Archive for the ‘Economics’ Category

Another problem with regulation: Dodd-Frank

August 11, 2011

Reacting to the financial meltdown of 2008, the Obama administration enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act to provide regulation that would supposedly prevent this sort of financial crisis. The bill is 2,300 pages, with many details (the actual regulations) TBD (to be determined).

I have long been skeptical that it would improve anything, and Conrad Black has, in his usual fashion, provided a pithy, literate explanation. His words have helped me get my hands around what is wrong with Dodd-Frank:

The two most offensive aspects of Dodd-Frank are that it is part of the concerted bipartisan effort of the entire political class to pretend that the economic crisis was entirely the result of private-sector greed, and that it doesn’t address at all the main discernible causes of the economic crisis of 2008, which have not gone away. The housing bubble and imprudent lending into it were the principal problem, and the principal culprit is the United States government, for legislating a substantial percentage of private-sector commercial mortgages to be on a non-commercial basis; for issuing executive orders to the giant, pseudo-private-sector Fannie Mae and Freddie Mac to make the majority of their mortgage loans on that basis; and for keeping interest rates and mortgage equity requirements so low for so long. This was certain to lead to mountains of excess residential housing and worthless mortgages.

It was also the federal government that extended the permissible borrowing ratio of debt to equity for merchant banks to 30 to one, and required constant mark-to-market current valuation of the assets against which they were borrowing up to 30 times. A moron could see that if a bank became impetuous and put too many eggs in one basket, and the market value of the eggs declined, it would have to issue securities to hold its ratio, at steadily declining prices, encouraging and rewarding short sales and assuring a power-dive into insolvency, as was allowed to happen to Lehman Brothers.

So a monstrosity of government regulation is supposed to fix a problem caused by, government policy and regulation ? Acts of Congress cannot arbitrarily cancel the laws of economics or eliminate the human tendency to take unreasonable risks, as this one tries to do. But at the very least, a law to prevent financial meltdowns should have done something about Fannie and Freddie. This is what Dodd-Frank does about those two Government Sponsored Enterprises (GSE): “nothing”.


Unintended consequences

August 9, 2011

A recurrent theme in this blog is that government regulation almost always has unintended (negative)  consequences. The latest example is the shortage in generic cancer drugs. These drugs are off-patent, so they should be cheap. But lately, many have become unavailable.

The reason is government regulation, specifically Medicare price controls, according to Ezekiel Emanuel (Rahm’s brother). In a 2003 law, government agreed to pay oncology doctors the ‘average selling price’ of cancer drugs they prescribe, plus a 6% overhead, rather than allow a classic fee for service. As the rules are set out by law, prices can only rise 6% every 6 months.

I am guessing the rule was written to prevent ‘excess profits’ by evil drug companies jacking up the price of a successful drug. But in their infinite wisdom, our governmental overlords overlooked that when a drug goes off patent, its price drops a lot, as much as 90%. As other manufacturers start making the generic drug, the price often fluctuates a lot as the market finds its new balance as the original and generic manufacturers figure out whether they can make and sell it profitably. The regulators cannot keep up with real-time conditions in the marketplace and (apparently quite frequently) the price can get stuck at a point too low to incentivize enough production to meet demand.

Amazingly, Emanuel sees government regulation as the answer:

One solution would be to amend the 2003 act to increase the amount Medicare pays for generic cancer drugs to the average selling price plus, say, 30 percent, after the drugs have been generic for three years. 

As if his proposed fix doesn’t have more unintended consequences lurking in possible scenarios that no one has yet imagined.

When will these folks lose their arrogance and realize that government regulations will never be smart enough to create the utopia they want to force upon us ?

Hat tip Megan McArdle.

OHO ! (Obama Hypocrisy Observation)

June 24, 2011

Every so often, the worst Administration in history does something to get this lazy blogger to take time out of his day to marvel at the sheer hypocrisy, venality, do-as-I-say-not-as-I-do-ness and overall low-down dirty trickery of this group that is incompetent to administer our government. Here is my first OHO ! or Obama Hypocrisy Observation:

Some of you may have noticed that Obama decided to release 30 million barrels of oil from the SPR (Strategic Petroleum Reserve). Three links let you pick one of my favorite blogs with the story. As an editorial notes:

The spigots have been opened just twice — in 2005 by President Bush, who released 11 million barrels after disruptions from Hurricane Katrina, and in 1992 by President Bush Sr., who tapped 20 million barrels in the wake of the Gulf War. President Obama’s release — which is far bigger than either of those two emergencies — is supposedly in response to disruptions from Libya, which isn’t even a U.S. supplier. It isn’t our crisis.

This had an immediate effect on the oil markets, dropping the price of oil over 5%. In all likelihood, that will lead to lower gas prices at the pump. Political, ya think ?

But that isn’t what got me worked up. I expect every decision from the Obama administration to be made for political gain. What got me was learning that in addition, he waived the Jones Act to allow foreign ships to transport the SPR oil*. The Jones Act requires that cargo shipped from one US port to another be carried by US vessels that are US owned with US crews, a protectionist measure we can debate, later. “Waivers have been granted in cases of national emergencies or in cases of strategic interest.”

Transporting SPR oil is NOT a national emergency that requires waiving the Jones Act. So why did Obama do it? After all, this is the same guy who has restricted oil drilling from day one and is doing his best to move us away from a carbon-based economy to a green economy, whatever that is, the merits of which we can debate, later.

The hypocrisy is that oil from evil corporations is bad, but oil sold by the government to reduce energy costs is so good that getting SPR oil to market is a national (reelection) emergency!

*You may recall that a Belgian firm DEME gave the Jones Act as the reason their offer to help clean up the Gulf of Mexicooil spill was declined. It is unclear if that was true.

Democrat policy on gas prices sows fear and ignores basic economics [UPDATED]

April 27, 2011

According to Greg Sargent, Democratic strategists have some talking points they want to push to ‘protect Americans at the gas station’ in response to rising gas prices. Here is the key policy:

* Although there is no single, easy answer for addressing increased gas prices in the short term, there are things we can do to guarantee that Americans aren’t victims of escalating gas prices in the long term.

* One thing we can do is eliminate unnecessary tax breaks for the oil and gas industry and instead invest that money into clean energy, so that we can cut our dependence on foreign oil.

Given the government’s track record in alternative energy (remember Synfuels ?), there is no guarantee government  ‘investments’ in clean energy will lead to lower energy prices. So what will be the effect of eliminating tax breaks for oil and gas companies ?

Eliminating tax breaks means raising taxes. If companies’ taxes go up, they will try to pass the cost on to their customers to keep their profits constant (that’s what I would do).

How will this brilliant Democratic strategy keep gas prices from rising ? The answer is it won’t. These talking points are pure demagoguery that seek to gain support from folks upset with rising prices by demonizing business.

I am not the only one to notice this. And I am hardly a fan of tax breaks for oil and gas companies – or tax credits or subsidies for ‘green’ cars, alternative energy sources, or ethanol, for that matter. These should all go away along with a host of other targeted government tax breaks and subsidies. Their primary effect is to buy votes. But eliminating tax breaks for oil and gas companies and throwing the money at clean energy is ignorant of basic economics. It guarantees that prices will go up in the short term. There is no guarantee the imagined benefits will ever come to pass.

UPDATE: Larry Kudlow weighs in on the $4B in tax breaks Dems want to eliminate. Hint – the piece is titled ‘The Left Hates Oil Companies.’

Fallacies of targeted economic policies and green technology

September 8, 2010

I am generally against targeted economic policies, taxes and tax breaks. Though I am not ashamed to admit I itemize deductions on my tax return, I think that targeted policies usually try to micromanage economic behavior to a degree that is counterproductive and often has unintended consequences.

Consider cars and gas mileage. By fiat, the US government decrees an automaker’s allowable Corporate Average Fuel Economy (CAFE) that its entire fleet of cars and light trucks sold must achieve. The goal is to reduce energy consumption and dependence on foreign oil. But wait. Very heavy cars or SUVs aren’t part of the CAFE standard. So there is a perverse incentive to produce vehicles that are so heavy they don’t count which yields worse efficiency!

Sometimes, the intended consequence may only be a temporary phenomenon. Witness the recent Cash for Clunkers program. Intended to both stimulate car sales in the Great Recession and take older, less efficient vehicles off the road, it did temporarily raise car sales. But as the graph shows, sales fell right after the program ended, negating the uptick during the program. Consumers who timed their purchases right got lots of cash from everyone else, but the economy as a whole did not benefit. And the prices of used cars have soared, so those down on their luck can’t get cheap wheels. Hat tips HotAir and Coyote Blog.

Green technologies have a similar problem. You would think that making a product more energy efficient would lead to less energy consumption and less CO2 production. For example, lighting technology is going through a revolution. The incandescent bulb invented by Edison is gradually becoming extinct due to government fiat and competition from new technologies offering longer lifetimes and greater energy efficiency. Compact fluorescent bulbs (CFL) were the first wave and light-emitting diodes (LED) are the second.

But don’t count on the demand for electricity dropping anytime soon. You see, once government enacts a new regulation or a new technology becomes available, people and corporations react to it and change their behavior in ways that benefit them but don’t always produce the intended or naively predicted effect. The experts (in this case LED researchers from Sandia National Laboratories) are saying that people will change their behavior if more efficient lighting becomes available in ways that counter the purported savings.

Over the past three centuries, according to well-accepted studies from a range of sources, the world has spent about 0.72 percent of the world’s per capita gross domestic product on artificial lighting.

The article predicts that number will not change with LED technology. People will increase “the amount of lit work space and bright time,” thereby “increasing their creativity and the productivity of their society.”

Remember the CAFE standards ? When gas mileage went up with higher MPG cars, some people used the savings to buy more gas and travel more ! Keep that in mind if the administration comes out with new economic proposals between now and November.

The biggest socialist since Richard Nixon !

August 27, 2010

Barack Obama leads the most socialist administration since Richard Nixon. Let me explain. As I said in a previous post, a government is socialist if it tries to control the economy by means other than the free market. In 1971, Richard Nixon imposed wage and price controls on the US economy, the only time outside of wartime (WWII and Korea) a president has done so.

I remember this because in 1974, I gave a speech on it. As an indication of how times have changed, not only did we have a long speech unit (several months and 6 speeches, if I recall correctly) but Newsweek magazine was my primary reference ! My speech was no more successful than Nixon’s wage and price controls. No one could follow it – my teacher said it cried out for visual aids – and the wage and price controls predictably did not halt inflation as intended.

Judging from Obama’s policies, he would have been in favor of this heavy handed approach to beating inflation. He is a big fan of the federal government. He signed a law where government will micromanage health care and health care insurance. And he is continually generating bills and regulations that embody the idea that unless government favors an activity, it won’t happen and unless government controls it, those involved (evil capitalists) will harm others or the environment.

The latest example is the conversion of the fishing industry from one with an overall quota to a ‘catch share’ system. Under the old system, anyone who wanted could fish until the quota for a given species was reached. Now, you need a permit with an associated quota to fish for a given species. This is equivalent to a farmer needing a permit to grow wheat, up to a certain amount, or a manufacturer needing a permit to produce a widget. As Ed Morissey from HotAir recently put it, this approach will “essentially turn fishermen into government employees, and they’re not happy about it.”

The new system has fishermen from New England, the Outer Banks of North Carolina, and the Florida Keys up in arms. The irony is that the overfishing problem has mainly been solved. Two Massachusetts congressmen (yes, even Barney Frank), recently called for resignation of Dr. Jane Lubchenco, the head of NOAA who administers the new system.

In case you were wondering, Dr. Lubchenco, recipient of a Macarthur “genius” award, was an academic – environmental scientist and marine ecologist – before Obama appointed her. Unlike the fishermen whose livelihood she controls, she has never worked in the private sector.

Harvard Business School: government stimulus doesn’t work

May 26, 2010

A very recent study out of the Harvard Business School puts the lie to those who still believe in Keynesian economics in general and that the stimulus package was beneficial in particular. The study, titled “Stimulus Surprise: Companies Retrench when Government Spends,” was looking to see how companies benefited when their senator or representative ascended to a committee chairmanship. This ascension typically increases local federal spending by 10-50% with more for senators than /representatives and more for earmarks than broader discretionary spending.

To their great surprise, the authors found corporate revenues and spending shrank despite the increase in federal spending. Here are some reasons why:

Some of the dollars directly supplant private-sector activity—they literally undertake projects the private sector was planning to do on its own. The Tennessee Valley Authority of 1933 is perhaps the most famous example of this.

Other dollars appear to indirectly crowd out private firms by hiring away employees and the like. For instance, our effects are strongest when unemployment is low and capacity utilization is high. But we suspect that a third and potentially quite strong effect is the uncertainty that is created by government involvement.

Why should we expect anything different when the spending is directed to the entire country ?

Hat tip Larry Kudlow at National Review.

Stimulus Surprise: Companies Retrench When Government Spends

Our (still very sarcastic) President

May 16, 2010

Am I the only person who thinks this sort of talk from the President about Republicans, at a recent DCCC fundraiser, is fine for Jon Stewart but is Just.Not.Presidential ?

So after they drove the car into the ditch, made it as difficult as possible for us to pull it back, now they want the keys back.  (Laughter.)  No!  (Laughter and applause.)  You can’t drive!  (Applause.)  We don’t want to have to go back into the ditch!  We just got the car out!  (Applause.)  We just got the car out!  (Laughter.)

If you have even a modicum of economic understanding, you will appreciate that the Great Recession caught nearly everyone by surprise, and to the extent policy decisions ’caused’ it, there is plenty of bipartisan blame to go around.

My take on the Great Recession

May 8, 2010

This is a long post. I think a long discussion is justified for arguably the most important financial event in decades that set events in motion that could affect the US and world economy for a very long time.

Economists will probably debate the causes of the 2008 recession and financial crash at least as long as they have been studying the Great Depression. And just as the stock market crash of 1929 was only the harbinger of the Great Depression, news from Greece and Europe indicates that the events of 2008 are still echoing throughout the world economy. However, since governments are already enacting policies to recover from what many are calling the Great Recession, and trying to prevent it from recurring, we need to try and understand it as soon as possible.

Everyone agrees that the Great Recession was associated with the collapse of a housing bubble. After going up at double digit rates for most of the decade, US housing prices crashed. Losses and defaults on associated investments and loans caused a credit crisis which the US government addressed with extraordinary measures – bailing out AIG, big banks, Chrysler, and GM – to restore some order to financial markets and the economy. In retrospect, it was irrational to assume housing prices would continue to rise much more than historical trends, just like it was irrational to assume dot com stocks with little revenue were fairly valued in 2000.

There are some great books on the details of the crash already in print. I read The Big Short: Inside the Doomsday Machine by Michael Lewis, a fellow Princetonian, which tells the story of the crash from the perspective of a few investors he found who predicted it and placed substantial financial bets on their predictions. I just started The End of Wall Street by Roger Lowenstein, a fellow Newtonite. So far, it tells the story of a mortgage market that evolved to a state where there was a total disregard of sound financial practice. Some banks had policies to discourage their people from asking applicants to back up anything they put on their mortgage applications, no matter how improbable, lest it result in the loan not getting approved ! Federal policies to increase home ownership, backed by Fannie Mae and Freddie Mac, also contributed to a situation where more money was lent to less qualified buyers in an overheated housing market.

The mortgage markets had other problems. Investment banks produced esoteric financial instruments like Collateralized Debt Obligations (CDOs), a type of derivative that aggregated mortgages, and synthetic CDOs without underlying mortgages but which tracked real CDOs. Insurers like AIG wrote Credit Default Swaps (CDS) protecting CDO issuers based on risk assessments from rating agencies like Moody’s and Standard and Poors. Unfortunately, the models used to assess risk were fatally flawed. The largest drop in housing prices allowed by the models was much less than what subsequently came to pass or what had been experienced twice since 1970. In addition, the models incorporated a logical fallacy that assembling a mix of low quality asset backed securities resulted in a high quality one.

The rating process for these esoteric securities was skewed in favor of the investment banks issuing them. Michael Lewis points out that the rating agency employees were Wall Street’s bottom of the barrel who couldn’t get hired by the investment banks and got paid much, much less. The contrast was visually apparent with the investment bankers wearing Armani suits and the rating agency employees clothed off-the-rack. Amazingly, the entire rating process had a huge conflict of interest, as agencies were paid by the issuers of the securities and only got paid if they gave a favorable rating !

Though these problems seem obvious in hindsight, they were not obvious at the time. In early 2007, I joined a stock club. We invested in AIG in June 2007 to have a presence in financial services. Soon after we bought, AIG started sinking. We knew there was exposure to subprime mortgages and tried to figure out what that exposure was. Our research showed the exposure should be limited, based on the figures we could discern, so we bought some more in February 2008. But the stock kept dropping, even after pundits said the price fully reflected the possible losses. So we sold, with a 50% loss in June 2008. As bad as that was, we felt like geniuses for getting out when we did when the company was bailed out and the stock became nearly worthless !

If you listen to certain politicians, the crash was the result of unchecked greed due to financial deregulation under Bush. I wish it were that simple. Some deregulation arguably contributed to the crash. Under Clinton, parts of the Glass-Steagall act were repealed that blurred the lines of commercial banks (think low-risk) and high-risk investment banks. Self-regulation of derivatives markets was enacted in 2000, also by Clinton, so pricing of the CDO and CDS derivatives was largely hidden from the market. In 2004, the SEC (not Bush) unanimously relaxed the net capital rule which some have argued led to overleveraging by investment banks such as Lehman Bros. which failed in 2008. In at least one instance, Congressional Democrats blocked Bush’s attempt to regulate Fannie Mae and Freddie Mac. The NY Times called the proposed legislation “the most significant regulatory overhaul in the housing finance industry since the savings and loan crisis.” And since government spending on financial regulation went up 26% in real terms during his presidency, it is hard to argue markets were radically deregulated by Bush.

Though he is more interested in telling the story than explaining its root causes, Michael Lewis points to the 1980s when the investment banks, originally partnerships, became public corporations as a significant factor. Goldman Sachs was undoubtedly more conservative when the partners were investing their own money, not other people’s.

David Frum points to something else as the cause. While it is indisputable that elevated housing prices, and mortgages on that housing, were the proximate causes of the crash, someone had to fund that runup in prices. Frum advances the theory that China, in its effort to fuel its growing economy with foreign demand while keeping its currency low enough so exports kept flowing, lent us money so we could buy Chinese goods. That money had to go somewhere, and much of it helped inflate our real estate prices. While I don’t pretend to understand the money supply (I never got that part of Econ 101), it sounds plausible.

I don’t think we can neglect the impact of the Federal Reserve Board, either. The Fed lowered interest rates dramatically after 9/11 to keep the economy from collapsing. By 2004, concerns about inflation led to increased rates which peaked in 2006-7. This 4-point swing, down then up in 5 years, clearly added instability to financial markets and caused some foreclosures when adjustable rate mortgages reset with higher rates.

If you look at airplane crashes and similar disasters, they often turn out to be caused by the conflation of several events, each of which has low probability. The Great Recession is not that sort of catastrophe. Falling housing prices were the driver behind the financial crisis. But since housing prices have fallen 10-20% in real terms twice before in my lifetime (peaks in 1979 and 1989), that cannot be considered a low probability event unless you believed that the rules of the economy had changed. Some people may have believed that Alan Greenspan’s fiscal policy had tamed the business cycle, but the Great Recession has effectively shattered that notion.

As a scientist, I believe that there are immutable laws of nature that govern how the world works. Even in the messy world of social science, there are some inviolable principles. One of them is that from time to time, markets exhibit irrational exuberance where some commodity will increase in value at rates well above the historical norm. There is no way to eliminate these bubbles. Eventually, the market corrects and the commodity returns to a reasonable valuation. There is no way to eliminate the pain or loss of those who bought during the bubble unless government steps in and makes them whole (and makes other people cover their loss).

If you accept that the Great Recession was just a particularly bad collapse of a bubble and downward portion of the business cycle, it doesn’t mean that we cannot try and find policies that mitigate the frequency and severity of such events in the future. I will have more to say about that, as well as on the financial ‘reform’ bill, in future posts.