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.