hard to believe that virtually all Republicans thought that both the stimulus and the climate-change bills were terrible. It is thus seems clear that, on these important issues, Republicans voted strictly along party lines. If party membership determined their congressional votes, members of Congress did not necessarily vote according to what they felt would be best for our country. And that, in my view, is a major problem. (To be fair, I'm equally certain many Democrats simply voted along party lines.)

The two-party system does more harm than good. The parties largely determine how members of Congress will vote on each issue. If party members stray, their reelection funding source may be cut off. With Waxman-Markey, conservative bloggers are absolutely livid about the eight Republicans who voted for it, saying that they have betrayed the principles of the Republican party (you know, the principles that President Bush and Congress upheld so firmly over the last eight years - principles like low government spending and limited government interference).

Maybe it seems silly that I'm upset about the backlash against Republicans who voted for Waxman-Markey, since I'm not in favor of the bill. But I would much prefer politicians who vote on the basis of what they think is best. Sure I may disagree with their votes, but at least I'm disagreeing with their ideas - not with what the party thinks best.

Regulatory Czar

President Obama, in what I view to be one of his best decisions, nominated Cass Sunstein to lead the Office of Information and Regulatory Affairs. The so-called regulatory czar can have an enormous effect on environmental regulations and regulatory analysis, since OIRA is required to review and approve regulations that have a $100 million-plus effect on the economy. I have enormous respect for Professor Sunstein. Much of my research coincides with Sunstein's solid work on the value of human life and cost-benefit analysis.

The Hill, however, reports that Senator Saxby Chambliss (R-Ga.) wishes to block Sunstein's nomination. The basis for Sen. Chambliss's opposition is statements Sunstein made about hunting and the rights of plants and animals. I find this resistance silly for at least three reasons.

First, no matter what Republicans do, they likely don't have enough votes to block the confirmation of Sunstein. Second, on all matters related to his future job description, Sunstein is quite moderate. Republicans can't hope to do much better but could certainly do much worse. Third, Sunstein likely won't be required to review hunting regulations. Even if he did, he would be required by law to follow cost-benefit guidelines, not his own political agenda.

I hope Sunstein is confirmed as soon as possible.

Man on the Moon

I finally watched In the Shadow of the Moon this weekend. It was an inspiring movie. It reminded me of why, as a child, I wanted to be an astronaut. The movie also made me wish our current space exploration program wasn't so tepid. I was glad to find out that NASA's planning a moon base, from which we could attempt a trip to Mars. It's not surprising that this new push to return to the moon and, eventually, Mars is fueled by foreign countries' plans to travel to the moon.

"The new thing is China, and they've announced they're going to the moon. The Europeans want to go; the Russians want to go; and if we don't go, maybe they'll go with the Chinese," Mars Institute Chairman Pascal Lee said in an interview.

The U.S.S.R.'s planned lunar trip provided impetus for our original trips to the moon. The wonders of competition can aid scientific achievement, too.

The movie also reminded me what our nation - and our government - can accomplish by working resolutely on a single problem. Our success, for a moment at least, created a bond between all nations. I wonder if working on the climate-change problem could have a similar effect on the nations of the world. I doubt it, since the results won't be as dramatic and visible as the picture above.

Cap & Trade: The Next Gov't Failure

There is a lot uncertainty about the future effects of the proposed Waxman-Markey climate-change bill. As the Wall Street Journal points out, the bill is full of exceptions and concessions. It will establish a system that looks nothing like the cap-and-trade model I teach to my econ students. According to the Journal:

The leadership's solution to this problem [of placating various Democrats] is to simply claim the bill defies the laws of economics.

The bill is terrible. I'm almost certain the costs of the bill will far exceed the benefits - a classic case of government failure. Once again, according to the Journal:

Americans should know that those Members who vote for this climate bill are voting for what is likely to be the biggest tax in American history.

The Congressional Budget Office (CBO) provided an optimistic appraisal of the bill, but:

A closer look at the CBO analysis finds that it contains so many caveats as to render it useless.

I'm not in favor maintaining the status quo. Global warming is a serious problem that needs to be dealt with soon. (I'm currently writing an article about climate-change cost-benefit analysis.) But I'm beginning to think that cap-and-trade won't work on this scale, given our political system's proclivity for satisfying special interests' rent-seeking requests.

Why can't Congress implement a carbon tax with zero exceptions? Administrative costs would be much lower. The tax revenue could be used to solve other environmental problems. Polluters would directly bear the costs of their action. We wouldn't need additional regulations for vehicle emissions, since drivers would already pay a higher price for low mpg vehicles. Sure a Pigovian tax wouldn't spur the innovation that advocates of cap-and-trade envision, but at least the rules of the game would be set beforehand and the system would be much less amenable to corruption.

Fractional Reserve Banking

I don’t understand how any libertarian can oppose fractional reserve banking (and very few do). With fractional reserve banking, two parties voluntarily enter into a contract that results in both parties becoming better off. The bank provides a free service and thus acquires cheap funds it can lend to others. The depositor gets someone to hold her money so that the money can be conveniently used when she makes a purchase. There is no deceit since depositors know that their money will be lent out. Sure the bank profits off the depositors’ money, but that’s how capitalism works - as long as no coercion is involved.

To say that fractional reserve banking is immoral is like saying, as Marx did, that capitalism is immoral because capitalists profit at the expense of their workers. What Marx didn’t really understand, however, is that the workers are made better off because of the opportunity to work. If depositors would be better without fractional reserve banking, banks would form that would promise not to lend people’s money. Of course, banking services would no longer be free, and I doubt the bank would find many customers.

Gold Standard

In most countries central banks control the supply of money. In the United States the Fed increases the supply of money by buying treasury bills on the open market or by buying bonds issued directly by the U.S. Treasury. The Treasury Secretary (currently Geithner) is a cabinet member in the presidential administration and can thus be pressured to sell bonds to allow the federal government to increase spending. If the Fed submits to the will of the Treasury by buying bonds whenever the federal government wants to spend money, there is a significant danger of inflation. Marriner S. Eccles was important in American history because he was a strong advocate of Fed independence. There is an inverse correlation between central bank independence and inflation.

Many people have argued that a gold standard is one way to ensure that federal government lives within its means. A gold standard, in theory, could prevent central banks from printing too much money and thereby causing rampant inflation.

One problem with a gold-backed currency (or a silver-backed currency, or any other –backed currency) is that the government determines the value of the currency. It mandates that, say, $20 is equal to an ounce of gold. If the government sets the gold/dollar exchange rate (as it did throughout the 1800s), the government can modify the exchange rate to reduce debt through inflation. The U.S. federal government did exactly this prior to World War II.

According Milton Friedman: “I think those people who say they believe in a gold standard are fundamentally being very anti-libertarian because what they mean by a gold standard is a governmentally fixed price for gold.” Of course, a gold standard where the dollar/gold exchange rate is determined by the market would not have the same “immoral” problem, but that’s not what most people argue for when they say we should return to the gold standard.

Interview with Paul Samuelson

Conor Clarke recently posted an interview with Paul Samuelson on The Atlantic (part 1 here; part 2 here). Although I'm not a thorough Keynesian like Samuelson, I have a lot of respect for Samuelson's work. One of my favorite Samuelson quotes comes from an Economics U$A video. He was talking about the resistance to and gradual acceptance of Keynesian economics at Harvard:

Funeral by funeral, science makes progress.

Anyway, I found the interview to be fascinating.

A great quote on Milton Friedman:

Milton Friedman. Friedman had a solid MV = PQ doctrine from which he deviated very little all his life. By the way, he's about as smart a guy as you'll meet. He's as persuasive as you hope not to meet. And to be candid, I should tell you that I stayed on good terms with Milton for more than 60 years. But I didn't do it by telling him exactly everything I thought about him. He was a libertarian to the point of nuttiness.

Interesting quote on behavioral economics:

In my view behavioral science describes an extremely large and important part of the modern picture. However, whenever the economy turns in a very irrational
say, that can create opportunities for very rational speculators to make a profit. So you can still get some approximation on the micro level of an efficient market.

A response to those who blame greed for the crisis:

[P]eople say, 'greed has suddenly increased.' But it isn't that greed's increased. What's increased is the realization that you've got a free field to reach out for what you'd like to do.

Stiglitz on Banking Regulation

Given the banking regulatory overhaul recommended by the Obama administration, The Economists' Voice today published a timely piece today entitled "America's Socialism for the Rich" by Nobel-laureate Joseph Stiglitz. Here are some excerpts.

Rewriting the rules of the market economy—in a way that has benefited those that have caused so much pain to the entire global economy—is worse than financially costly. . . .

But this new form of ersatz capitalism [writing about Obama’s regulatory approach], in which losses are socialized and profits privatized, is doomed to failure. . . .

We need to break up the too-big-to-fail banks; there is no evidence that these behemoths deliver societal benefits that are commensurate with the costs they have imposed on others. And, if we don’t break them up, then we have to severely limit what they do. They can’t be allowed to do what they did in the past—gamble at others’ expenses. . . . (p. 2)

I don’t agree with everything Stiglitz writes, but his arguments are convincing. I too think that banks are too big, and I agree with his statement, "Because government provides deposit insurance, it plays a large role in restructuring (unlike other sectors)." Still, I wish Stiglitz would have discussed the moral hazards created by FDIC insurance and the Fed. Sure the government should regulate the banking industry, but it should also pay attention to the incentives it creates.

Clean Air Act - People Live 5 Months Longer!

There was an interesting and important pollution study published in the New England Journal of Medicine a few months ago. According to researchers C. Arden Pope III, Majid Ezzati, and Douglas W. Dockery:

On the basis of the average reduction in the PM2.5 concentration . . . in the metropolitan areas included in this analysis . . . the average increase in life expectancy attributable to the reduced levels of air pollution was approximately 0.4 year. . . . [T]hese results suggest that the individual effect of reductions in air pollution on life expectancy was as much as 15% of the overall increase. (p. 384)

Thanks to the regulations authorized under the Clean Air Act, the average person lives roughly five months longer. This doesn’t mean, of course, that the benefits outweigh the $27 billion costs. But the results are interesting nonetheless.

"Spread the Wealth" - and the Proper Role of Government

Wealth redistributions are anathema to libertarians. This isn't surprising. Without Jane's consent, it seems unfair to give some of Jane’s hard-earned money to John, who has never a worked a day in his life. Many conservatives and a few liberals were thus upset when President Obama, prior to his election, suggested to Joe the Plumber that wealthy Americans should be willing to the “spread the wealth.”

In response to the ensuing debate I wrote the following letter to the local newspaper. In my view some wealth redistributions are inevitable:

Many are upset about the idea of "spreading the wealth." Our current tax system, the progressive income tax, is a de facto redistribution of wealth. If all citizens are entitled to the same government benefits, and Jane makes $300,000 per year and pays 35 percent of her income in taxes while John makes $30,000 per year and pays 15 percent, there is a shift in income from Jane to John. Jane pays more for the same government benefits.

The solution for some is to implement a flat tax: All workers pay taxes at the same rate, say 25 percent. Still, even a flat-tax rate causes wealth redistribution. If Jane pays $75,000 in taxes (25 percent of $300,000) and John pays $7,500, Jane spends far more for equal benefits.

If Americans want to rid themselves of wealth redistributions, all households must pay taxes exactly equal to the value of the government benefits they receive. This would be both impossible and infeasible. It would be impossible to know the exact value of the roads, clean air, police protection, and court systems that people receive; such public goods are non-excludable. It would be infeasible because few Americans feel that government should stop spending money to protect the homeless, elderly, disabled, etc.

The question, then, is not whether we should redistribute wealth; the question is to what degree.

Some libertarians might say that Social Security and food stamps are different from public goods, since the government forcibly takes money from one group of people and gives it directly to another via transfer payments. This is true. Nonetheless, it is impossible to deny that with both public goods and transfer payments, some people pay more money than they receive in benefits and some pay less. This is precisely how I would define wealth redistributions.

Given that wealth redistributions are permitted and inevitable under the Constitution, there are a few ways our government can proceed. First, it can seek to minimize redistributions of wealth. For this to happen Americans would need to pay taxes equal to the benefits they receive. Trying to determine the exact value of the benefits everyone received would be exceptionally expensive. Each household would need to be assigned a nonmarket valuation economist who would assist in determining the household’s willingness to pay for national defense, clean air, and public parks. I doubt few would advocate the first approach.

Second, government could seek to achieve equal distributions of wealth. There are a number of problems with this approach. By ensuring that each slice of pie is equal, the government would shrink overall size of the pie as work incentives dissipate. Also, it would be difficult to define equal. Do parents with more children get more wealth? Would this encourage people to have more children? Would people who worked longer hours receive more wealth? Would an eighteen-year-old be entitled to the same slice as an eighty-year old? Like zero redistribution, equal redistributions would be impossible to implement perfectly.

Finally, government officials can redistribute income in such a way as to maximize social welfare. In doing so, government officials should be ever cognizant of the possibility that their mandated redistributions might lower social welfare. When in doubt, officials should respect status quo distributions over other possible redistributions. This in my view is the proper role of government.

Real Gas Prices

Gas prices surged in 2008, causing a number of commentators to conclude we would soon run out of oil. Prices, of course, came down. And as I’ve blogged before, we won’t suddenly run out of oil.

I put together a graph of real gas prices (inflation-adjusted) in the United States during summer months since 1990 (data courtesy of the Department of Energy and Bureau of Labor Statistics).

Prices were roughly constant from 1990 until the early 2000s. Speculation, growing international demand, and a booming domestic economy then combined to drive up the price of gasoline. The main reason prices have fallen since last year is that gas demand and speculation has weakened since the onset of the global recession.

Nonetheless, gas prices have been creeping back up. Current prices are lower than they have been during the last three summers, but they’ll probably go up a little more through the rest of June and July. Seasonal gas prices have historically peaked in late July.

I’m predicting prices will peak this year at just under $3.00. Anyone want to bet?

Did the Free Market Cause the Current Crisis? - Part III

In earlier posts (Part I here, Part II here) I began answering the question: “Did the free market cause the current crisis?” I explained that three main factors caused the housing bubble, which I have branded the but-for cause of the recession. Two of the three factors – homeownership incentives and bad Fed policy – have little to do with the free market and everything to do with government intervention. The third factor, however, is a direct result of free markets.

President Carter began the deregulation movement back in the 1970s. Deregulation has been a good thing for most industries: the markets for telephone service, air travel, and package delivery are more robust than they were 30 years ago. Reagan, of course, continued and strengthened the deregulatory agenda. Unsurprisingly, the clamor for deregulation soon spread to the banking industry. This was not a good idea. The banking industry is different from other industries in two critically important ways.

First, banks (including investment banks) allow cash lenders, or savers, to find potential borrowers with as little friction as possible, thereby enabling beneficial gains from trade. Because (a) so many people are willing to lend through banks (Americans know they need to save – though they don’t always do a good job) and (b) borrowed money pays for most business expansions, banks can have an enormous influence over the entire economy. When banks no longer act as economic lubricants – perhaps they are worried many borrowers will not repay their loans – one of businesses’ major funding sources is cut off.

If businesses can’t borrow money to open new factories, buy new machines, or pay wages, the entire economy feels the ripple effects. When a single person loses his job, he spends less money. The spending decline doesn’t stop there, however. The future beneficiary of the first person’s spending now sells fewer goods, so he also experiences an income drop. This process continues throughout the economy. Keynes used this multiplier effect to explain how a fall in consumer confidence and investment spending in the late 1920s and early 1930s spiraled into the Great Depression. Although other industries can influence the macroeconomy, none is as influential as banks. It’s no wonder that a majority of recessions in America have been correlated with problems in the banking industry.

The second critical way the banking industry differs from other industries relates to the first point. Banking risks impose a negative externality on society. Negative externalities are typically reserved for microeconomic analysis. But negative banking externalities are relevant to the macroeconomy for the reasons noted in the above paragraph. I’ve attempted to model the problem using a simple-form game below.

		Bank 2
		Safe	Risky
Bank 1	Safe	5, 5, 0	1, 7, -1
	Risky	7, 1, -1	2, 2, -2

Each bank seeks to maximize its profits and can engage in safe or risky behavior. The four rectangles filled with numbers contain Bank 1’s profits, Bank 2’s profits, and external social costs, respectively. The sum of the three numbers are the net social benefits. Thus, if both banks engage in safe lending, each earns a profit of 5, there are no external costs, and net social benefits are 10. If one bank engages in safe lending while the second engages in risky lending, the second will earn higher returns and people will begin to invest more money in the second bank and less in the first. The risky bank’s profits will be 7 while the safe bank’s profits will only be 1. The bank’s risky behavior begins to impose a cost on society (because there is a higher risk of failure), which I’ve quantified as -1. Why does the second bank earn a higher expected profit when it engages in risky behavior?

Although it seems that people should be hesitant to put their money in risky banks, it is possible that people are unable to assess the riskiness of banks. But even if people recognize that the second bank has a much higher probability failure, it might be rational to invest in the risky bank for at least two reasons. First, investors recognize that banks receive special treatment from the government; when banks fail the Fed acts as the lender of last resort and governments put together a bailout package. Second, even in markets entirely free of government intervention, investors can hedge against losses through various financial instruments, so investors can profit off the higher returns but cash out before experiencing huge losses. The government makes things worse by offering FDIC insurance.

The safe bank will soon realize that if the other bank is engaging in risky lending, then it will increase its profits by also offering risky loans. Once the second bank starts taking on risky loans, expected profits rise from 1 to 2, and the other bank’s expected profits fall from 7 to 2 (because more people invest in the second bank). Now that all banks are taking on excessive loans, however, they impose a huge cost on society. If they fail, they can bring the entire economy to its knees. Net benefits fall from 10, when both banks are safe, to 2 with excessive risk taking.

This is the classic prisoner’s dilemma with a twist, because now there are external social costs. In the simple two-bank game presented, of course, both banks could simply agree to engage in safe behavior. This would maximize joint profits and social benefits. Furthermore, anti-trust laws do not prevent this form of “collusion.” In real life, though, collusion would be difficult because there are hundreds of banks and enforcement would be impossible. Banks would surreptitiously try to take on riskier loans, thereby hoping to gain an edge over their competitors.

The results of this analysis is that banks take on suboptimal levels of risk without government regulation, and a fortiori when government introduces moral hazards problem. This analysis certainly explains the banking industry’s increasing acceptance of mortgage-backed securities and collateralized debt obligations over the past decade. Subprime loans weren’t safe, but banks were willing to take on a lot of them because of the higher expected return. Banks knew there was a probability that the housing market would fall apart, but the prisoner’s dilemma pushed them to either offer risky loans or become unprofitable.

Therefore, because (a) banking problems can have a massive effect on the entire economy and (b) banks have a tendency to engage in suboptimal levels of risk, they, unlike most other industries, should not have been deregulated. Governments should limit capital-to-equity ratios and should perhaps prevent banks from becoming excessively large.

Nonetheless, in answer to my main question, “Did the Free Market Cause the Current Crisis?” I still feel that it is disingenuous to blame the deregulatory movement. Imagine that the government “deregulates” driving by allowing people to drive as fast as they want – without seatbelts. To make the analogy complete, the government also encourages everyone to drive more quickly, telling them that formerly risky driving is now safe. New smooth roads are constructed that make drivers feel as if they aren’t traveling very fast. In this situation we would see a lot of speeding. We probably wouldn’t be surprised when accident and fatality rates increased. Furthermore, I don’t think we’d blame the accidents on freedom, but on bad government regulations. And, in the end, bad government regulation is responsible for the current crisis.

Current Deficits

David Leonhardt published a great article on U.S. deficits in yesterday's N.Y. Times. Here's a pie chart breaking down the sources of the current deficit (thank Yglesias).

The first two paragraphs provide a nice summary of the article’s conclusions:

There are two basic truths about the enormous deficits that the federal government will run in the coming years.

The first is that President Obama’s agenda, ambitious as it may be, is responsible for only a sliver of the deficits, despite what many of his Republican critics are saying. The second is that Mr. Obama does not have a realistic plan for eliminating the deficit, despite what his advisers have suggested.

Of course, the reason Obama's agenda increases the deficit by only a "sliver" is that he plans to raise taxes while increasing government spending. As economist Alan Auerbach notes in the article,

Bush behaved incredibly irresponsibly for eight years. On the one hand, it might seem unfair for people to blame Obama for not fixing it. On the other hand, he’s not fixing it. And . . . not fixing it is, in a sense, making it worse.

Although Obama's not the sole (or even main) cause of the deficit, Americans should hold him accountable if he fails to improve the situation.

A Textbook Example of the Free-Rider Problem

The other day one of my colleagues commented that he's surprised students are willing to buy (cheaper) international editions of textbooks. This form of price discrimination allows low-income foreigners to buy otherwise prohibitively expensive textbooks. But when American students buy international editions, they increase the demand - and thereby the textbook price - for foreigners. "Don't American students have any sympathy for foreigners?" he wondered.

My colleague (an economist, by the way) didn't recognize that even if American students care about the welfare of foreigners, they still have a strong in incentive to buy international editions. This is a "textbook" case of the free-rider problem. A single student who refrains from buying the international edition bears the entire cost of paying a higher price. She does not, however, receive the benefits of knowing foreign students can buy affordable textbooks, since she recognizes other American students won't similarly refrain. Perceiving that others will buy the international edition, each student has an incentive to buy the cheaper textbook.

This free-rider problem could be overcome through the legal system. But I don't know (a) if buying (or selling) international editions in America is illegal, or (b) if any government agency enforces these laws if they do exist. My students don't know the answer either, so if such laws exist, they're obviously not an effective deterrent.

We Need Accurate Predictions!

Brad Delong, a Berkeley economist whose work I generally respect, reviewed Judge Richard Posner’s book A Failure of Capitalism. The review is very critical of both the book and of the Chicago school of economics. The Chicago school is a branch of economics that has been quite influential over the past half century. The intellectual founder was the late Milton Friedman.

The Chicago school is deductive in its results; virtually all its theories rely on the assumption that consumers and producers are rational. To Chicago-school economists rationality means that consumers use all available information to make choices that maximize subjective well-being. While Chicago-school economists do not suppose that people are all knowing, they do assume that people are generally correct in their beliefs and assumptions about the future. Critics of the Chicago school typically overstate the assumptions of its adherents, claiming that such economists envision people as being omniscient.

Milton Friedman responded to some of these criticisms in an essay, "The Methodology of Positive Economics." According to Friedman, the way to test the validity of models is by analyzing the accuracy of their predictions, not by the accuracy of their assumptions. Thus, although people may not be as rational as the Chicago school supposes, Chicago-school theories are valid if they make accurate predictions. The reason that the Chicago school has been so successful is that its models have been confirmed by a wealth of data.

Furthermore, according to Friedman – and the principle’s embodied by Ockham’s razor – if multiple models make equally accurate predictions, the best model is the simplest. These views are not exclusive to economists: the great theoretical physicists Stephen Hawking makes similar claims in A Brief History of Time.

Anyway, back to Delong –

The review is based on an analogy comparing (a) Chicago-school adherents to 17th Century Jesuits and (b) enlightened economists (presumably behavioralists who acknowledge irrationality) to Copernicans. Jesuits believed that the sun revolved around the earth. Copernicus’s model claimed otherwise. Despite mounting evidence, the Jesuits clung to their beliefs by developing increasingly complicated models. Nonetheless, the Jesuit models couldn't predict planetary movements as successfully as Copernicus's simple but elegant model.

The Jesuit/Copernican analogy is the most ill-advised part of the review (other than perhaps DeLong’s failure to define rationality, as Posner points out in a response). The reason is that in economics, it is the behavioralists who are proposing increasingly complicated models and assumptions. Furthermore, with a few exceptions the behavioralist models are not able to predict behavior as effectively and accurately as rationality-based models. The assumptions of behavioralist models are often vague, ad hoc, and inconstant from model to model. Behavioral predictions are generally non-quantifiable and difficult to implement in non-laboratory settings. Until behavioral economics can make predictions that are more accurate than neoclassical predictions, its claims of irrationality will be meaningless.

This post may seem surprising, given the blog subtitle. I indeed identify as a behavioral economist - or rather as an economist who dabbles in behavioral research. In my view behavioralism can offer useful insights into economic decision-making. Nevertheless, behavioral economics will be little more than an interesting footnote until it can consistently make accurate predictions.

In a later post I'll identify some behavioral predictions that are more accurate than neoclassical predictions.

"His analysis, however, slices far from the fairway"

I recently happened upon one of the best ever judicial opinions, written by Judge Wallace Dixon of North Carolina (thanks ATL). The plaintiff in Giuliani v. Duke University is none other than the son of Rudy Giuliani, Andrew Giuliani. Andrew Guiliani enrolled at Duke to play golf (and to attend school, or do collegiate actually attend classes?). He was not offered a scholarship, nor did he sign a letter of intent. Because the previous coach had recruited Giuliani with specific promises, Giuliani claimed there was an implied contract, which Duke broke when the coach released Giuliani from the team. The judge dismissed this claim in a straightforward analysis. The analysis, however, is not the interesting part.

In his 12-page opinion, Judge Dixon used golfing metaphors to explain his legal reasoning at least 10 time (there may be more examples that I missed). At one point the judge quotes a line from Caddyshack. Anyway, I included all of the references for your reading pleasure. Good stuff:

Plaintiff tees up his case . . . (p. 2). His analysis, however, slices far from the fairway (p. 5). This attempt to change arguments . . . is like trying to change clubs after hitting the golf ball–Plaintiff is stuck with the club (in this case the argument) that he first picked (p. 6). Therefore, Plaintiff’s reliance on four student policy manuals as evidence of a contract is a swing and a miss (p. 6). Ross serves as a putter, however, where Plaintiff needs a sand wedge to get out of the hazard (p. 7). Plaintiff attempts to take a mulligan with this argument; however, this shot also lands in the drink (p. 9). Plaintiff also shanks this claim (p. 10). Plaintiff’s promissory estoppel claim . . . brings to mind Carl Spackler’s analysis from the movie CADDYSHACK (Orion Pictures 1980): “He’s on his final hole. He’s about 455 yards away, he’s gonna hit about a 2 iron, I think” (p. 10). Plaintiff tries to get around the slow play of his promissory estoppel claim . . . (p. 11). Plaintiff’s fifth and final claim . . . can be disposed of with a hole-in-one sentence: no valid contract means no declaratory judgment (p. 11).

Are We Running Out of Oil?

When applying for graduate school a while back, I wrote a 250-word essay. I chose to write about supposed impending oil shortages. I think the arguments are still relevant today.

Here's my essay (slightly modified):

Even economists make mistakes. William Jevons’ book The Coal Question provides a prime example. Jevons was a brilliant nineteenth century intellectual. He was not, however, infallible. In his treatise, Jevons predicted the collapse of England’s economy due to impending coal shortages: “[the current] rate of growth will before long render our consumption of coal comparable with the total supply...we shall meet that vague but inevitable boundary that will stop our progress.” W. Stanley Jevons, The Coal Question: An Inquiry Concerning the Progress of The Nation, and the Probable Exhaustion of Our Coal-Mines 200 (3rd ed. 1906) (1865).

Jevons disregarded the underlying economic principles he professed. If less coal is available, its price increases. This leads to three effects. First, because each lump of coal costs more, people are conservative in their coal use. Second, coal’s higher price serves as an impetus for exploration; entrepreneurs seek new deposits. Finally, lucrative markets for substitutes emerge.
What happened in Great Britain? Was Jevons right? Clearly, coal has not vanished. Furthermore, the economy has increasingly relied on another energy source: oil. Adam Smith’s invisible hand works.

Modern forecasters are raising similar concerns about the coming oil crisis. We have reached “peak oil,” and our economy must soon change how it meets its energy needs. Current naysayers present arguments that are eerily similar to Jevons’: “[as] consumption begins to exceed production by even a small amount,” there will be “a global recession.” Such alarmists likewise fail to consider fundamental truths. Though society must eventually shift to other energy sources, the conversion will be neither catastrophic nor expeditious. Markets will facilitate the change through gradual adjustments in price, conservation techniques, and alternative energy options. There is no impending oil crisis.

The Purpose of Behavioral Economics

Professors Christine Jolls, Cass Sunstein, and Richard Thaler published a great 1998 article on behavioral (law and) economics in the Stanford Law Review. One quote strikes me as being particularly insightful:

The project of behavioral law and economics, as we see it, is to take the core insights and successes of economics and build upon them by making more realistic assumptions about human behavior. We wish to retain the power of the economist’s approach to social science while offering a better description of the behavior of the agents in society and the economy. Behavioral law and economics, in short, offers the potential to be law and economics with a higher “R2”—that is, greater power to explain the observed data. We will try to highlight some of that potential (and suggest cases where it has been realized) in this article. (p. 1487)

Proposing more realistic economic assumptions is a pointless exercise unless the assumptions increase the ability of models to predict. Thus, the proof of behavioral economics is, as they say, in the pudding.

Did the Free Market Cause the Current Crisis? - Part II

In an earlier post I began answering the question: “Did the Free Market Cause the Current Crisis?” My short answer is no, but not without qualifications. I argued that three factors led to the housing bubble – the but-for cause of the current recession. Two of the factors are government-related: the Fed and government-created homeownership incentives (I address the latter in this post). Only the third factor, banks’ excessive risk taking, is a direct result of the free market. I will address banks in Part III.

Factor #2: The Government - "Ownership Society"

In the late 1990s people began to believe that homes were always safe investments. One reason is that home prices had steadily risen during previous decades, and people simply believed that the increase would continue (behavioral economists call this "status quo" bias). Another reason is that income and population were rising in the 1990s, so more people could afford homes.

As people increasingly viewed homes as safe investments, demand and therefore prices rose. Soon many people were unable to afford 20 percent down payments. People began arguing that low income Americans, especially minorities, were unfairly denied the American dream. Beginning with the Clinton administration, the government began pushing Fannie Mae and Freddie Mac to offer loans to low-income Americans - under the implicit guarantee that the government wouldn't allow these institutions to fail. (This implicit guarantee explains why these institutions could borrow at low rates, despite the fact that they back so many risky loans). The government encouraged lenders to offer loans to people who would be unlikely to afford payments. Unfortunately, the Bush administration continued Clinton's inauspicious policies. President Bush hoped to achieve an “ownership society.” Furthermore, the federal government - and many state governments - began offering strong tax incentives to home buyers.

Still, it's possible to argue that it's a good idea for the government to encourage homeownership because of the positive externality effect: homeowners take better care of their properties than renters do, which increases neighborhood property values. Homeownership may also reduce crime - at least according to Giuliani's "broken window" theory. Nevertheless, as the recent crisis suggests, the government went way too far in its encouragement of homeownership.

The perpetuation of the idea that homes were safe investments and the government's encouragement of homeownership were not independent events. Each fueled the other. These events, along with the Fed's lowering of interest rates and banking deregulation, led to the huge spike in real home prices.

Before claiming that free markets caused the current crisis, however, it’s important to recognize that two of the three culpable events have nothing to do with free markets and everything to with government intervention.

Privatizing Social Security is a Good Idea - Still

In Richard Posner's book A Failure of Captilism (a great book I'll blog more about in the future), Judge Posner listed lessons this crisis has taught us. One thing he mentioned is that privatizing Social Security would have been a bad idea. He never explained his rationale (perhaps he thought it was self-evident?), and, for the reasons listed below, I don't agree with his claim.

First, it would initially seem that the people who would have been hurt the most by privatization are those (a) who had heavily invested their money in the stock market, and (b) who are close to retirement. But privatized accounts would likely work much like 401(k)'s. People could choose to invest in stocks, bonds, or some preset mix. As people approached retirement, most would shift their money to bonds, where funds have largely been sheltered. Most soon-to-be retirees wouldn't have been significantly affected by the crisis.

Secondly, it’s true that crisis would have harmed anyone who had invested in stocks. Still, I expect the return on stocks over the next decade or two to exceed the current return on Social Security contributions (which is close to two percent). Even those who would have been significantly hurt in the short-run would be better off by investing in stocks than by "investing" in Social Security - as long as they aren't looking to retire in the next couple of years.

Finally, privatizing social security would have encouraged higher savings rates, so people would have saved more in the early 2000s. Thus, when the crisis hit, people could have drawn on their savings, mitigating the sharp decline in consumption. Much of the savings, of course, would have gone to untouchable 401(k)-type accounts, but Congress could have simply passed a law allowing people to withdraw early without the standard penalty. Because the value of stocks will likely grow faster than two percent, people who withdrew early would still have money for retirement.