Saturday, June 13, 2009

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
Bank 1Safe5, 5, 01, 7, -1
Risky7, 1, -12, 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.
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Thursday, June 11, 2009

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.

Wednesday, June 10, 2009

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.

Tuesday, June 9, 2009

"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).

Sunday, June 7, 2009

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.