Bankruptcy, not bailout

At cnn.com economist Jeffrey A. Miron argues that Bankruptcy, not bailout, is the right answer to the current problems in the US financial markets. Miron is senior lecturer in economics at Harvard University ands one of 166 academic economists who signed a letter to congressional leaders last week opposing the government bailout plan. In this article Miron explains why the plan is a bad idea.

He opens his piece by noting

The current mess would never have occurred in the absence of ill-conceived federal policies. The federal government chartered Fannie Mae in 1938 and Freddie Mac in 1970; these two mortgage lending institutions are at the center of the crisis. The government implicitly promised these institutions that it would make good on their debts, so Fannie and Freddie took on huge amounts of excessive risk.

Worse, beginning in 1977 and even more in the 1990s and the early part of this century, Congress pushed mortgage lenders and Fannie/Freddie to expand subprime lending. The industry was happy to oblige, given the implicit promise of federal backing, and subprime lending soared.

This subprime lending was more than a minor relaxation of existing credit guidelines. This lending was a wholesale abandonment of reasonable lending practices in which borrowers with poor credit characteristics got mortgages they were ill-equipped to handle.

Once housing prices declined and economic conditions worsened, defaults and delinquencies soared, leaving the industry holding large amounts of severely depreciated mortgage assets.

Miron argues that any response to the crisis should eliminate the conditions that created the problems in the first place. What such a response shouldn't do is attempt to fix bad government with even more government. He writes

The obvious alternative to a bailout is letting troubled financial institutions declare bankruptcy. Bankruptcy means that shareholders typically get wiped out and the creditors own the company.

But keep in mind that bankruptcy doesn't mean the company disappears. What happens is that the firm is now owned by someone new. Importantly bankruptcy punishes those who took excessive risks while preserving those aspects of a businesses that remain profitable. Contrast this with the bailout plan which transfers enormous wealth from taxpayers to those who knowingly engaged in risky subprime lending.

Thus, the bailout encourages companies to take large, imprudent risks and count on getting bailed out by government. This "moral hazard" generates enormous distortions in an economy's allocation of its financial resources.

Many of the more thoughtful advocates of the bailout will concede the moral hazard point, but will still argue that a bailout is necessary to prevent economic collapse. Their argument is that lenders are not making loans, even for worthwhile projects, simply because they cannot the capital to do so. Miron accepts that there is a grain of truth in this and that if the bailout does not occur, more bankruptcies are possible and credit conditions may worsen for a time. He goes on to note, however, that

Talk of Armageddon, however, is ridiculous scare-mongering. If financial institutions cannot make productive loans, a profit opportunity exists for someone else. This might not happen instantly, but it will happen.

Miron further notes that the current credit freeze may well be due to Wall Street's hope of getting a bailout. Bankers will not sell their toxic assets for 20 cents on the dollar if the government might pay more than that.

Anticipation of the bailout will engender strategic behavior by Wall Street institutions as they shuffle their assets and position their balance sheets to maximize their take. The bailout will open the door to further federal meddling in financial markets.

So what should be done? Miron's answer is,

Eliminate those policies that generated the current mess. This means, at a general level, abandoning the goal of home ownership independent of ability to pay. This means, in particular, getting rid of Fannie Mae and Freddie Mac, along with policies like the Community Reinvestment Act that pressure banks into subprime lending.

He ends by saying,

The right view of the financial mess is that an enormous fraction of subprime lending should never have occurred in the first place. Someone has to pay for that. That someone should not be, and does not need to be, the U.S. taxpayer.

A must read for Matt McCarten ... and others (updated)

Steven Horwitz, Department of Economics, St. Lawrence University, has written An Open Letter to my Friends on the Left to do with the financial crisis in the US. The letter attempts to persuade those on the left that the current financial mess is not the product of free markets but a whole variety of government interventions. It also makes an attempt to persuade them that, for reasons they might share, solutions that bailout the lenders and ask for more regulations will be counter-productive.

At one point Horwitz writes,

One of the biggest confusions in the current mess is the claim that it is the result of greed. The problem with that explanation is that greed is always a feature of human interaction. It always has been. Why, all of a sudden, has greed produced so much harm? And why only in one sector of the economy? After all, isn't there plenty of greed elsewhere? Firms are indeed profit seekers. And they will seek after profit where the institutional incentives are such that profit is available. In a free market, firms profit by providing the goods that consumers want at prices they are willing to pay. (My friends, don't stop reading there even if you disagree - now you know how I feel when you claim this mess is a failure of free markets - at least finish this paragraph.) However, regulations and policies and even the rhetoric of powerful political actors can change the incentives to profit. Regulations can make it harder for firms to minimize their risk by requiring that they make loans to marginal borrowers. Government institutions can encourage banks to take on extra risk by offering an implicit government guarantee if those risks fail. Policies can direct self-interest into activities that only serve corporate profits, not the public.

The whole letter is worth taking the time to read.

(HT: The Austrian Economists)

Update: The visible hand in economics asks Does the credit crisis indicate the failure of the “free market”. Matt sees the issue as one of asymmetric information, which must be to a degree true. But I'm not sure it is one of the primary causes of the current mess. I think a lot of people knew what they are trading and traded anyway due to the incentives provided by the government or its agencies. So I see the causes as more to do with incentives than information.

More on General Motors-Fisher Body

The seemingly never ending debate about the General Motors-Fisher Body vertical integration has taken another step towards not ending with the publication of two new papers on aspects of the issue.

Victor P. Goldberg has a paper in the journal Industrial and Corporate Change, Volume 17, Number 5, pp. 1071–1084 in which he argues that the 1919 General Motors–Fisher Body contract was legally unenforceable. The abstract of his paper, Lawyers asleep at the wheel? The GM–Fisher Body contract, reads

In the analysis of vertical integration by contract versus ownership, one event has dominated the discussion—General Motors’ (GM) merger with Fisher Body in 1926. The debates have all been premised on the assumption that the 10-year contract between the parties signed in 1919 was a legally enforceable agreement.However, it was not. Because Fisher’s promise was illusory the contract lacked consideration. This note suggests that GM’s counsel must have known this. It raises a significant question in transactional engineering: what is the function of an agreement that is not legally enforceable?

In a note on the Goldberg paper, Benjamin Klein argues that even if Goldberg’s contract law conclusion were correct, and Klein argues they are not, it is economically irrelevant. The abstract of the Klein piece, The enforceability of the GM–Fisher Body contract: comment on Goldberg, reads,

Goldberg unconvincingly claims that the General Motors (GM)–Fisher Body contract was in fact legally unenforceable. But even if Goldberg’s contract law conclusion were correct, it is economically irrelevant. It is clear from the actions of Fisher and GM and from the testimonial and other contemporaneous evidence that both transactors considered the contract legally binding and behaved accordingly. Therefore, proper economic analysis of the Fisher–GM case should continue to assume contract enforceability, and the economic determinants of organizational structure illustrated by the case remain fully valid.

(HT: Organizations and Markets)

Will Wilkinson interviews Arnold Kling

This video comes from Bloggingheads.tv. Wilkinson and Kling talk about the current financial problems in the US and the Paulson plan to deal with it.

Understanding Crisis in the Markets: A Panel of Harvard Experts

The following link is to a video for "Understanding Crisis in the Markets: A Panel of Harvard Experts" which occurred on September 25, 2008. The panel of experts included

• Robert Kaplan, Professor of Management Practice
• Jay Light, Dwight P. Robinson, Jr. Professor of Business Administration and Dean of the Faculty of Business Administration
• Gregory Mankiw, Robert M. Beren Professor of Economics
• Robert Merton, John and Natty McArthur University Professor
• Kenneth Rogoff, Thomas D. Cabot Professor of Public Policy
• Elizabeth Warren, Leo Gottlieb Professor of Law

Arnold Kling recommends listening to three of the panel in particular,

Greg Mankiw (starts about minute 44) said that chapter 26 of his textbook explains the importance of the financial sector. [...]

Ken Rogoff (starts about minute 57) says that the financial sector needs to shrink. He's been writing that, and I've incorporated his views into my criticism of the Paulson plan.

Please listen to Ken, who is a respected policymaker as well as a leading academic. He calls the financial sector bloated, and he draws out the same implications that I do. In particular, rather than being a trigger for a new depression, the shrinkage of the financial sector is part of a necessary adjustment. But hear how he tells it.

Ken also describes our international position as precarious. He will drive Don Boudreaux crazy, because he sees this in terms of currency values and "our" trade deficit. But I think that the point that our government may suddenly find itself facing higher borrowing costs is certainly worthy of emphasis.

[Robert] Merton (right after Rogoff, but you don't want to skip Rogoff) is one of those speakers whose mind produces so many thoughts that all you get to hear are excerpts. One point he makes is that there has been a large real loss of wealth in housing, amounting to trillions of dollars.

Alex Tabarrok at Marginal Revolution has a short summary, by Elizabeth Warren of Credit Slips, of Ken Rogoff's discussion,

Any liquidity crisis is caused by the promise of a government bailout. Ken said that his many friends in investment banking said that there is plenty of money to invest in financial services, but right now it is "sitting on the sidelines." Why? Because the financial services industry does not want to pay the terms required to get that money back in circulation (e.g., give up equity). As he put it, why do business with Warren Buffett who will negotiate a tough deal, if you believe that the government will ride in soon with cheaper cash?

Ken also talked about the need to shrink the financial services sector. He thinks it is good that the investment banking houses are failing and many people on Wall Street are losing their jobs because, in his view, we have an oversupply in that sector and our economy just can't support it.

Ken's background with the IMF and on the Board of the Federal Reserve add a certain credibility to his assessment of conditions on Wall Street. If he is right, the $700 bailout is saving some investment bankers' jobs in the short term, but overall it is just making the financial system worse.

Matt McCarten has lost the plot

Thanks to Kiwiblog I have discovered that Matt McCarten has lost the plot ... again. In his latest rant in the Herald on Sunday McCarten says

The trillion-dollar, taxpayer-funded handout to criminal and irresponsible corporations in the United States surely puts an end to the nonsense that there is any such thing as a "free" market.

What the bailout does show that the banking sector in the US was not a free market to begin with, much of the blame for the crisis is due to this fact. Government interference with the normal operations of markets played a big role in creating the current crisis. As John Stepek pointed out in a recent piece in MoneyWeek,

This crisis has its roots in the actions of central banks. I think it's important to make this point very clear right now.

Central banks, the Fed in particular, could have popped what was obviously a rampant property bubble before it got too big. They didn't. As Roger Kerr wrote, correctly, recently

What caused this bubble? A prime source was easy money - the Federal Reserve cut interest rates in response to the dotcom cash earlier this decade and kept them low despite inflation pressures and the surge in the prices of housing and other assets.

Moreover, the Fed’s 1998 rescue of Long Term Capital Management and its response to the dotcom crash led many to believe in the so-called ‘Greenspan put’ - the expectation that the Fed would bail out troubled financial firms, especially large ones. This arguably resulted in imprudent borrowing and lending

Also there were the incentives created by legislation, the 'anti-redlining' laws, being one example. Such regulations set out to stop lenders refusing loans to people who happened to live in a poor part of town. That gave millions of poor people access to home loans – but at the expense of the institutions taking on riskier customers. As Kerr puts it

Another factor was political pressure on banks to lend in the name of ‘affordable housing’ (sound familiar?). As a Brookings economist put it, banks “had to show they were making a conscious effort to make loans to subprime borrowers.”

Then there was the implicit government guarantee on Fannie Mae and Freddie Mac. Seemingly insulated from all harm, they became reckless - a nice example of moral hazard. They constructed a giant pyramid of debt on a very small base of capital. Again, as Kerr has written

Another very important contributor was the implicit government support of Fannie Mae and Freddie Mac, the two huge corporations that back nearly half of the $12 trillion mortgages outstanding in the United States.

This was a train wreck waiting to happen. The government backing undercut private lenders and encouraged risky practices.

McCarten goes on

Right-wing ideologues have bullied us for three decades that the only way for growth and prosperity is to have unregulated free markets, guided by some mystical force called the "invisible hand". After the meltdown in the US this week there has been a deafening silence from these sages.

There is much evidence that well functioning free markets are a big factor in growth and prosperity. Herbert Grubel concludes that

This paper uses the Economic Freedom Index to show that greater economic freedom does not have a cost in terms of income levels, income growth, unemployment rates, and human development, as has been the conventional wisdom during much of the postwar era. To the contrary, economic freedom is associated with superior performance on all of these criteria of human well-being.

The size of government is normally associated with less economic freedom and less growth. As Gwartney, Holcombe and Lawson note

The findings of this paper show a strong and persistent negative relationship between government expenditures and growth of GDP, both for the developed economies of the OECD and for a larger set of 60 nations around the world.

To see the basic point consider the following graphs. The first shows the relationship between economic freedom and income. The relationship is positive.

The second two show the relationship between economic freedom and income and economic growth,

McCarten continues

The free marketeers' ideology goes something like this: there should be no regulation and the market is always self-correcting. If managers of enterprises make mistakes, their businesses would fold and new ones would take their place.

The problem is that without any rules the law of the jungle applies. The bullies and thugs who lie and cheat are the ones who survive. After they've gobbled up many of their competitors, they become so big and monopolistic that they can do whatever they like without consequence.

McCarten doesn't understand what a market is. Markets are, basically, a form of regulation. Markets are an institution that evolved to facilitate trade, that is, they are a set of rules and regulations that make trade between strangers possible and efficient. All markets have rules: what can be traded, how it can be traded, when it can be traded, by whom it can be traded etc. In markets the law of the jungle does not apply, that is what makes a market a market. Trade takes place not robbery.

As to McCarten's point in the first paragraph above, in competitive markets that is what happens. The problems occur when governments step in to prevent this from happening, as when it funds a bail out of firms.

McCarten then get even more bizarre. He writes

Here's how they got themselves into this mess. After the internet bubble burst, the hucksters in these institutions decided that property was the new scam where exorbitant profits could be made.

The new capitalist reward system structures their incomes around the concept of the higher the return for shareholders, the better their bonuses. Recklessness and irresponsibility in the short term made these people millions. They normally exit before they get exposed.

The problem is, it's not just in the US but in most of the Anglo-Saxon world that they're doing it. These financial barons were lending billions and billions of dollars to suspect property deals. When they ran into trouble, they would package them up with other suspect deals and sell them to another bank as an asset.

In the end, all of them were doing it to each other and receiving huge bonuses for making apparent record profits. It seems these packages were fake and weren't worth anything. What brought them down was that they were all doing it to each other.

I notice he does produce any evidence to back up these claims. I guess because there isn't any. The causes of the current situation are many and varied but as pointed out above the biggest factor were actions by government agencies. The Fed, financial regulators, legislators all have questions to answer.

McCarten ends by saying

Our politicians and business leaders need to come clean and admit that free market capitalism doesn't work and never has.

What writers in the Herald on Sunday have to come clean about it that the situation we are dealing with isn't free market capitalism. Capitalism, even in the weak form we know it, has worked better than all known alternatives, including all known forms of socialism. As Tyler Cowen has said of the capitalism, it is

... the economic system that brought about modern America, the Industrial Revolution, and high standards of living around the world.

It has been the most successful anti-poverty weapon we have yet found. As Bill Easterly has written,

Profit-motivated capitalism, on the other hand, has done wonders for poor workers. Self-interested capitalist factory owners buy machines that increase production, and thus profits. Capitalists search for technological breakthroughs that make it possible to get more output for the same amount of input. Working with more machinery and better technology, workers produce more output per hour. In a competitive labor market, the demand for these more productive workers increases, driving up their wages. The steady increase in wages for unskilled labor lifts the workers out of poverty.

The Easterly bottom line,

... profit-motivated capitalism is still the best hope for the poor.

McCarten is so strange that I honestly find it hard to comprehend that he actually believes what he writes. Does anyone believe it?

Termites in the trading system

I have in previous posts supported the government when it successfully negotiated a free trade agreement. Now I'm not so sure. The reason for a possible change of hart is a reading of Jagdish Bhagwati's latest book Termites in the Trading System: How Preferential Agreements Undermine Free Trade.

Bhagwati is University Professor at Columbia University and Senior Fellow in International Economics at the Council on Foreign Relations. He is one of the world's leading trade economists and a long time fighter for free trade - see, for example, his books Free Trade Today and In Defense of Globalization. So when I saw he had written a book arguing that Preferential Trade Agreements (PTAs) are bad for free trade I had to read it. This is relevant for New Zealand since most PTAs are in the form of Free Trade Agreements (FTAs), a number of which New Zealand has signed in recent years.

The standard objection to PTAs, due to Jacob Viner, is simply that they could divert trade from the cost-efficient nonmember countries to the relatively inefficient member countries. The reason, of course, is that the nonmembers continue to pay the pre-PTA tariffs, whereas the higher cost member countries no longer have to. It is obvious that shifting production away from a low cost country towards a high cost country must sabotage the efficient allocation among countries and thus reduce total welfare. This process is known as trade diversion. Viner was the first economist to note the possibility of trade diversion arising with discriminatory reductions in trade barriers via PTAs. But the negative effects of trade diversion can go further. The liberalising country itself may also be hurt. How so? Because when a country (call it the "home" country) shifts to a higher cost within-the-PTA supplier it is buying its imports more expensively, incurring what economists call a "terms of trade" loss. The terms of trade is the ratio of export prices to import prices. As import prices increase the terms of trade decrease which implies that the volume of imports that can be bought with one unit of exports decreases.

Bhagwati notes, however, that

Trade diversion is not a slam-dunk argument against PTAs, for offsetting the loss from trade diversion can be a gain if trade creation takes place. Trade may grow because consumers in the home country now pay lower prices in their own markets; the higher cost supply from the member country is still cheaper than what the domestic consumers had to pay before the PTA was formed. Again, the import competing producers in the home country will reduce their own inefficient production as the domestic price of imports falls after the PTA comes into operation; this also leads to welfare-enhancing trade creation. Therefore, whether a specific trade-diverting PTA brings loss or gain to a country depends on the relative strengths of the trade diversion and trade creation effects. (p. 50)

The important point about trade diversion is that we can no longer assume that it does not matter how we liberalise trade. The use of PTAs is a two-edged sword in which we could end up impaled. It can matter whether we liberalise via bilateral or multilateral agreements.

Bhagwati goes on to argue that proponents of PTAs are too complacent about trade diversion. He considers seven arguments (p.52-7):

1. There is evidence of fierce competition in many products and sectors today, with few managing to escape with "thick" margins of competitive advantage that provide comforting buffers against loss of comparative advantage.Thus, even small tariffs are compatible with trade diversion as tariffs are removed from members of a PTA while they remain in place on nonmembers.
2. The thinness of comparative advantage also implies that today we have what I have called kaleidoscopic comparative advantage, or what in jargon we economists call "knife-edge" comparative advantage. Countries can easily lose comparative advantage to some "close" rivals, who may be from any number of foreign suppliers. So even if preferences today do not lead to trade diversion, the menu of products where you develop comparative advantage in a world of volatility and rapidly shifting comparative advantage will be forever changing, and any given preferences may lead to trade diversion in the near future, if not today.
3. While Article 24 requires that the external tariffs not be raised when the PTA is formed so as not to harm nonmembers, the fact is that they can be raised when the external (MFN) tariffs are bound at higher levels than the actual tariffs. In these cases, a member of the PTA is free to raise the external MFN tariffs up to the bound levels, whereas typically the scheduled tariff reductions in the PTA, when a hegemonic power is involved, will be hard to suspend. This is in fact what happened during the Mexican peso crisis of 1994, when external tariffs were raised on 502 items from 20 percent or less to as much as 35 percent, while the NAFTA defined reductions in Mexican tariffs on U.S. and Canadian goods continued. So the prospect of trade diversion actually increased, despite the intent of those who drafted Article 24.
4. Article 24 freezes only external tariffs when the PTA is formed, with no increase in the external tariff allowed. But it does not address the modern reality that "administered protection" (i.e., antidumping and other actions by the executive) is both elastic and can be used and abused more or less freely in practice. Once you take into account the fact that trade barriers can take the form of antidumping measures, which are arbitrary in their design and protectionist in their practice, there is a real danger that initially welfare-enhancing trade creation can be transformed into harmful trade diversion through antidumping actions taken against nonmembers. Thus, if a member country is gaining a market in the member "home" country, creating trade by replacing inefficient home country production with less inefficient production and imports from another member country, that pressure could be accommodated, not by allowing domestic industry to yield to these imports from a member country, but by discouraging imports from the nonmember countries by using antidumping actions against them. Thus trade-creating imports from member countries could be replaced by trade-diverting restrictions on imports from nonmember countries.
   Such an "endogenous" response of the external trade barriers, typically in the shape of antidumping actions, violates the spirit of Article 24, which explicitly prohibits trade barriers on non-members from being raised but is confined to tariffs and does not extend to "administered protection."
5. There is plenty of evidence that trade diversion can occur through content requirements placed on member countries to establish "origin" so as to qualify for the preferential duties. Thus, typically, to qualify for the preferential tariffs in PTAs that include the United States, one must satisfy requirements such as that the imports of raw materials and components must come from the United States. For example, if apparel exports to the United States are accorded preferential tariffs, they must be made with U.S. textiles. This naturally diverts trade in textiles from efficient nonmember suppliers to inefficient U.S. textile producers.
6. Many analysts do not understand the distinction between trade diversion and trade creation and simply take all trade increase as welfare-enhancing. However, some recent analysts who are familiar with the phenomenon of trade diversion have tried to estimate it using what is called the "gravity model." Dating back some decades, this equation simply explains trade between two countries as a function of income and distance. Adapting this simple equation to their use, the economists Jeffrey Frankel and Shang-Jin Wei, who pioneered the use of gravity analysis to estimate trade creation and trade diversion, estimated total bilateral trade between any pair of countries as a function of their income and per capita incomes, with bilateral distance accounted for by statistical procedures. If the countries belonged to, say, the Western hemisphere and they traded more with each other than with a random pair of countries located outside the region, that would mean that the PTA between countries in the Western hemisphere had led to trade creation. But it is clear that even if one disregards other objections, the real problem with the analysis is that more trade between partners in a PTA can take place with both trade creation and trade diversion, so that one simply cannot infer trade creation alone from this procedure. Hence, the recent estimates based on gravity equation, which are improved variations on the original Frankel-Wei approach and which sometimes (but not always) suggest that PTAs in practice have led to more trade creation than diversion, cannot be treated as reliable guides to the problem of determining whether or not a PTA has led to trade diversion.
7. Several economists have suggested that we need not worry about trade diversion and that beneficial effects will prevail if PTAs are undertaken with "natural trading partners." The initial proponents of this idea, Paul Wonnacott and Mark Lutz, declared, "Trade creation is likely to be great and trade diversion small if the prospective members of an FTA are natural trading partners." One criterion proposed for saying that PTA partners are natural trading partners is the volume of trade already between them; the other is geographic proximity. Neither really works.
   At the outset, note that though some writers, including Paul Krugman and Larry Summers, both heavy hitters, have occasionally argued as if the two criteria go together, they do not. There is no evidence that pairs of contiguous countries or countries with common borders have larger volumes of trade with each other than do pairs that are not so situated, or that trade volumes of pairs of countries arranged by distance: between the countries in the pair will also show distance to be inversely related to trade volumes. This is evident from Table 3.1 [on p.58], which contains destination-related trade volume for major regions in 1980, 1985, and 1990. There are some compelling examples. Chile shares a common border with Argentina, but in 1993 it shipped only 6.2 percent of exports to and received only 5 percent of imports from Argentina. By contrast, the United States does not share a common border with Chile , nor are the two countries close geographically. Yet in 1993, the United States accounted for 16.2 percent of Chilean exports and 24.9 percent of its imports. The volume-of-trade criterion would thus make the United States, not Argentina, Chile's natural trading partner, clearly contradicting the claim that the volume-of-trade criterion translates into the regional criterion, even in a broad-brush sense. The two criteria, and their inappropriateness in ensuring that trade diversion will be minimized and beneficial effects of the PTA guaranteed, must therefore be assessed separately, as immediately below. [This is done on p.57-60.]

The General Agreement on Tariffs and Trade (GATT) was designed to reduce trade barriers via multilateral trade negotiations. Exceptions to the multilateral nature of negotiations had to be explicitly provided for, Article 24 - referred to above - is such an exception for free trade areas and customs unions:

Article 24 --Territorial Application; Frontier Traffic; Customs Unions and Free Trade Areas

Customs unions and free trade ease (FTAs) are exempted from the MFN clause, but such an arrangement must not increase existing levels of trade restrictions affecting nonmember countries. If existing trade barriers are raised to outsiders, compensation may be required. The arrangement must lead to significant liberalization --in particular, it must cover "substantially all" trade between participating countries --and interim arrangements should lead to formation of Ff As or customs unions within a reasonable period of time. Article 24 also provides that, regardless of political status, any area that maintains its own tariffs and commercial regulations may be treated as a contracting party.

Another problem with the ever increasing number of PTAs is the "Spaghetti Bowl" that they give rise to. There are two basic problem here. The first is that when a country enters into a number of FTAs, a given commodity will be subject to different tariff rates if the trajectories of tariff reductions vary across FTAs. This is normally the case. The second issue is the fact that tariffs on specific goods must depend on where a product is supposed to originate which gives rise to inherently arbitrary "rules of origin". Bhagwati writes

With PTAs proliferating, the trading system can then be expected to become chaotic. Crisscrossing PTAs, where a nation had multiple PTAs with other nations, each of which then had its own PTAs with yet other nations, was inevitable. Indeed, if one only mapped the phenomenon, it would remind one of a child scrawling a number of chaotic lines on a sketch pad. (p.61)

Rules of origin are there to determine which product is made by whom. But in this globalised world where multinational firms source components from all around the world trying to determine the origin of a given good is in Bhagwati's description "a mug's game". It is virtually impossible to say which product is whose. This gives rise to endless problems. As Bhagwati explains

There are in fact numerous cases where such questions have led to disputes that come for resolution before arbitration and bilateral dispute settlement panels. In a classic case, the U.S. Customs Service refused to certify Hondas produced in Ontario, Canada, as "North American," and hence eligible for duty-free exports from Canada to the United States, on the grounds that, in its own estimation, Canadian Hondas did not meet the local content requirement of more than 50 percent imposed by the Canada-U.S. Free Trade Agreement (CUFTA). Honda countered that its estimates showed that they did. There is no surefire, analytically respectable way to determine the truth in such a case: it all boils down to who has greater stamina and whether Honda is willing to put moneys into legal costs. (p.68)

Such problems so not arise if there is a multilateral agreement which imposes the same tariff on goods from all countries. Bhagwati quotes Hong Kong businessman Victor Fung, from the Financial Times, on the distortions and costs imposed on business by the spaghetti bowls,

Bilateralism distorts the flow of goods, throws up barriers, creates friction, reduces flexibility and raises prices. In structuring the supply chain, every country of origin rule and every bilateral deal has to be tacked on as an additional consideration, thus constraining companies in optimizing production globally. In each new bilateral agreement, considerations relating to "rules of origin" multiply and become more complex. This phenomenon is what trade experts call the "spaghetti bowl effect." While larger companies have a hard time keeping track, for small groups it is impossible. Bilateral agreements cause the business community to work below its potential. In economic terms, bilateral agreements destroy value. If left unchecked, their continued growth has the potential to hinder the development of the global production system. (p.70)

Additional problems enter the picture when "trade-unrelated" demands are placed on an FTA. Such issues are easier to put in PTAs than multilateral agreements where the possible number of parties who will oppose the move is much greater. Issues such as intellectual property protection, which has more to do with collecting royalties than with trade, is an obvious example. Other examples would be "values-based" demands on things such as labour standards and environmental standards. In many cases demands to harmonise such standards are just a form of protectionism for oneself against foreign rivals.

So the issue of New Zealand's FTAs just got a whole lot more complicated. How we deal with these issues will determine just how beneficial our FTAs turnout to be. If there is anything to the arguments above it would suggest we may need to rethink a position with regard to bilateral v's multilateral trade agreements.

Corruption in Italian soccer

Drawing on records from ‘Calciopoli’, a judicial inquiry into corruption in the Italian soccer league, Tito Boeri and Battista Severgnini have investigated what drives match rigging, including referees’ career concerns, competitive balance and media concentration. In this interview with Romesh Vaitilingam, from VoxEU.org, Severgnini discusses their findings.

More views on the US bailout plan

As Congress and President Bush set to "hammering out the details" of a proposed $700 billion bailout for investment banks, reason magazine asked free-market-friendly economists three pressing questions:

1. How bad is the current market situation?;
2. How bad are the current proposed bailout plans?; and
3. What's the one thing we should be doing that we're not?

The economists asked are Bryan Caplan, Robert E. Wright, Jeffrey A. Miron, Chris Dillow, Frederic Sautet, Mark Thornton, Yves Smith, Robert Higgs and Mike Munger. Their answers are here.

Kling on the bailout

Economist Arnold Kling, founder of Homefair.com, Econlog blogger, and former Freddie Mac employee, talks about the bailout plan over at reason.tv.

Greed, or incentives?

Greed, Or Incentives? This is the question asked by professor of law at the University of Chicago Richard Epstein, in a piece at Forbes.com, about the current financial crisis. Epstein asks two related questions about the current situation,

How did we get to that sorry state where great institutions topple, and what should be done?

He goes on

On both questions, our bipartisan consensus is holding true to form. In a system that is chock-full of heavy regulation, they instantly blame the current collapse on the excesses of the free market, for which a still heavier dose of regulation supplies some supposed cure. That indictment contains few particulars. It typically rests on a populist broadside whose centerpiece is greed on Wall Street, but never on Main Street--where there are more voters.

This prior is all wrong.

Why? First, greed is a constant of human nature. But

Financial meltdowns are not a constant of economic political life. It takes, therefore, an understanding of the overall incentive structure to explain why selfish economic behavior produces great progress on some occasions and financial ruination on others.

On this question, your stalwart libertarian is persona non grata in respectable company. If voluntary markets normally align private incentives with social welfare, then always look first for a government intervention that knocks those incentives off line. It’s not hard to find some culprits.

One bad move has government legislators and courts intervening to slow down mortgage foreclosures because it is socially unacceptable for people to lose their homes. Unpleasant yes, but unacceptable no. [...]

Yet once regulators slow down foreclosures, other potential homeowners are denied opportunities to purchase housing they can afford. The housing stock cannot recirculate. Banks that acquired this mortgage paper see their portfolios nosedive. That dicey paper, as William Isaac noted in last week’s Wall Street Journal, drives the entire economy over the edge by strict government regulations that require all financial institutions to “mark-to-market” the various instruments in their portfolio.

Unfortunately, there is no working market to mark this paper down to. To meet their bond covenants and their capital requirements, these firms have to sell their paper at distress prices that don’t reflect the upbeat fact that the anticipated income streams from this paper might well keep the firm afloat.

Unfortunately, as Epstein notes, one bad regulation leads to another and the bailouts come thick and fast.

At the nth hour, wise heads often rightly conclude that some desperate measure has to be taken to prevent the financial disintegration brought on by, well, prior government regulation. Those bailouts, of course, come from the hides of taxpayers who borrowed prudently. The entire system subsidizes destructive behavior, which means that we will get more destructive behavior in the future. We might as well sell flood insurance at bargain prices in Galveston, Texas, and New Orleans.

The moral of this story is that bad regulation metastasizes. Short term heroics are no substitute for dispassionate deregulation, which won’t happen so long as our political leaders are fixated on greed. Taking steps to prevent financial meltdowns is more likely to hasten their unwelcome arrival, so says the libertarian.

New iPredict stocks

iPredict has two new stocks on offer:

1. Strike.Wgtnbus - pays $1 if Wellington Tramways Union and GO Wellington announce by the end of Monday 29 September that an agreement has been reached. Has launched at $0.50
2. Dunedin.Stadium - pays $1 if construction of a new roofed stadium for Dunedin commences before 1 January 2010. Has launched at $0.50.

EconTalk this week

This week on EconTalk Karol Boudreaux talks about wildlife, property, and poverty in Africa. Boudreaux, Senior Research Fellow at the Mercatus Center at George Mason University, talks with EconTalk host Russ Roberts about wildlife management in Africa. Their conversation focuses on community-based wildlife management in Namibia, a policy to give communities the incentives to protect wildlife and avoid the tragedy of the commons.

Posner on the financial crisis

In a number of previous posting I have noted that many commentators hold agencies of the government largely responsible for the current financial crisis. But not all commentators do. One person who does not is, perhaps surprisingly, Richard Posner.

In an essay, The Financial Crisis: the Role of Government, at the Becker-Posner Blog, Posner argues that the current crisis is not the result of government actions. He writes

I do not think that the government does bear much responsibility for the crisis. I fear that the responsibility falls almost entirely on the private sector. The people running financial institutions, along with financial analysts, academics, and other knowledgeable insiders, believed incorrectly (or accepted the beliefs of others) that by means of highly complex financial instruments they could greatly reduce the risk of borrowing and by doing so increase leverage (the ratio of debt to equity). Leverage enables greatly increased profits in a rising market, especially when interest rates are low, as they were in the early 2000s as a result of a global surplus of capital. The mistake was to think that if the market for housing and other assets weakened (not that that was expected to happen), the lenders would be adequately protected against the downside of the risk that their heavy borrowing had created. The crisis erupted when, because of the complexity of the financial instruments that were supposed to limit risk, the financial industry could not determine how much risk it was facing and creditors panicked. Compensation schemes that tie executive compensation to the stock prices of the executives' companies but cushion them against a decline in those prices (as when executives are offered generous severance pay or stock options are repriced following the fall of the stock price) further encouraged risk taking. Moreover, even when businesses sense that they are riding a bubble, they are reluctant to get off while the bubble is still expanding, since by doing so they may be leaving a lot of money on the table. Finally, if a firm's competitors are taking big risks and as a result making huge profits in a rising market, a firm is reluctant to adopt a safe strategy. For that would require convincing skeptical shareholders and analysts that the firm's below-average profits, resulting from its conservative strategy, were really above-average in a long-run perspective.

When discussing the government's responses to the crisis Posner says,

But here is a remarkable thing about these responses. To a great extent they are not responses by government, really, but by the private sector. Bernanke and Paulson are neither politicians nor civil servants; Bernanke is an economics professor and Paulson an investment banker. Their principal advisers are investment bankers rather than Fed and Treasury employees. Even the prohibition of short selling, which seems like a product of the kind of mindless hostility to speculation that one expects from politicians, has been strongly urged by Wall Streeters, including the CEO of Morgan Stanley. The White House, the Congress, and even the SEC have been only bit players in the response to the crisis. In effect, the government's power to repair the crisis that Wall Street created has been delegated to Wall Street.

Posner ends his article by saying

I do not criticize the delegation of the handling of the crisis to (in effect) the finance industry. I imagine that Bernanke and Paulson and their private-sector advisers are the ablest crisis managers whom one could find. I merely want to emphasize that the financial crisis is indeed a "crisis of capitalism" rather than a failure of government, though it will not and should not lead to the displacement of free-market capitalism by an alternative system of economic management. But it is already shifting the boundary between the free market and the government toward the latter.

I still find myself with questions as to the actions of the financial regulators and central banks. As Arnold Kling has noted

Government regulators can be faulted for two things. First, they enabled the private sector delusions. Regulators did not sound warnings about credit scoring, and they issued only minor scolding on derivatives.

Second, government operated under the delusion that low-down-payment mortgages are a good thing. I have coined the expression "home borrower" to describe someone who puts little or nothing down to buy a home. Government encouraged home borrowing, and that made the bubble inflate higher on the way up and crash harder on the way down.

Along with this it should be noted that the central bankers could have popped the property bubble before it grew too big. But they didn't. Also there were the incentives created by legislation. The 'anti-redlining' laws, for example. Such regulations set out to stop lenders refusing loans to people who happened to live in a poor part of town. That gave millions of poor people access to home loans – but at the expense of the institutions taking on riskier customers. Then there was the implicit government guarantee on Fannie Mae and Freddie Mac. Seemingly insulated from all harm, they became reckless - an example of moral hazard. They constructed a giant pyramid of debt on a very small base of capital. So I feel Posner maybe underestimating the responsibility of the government for the crisis we now face.

The moral hazard of governemnt actions

Moral hazard is a term that come from the insurance literature where it meant the change in behaviour that occurred because the a person had insurance. A person with insurance is more likely to act carelessly than a person without insurance. For example, a person who insures their car against theft is more likely not to worry if the car is locked when they leave it than someone without theft insurance. This is simply because the insured person does not bear the full costs of their actions. The insurance company compensates them for some of the loss. While the idea of moral hazard may have originated with insurance it soon became clear that the idea applied in many other settings, including financial markets.

In a recent posting at the Becker-Posner Blog, Gary Becker discusses, among other things, some of the moral hazard problems that arise from the recent actions taken by the US Treasury and the Fed in an effort to deal with the current financial problems. Becker writes

Future moral hazards created by these actions are certainly worrisome. On the one hand, the equity of stockholders and of management in Fannie and Freddie, Bears Stern, AIG, and Lehman Brothers have been almost completely wiped out, so they were not spared major losses. On the other hand, that makes it difficult to raise additional equity for companies in trouble because suppliers of equity would expect their capital to be wiped out in any future forced governmental assistance program. Furthermore, that bondholders in Bears Stern and these other companies were almost completely protected implies that future financing will be biased toward bonds and away from equities since bondholders will expect protections against governmental responses to future adversities that are not available to equity participants. Although the government was apparently concerned that foreign central banks were major holders of the bonds of the Freddies, I believe it was unwise to give them and other bondholders such full protection.

The full insurance of money market funds at investment banks also raises serious moral hazard risks. Since such insurance is unlikely to be just temporary, these banks will have an incentive to take greater risks in their investments because their short-term liabilities in money market funds of depositors would have complete governmental protection. This type of protection was a major factor in the savings and loan crisis, and it could be of even greater significance in the much larger investment banking sector.

The whole Becker piece, The Crisis of Global Capitalism?, is worth reading.

Central bankers: have they killed capitalism?

Over at MoneyWeek John Stepek looks at the current financial crisis and asks Is this the death of capitalism?

One important question he asks is Who's really to blame for this crisis? The short answer, in his view, is central banks. He writes,

This crisis has its roots in the actions of central banks. I think it's important to make this point very clear right now. George Bush might say there'll be plenty of time for "blame-storming" later. But funnily enough, once 'later' comes around, no one can quite remember who really was to blame, and the government ends up getting to point the finger at whoever it likes – usually the media

Stepek argues that the central bankers should have popped the property bubble before it grew too big. But they didn't.

There was a rampant property bubble. The world's central bankers should have popped it before it grew too big. They didn't (although Mervyn King clearly thought that it would have been a good idea), mainly because Alan Greenspan put his hands over his eyes and said he couldn't see any bubble. He also added that, even if there was one, it would be better to clear up the mess after it had popped. It was obviously nonsense at the time, and by now hopefully everyone realises that.

Because instead of pricking it at a time when the fallout was manageable, we let it grow until harsh reality finally had to step in. Things grew so crazy that the long-term unemployed in the US were being given hundreds of thousands of dollars to buy homes on which they didn't make a single payment. This bubble stopped growing simply because it ran out of room. It just couldn't get any bigger.

Some of you might think it's too simplistic to blame central banks. But think about it for a minute. The first instinctive call of every columnist, estate agent, and business leader in the land, as they realised recession was coming, was to scream for a rate cut. That's a dramatic display of faith in the idea that whatever the problem, a quick wave of the Bank of England's magic wand would make it go away. Even now, some are still labouring under this misapprehension, even though the Fed has amply demonstrated that even slashing rates by more than half has done nothing to ease this crisis.

Because everyone thought that central banks would always be willing and able to save the economy – and the financial services industry – lenders thought they could get away with murder. All the risk ultimately lay with the government, after all. And if you take away the risk, people then do whatever they like without fear of consequences – particularly if regulators have adopted an otherwise hands-off approach.

The next question to ask is What is the solution to this?

Ideally, I'd say just ditch central banks and let the market set interest rates. Central banks, regardless of how ostensibly independent they are, are instruments of the government. The government wants happy voters, and free money makes people happy. So there's always the temptation to keep the money flowing freely.

The market on the other hand, couldn't care less what voters think. One feature of the credit boom is that most people in the City and on Wall Street knew it couldn't last forever, and they had a hunch it would blow up in a very unpleasant way. But they couldn't stop playing along, because they had to compete with their peers. However, if markets set interest rates rather than governments, then arguably this mood of rising concern among the participants, would be reflected in the price of money long before things got out of hand. Anyone who had overplayed their hands would run into trouble long before they became "too big to fail".

What is the alternative to the market?

The alternative is that we decide that banking is such a vital part of our infrastructure, that it cannot be left to the market. And if it really is the case that "banking is too important to be left to the bankers," as Roger Bootle argues in today's Telegraph, then there's no choice. We have to turn it into a utility. And just like with the water and power regulators, we need a big domineering regulator, who tells them how much profit they can make and how much they can charge us, and in return we get a government-backed banking system.

But what is likely to happen? One would suspect that by the end of all of this, we'll end up with some half-hearted mish-mash which will do little more than simply sow the seeds for the next crisis.

Field experiments in economics

Additions to the economists' tool kit over recent times have included prediction markets, laboratory experiments and field experiments. In a new NBER working paper Steven D. Levitt and John A. List take a look at Field Experiments in Economics: The Past, The Present, and The Future.

The abstract reads,

This study presents an overview of modern field experiments and their usage in economics. Our discussion focuses on three distinct periods of field experimentation that have influenced the economics literature. The first might well be thought of as the dawn of "field" experimentation: the work of Neyman and Fisher, who laid the experimental foundation in the 1920s and 1930s by conceptualizing randomization as an instrument to achieve identification via experimentation with agricultural plots. The second, the large-scale social experiments conducted by government agencies in the mid-twentieth century, moved the exploration from plots of land to groups of individuals. More recently, the nature and range of field experiments has expanded, with a diverse set of controlled experiments being completed outside of the typical laboratory environment. With this growth, the number and types of questions that can be explored using field experiments has grown tremendously. After discussing these three distinct phases, we speculate on the future of field experimental methods, a future that we envision including a strong collaborative effort with outside parties, most importantly private entities.

An interesting overview for anyone interested in the area.

Combinatorial prediction markets by Robin Hanson

Several hundred organizations are now using prediction markets to forecast sales, project completion dates, and more. This number has been doubling annually for several years. Most, however, are simple prediction markets, with one market per number forecast, and several traders per market. In contrast, a single combinatorial prediction market lets a few traders manage an entire combinatorial space of forecasts. For millions of numbers or less, implementation is easy, and lab experiments have confirmed feasibility and accuracy. For larger spaces, however, many open computational problems remain.

In this video, which is part of the Pascal Lecture Series at VideoLectures.Net, Robin Hanson of the Department of Economics at George Mason University discusses Combinatorial Prediction Markets.

(HT: Eric Crampton)

Another view on the Paulson plan (updated x2)

Over at VoxEU.org Charles Wyplosz explains why Why Paulson is (maybe) right. Wyplosz writes,

The world’s bankers created a reckless mix of lending and securitisation that exploded in their faces last year; they’ve stonewalled since. It would be criminal to bail them out, but spilling blood for its own sake is foolish.

Wyplosz explains how the so-called "Paulson Package", which amounts to history's largest bet, just might work and might not cost taxpayers too much. It's too early to know which label to apply: "bailout" or "shrewd cleansing operation".

Wyplosz explains the situation as

Even though many serious economists (the likes of Robert Shiller and Nouriel Roubini) had warned for years – not months – that the credit boom and the housing price bubble would end up in tears, bankers superbly closed their ears and soldiered on, driven by greed and short-term analyses. When the mix of reckless lending and securitisation exploded in their faces, more than one year ago, they stonewalled and drove the economy down in the hope of being bailed out. It would be criminal to bail them out. It would guarantee even worse crises in the future. Conclusion, there must be blood.

This being said, spilling blood for the sake of it is a bit silly. Banks are not oil companies. When an oil company goes bust, by definition, it is because its liabilities exceed its assets. After bankruptcy, its assets remain as valuable as before. Oil is safely tucked away under ground, refineries and gas stations stay put above ground.

A bank goes bust when its assets have collapsed. Bankruptcy means that its liabilities collapse too and these are assets of other banks and of millions of hapless citizens. This is why contagion and bank runs occur more frequently than oil runs. Sure, with patience, both assets and liabilities can regain value, but in the meantime the financial system is impaired and the resulting credit crunch provokes an economic crisis that spares no one. This is why large, systemic financial institutions cannot be summarily dispatched to receivership. Avoiding a credit crunch ought to be every one’s priority.

As to the Paulson plan he writes

The details of the plan are not known yet, so it is too early to determine whether it is a bailout or more blood. All will depend on two things. The price at which the assets will be acquired by the yet unnamed RTC, and the price at which the RTC will dispose of these assets.

Indications are that these assets will be bought at auctions. These will have to be reverse auctions, probably of the Dutch variety. If the sellers are confident in their financial health, or just smart enough to collectively bluff Paulson, the price will be close to the purchase price and it will be a bailout. If the sellers are scared and unable to organise themselves, the price will be a deep discount. Willem Buiter argues that the auctions are likely to force the sellers to reveal their true reservation price and I tend to agree.

Assume that the toxic assets will be acquired at a deep discount and thus the RTC will hold a huge portfolio of these assets. But it will be in no rush to sell them?

Like the previous RTC, thanks to taxpayers’ money, it can take years to do so. If the toxic assets gain some value, the RTC and the taxpayers will make a profit and the financial institutions that sold them will definitely not have been bailed out. We will be able to call the operation a bailout only if toxic-asset prices go on falling, since it will then be established that the financial institutions managed to sell these assets above market price and at taxpayer’s expense.

Wyplosz's conclusion,

It is therefore much too early to call the operation a bailout or a shrewd cleansing operation. Judgment will have to wait until the yet-to-be-created RTC is folded, several years from now. Meanwhile, for the first time since mid-2007, we can foresee the beginning of the end of the crisis since the financial institutions will have either to promptly recapitalise or fold. This, in my view, justifies Paulson’s bet, probably history’s biggest ever.

For more commentary on the financial situation here's a list from Greg Mankiw,

1. Roger Lowenstein
2. Charlie Calomiris and Peter Wallison
3. Barry Eichengreen
4. Larry Lindsey
5. Thomas Sowell
6. Robert Samuelson
7. Anil Kashyap and Jeremy Stein
8. Martin Baily and Robert Litan

Update: The The visible hand in economics asks Is the US taxpayer being forced to surrender to Wall Street?

Update 2: More commentary on the financial situation, again from Greg Mankiw,

1. Lucian Bebchuk
2. Steven Landsburg
3. Anne Krueger
4. Glenn Hubbard, Hal Scott, and Luigi Zingales
5. Richard Epstein
6. Sebastian Mallaby
7. Robert Samuelson
8. Nouriel Roubini

Economists always disagree? (updated)

Common ground amongst economists seems to be developing against the Paulson plan to deal with current financial crisis. This is the text of an open letter to Congressional leaders:

As economists, we want to express to Congress our great concern for the plan proposed by Treasury Secretary Paulson to deal with the financial crisis. We are well aware of the difficulty of the current financial situation and we agree with the need for bold action to ensure that the financial system continues to function. We see three fatal pitfalls in the currently proposed plan:

1) Its fairness. The plan is a subsidy to investors at taxpayers’ expense. Investors who took risks to earn profits must also bear the losses. Not every business failure carries systemic risk. The government can ensure a well-functioning financial industry, able to make new loans to creditworthy borrowers, without bailing out particular investors and institutions whose choices proved unwise.

2) Its ambiguity. Neither the mission of the new agency nor its oversight are clear. If taxpayers are to buy illiquid and opaque assets from troubled sellers, the terms, occasions, and methods of such purchases must be crystal clear ahead of time and carefully monitored afterwards.

3) Its long-term effects. If the plan is enacted, its effects will be with us for a generation. For all their recent troubles, Americas dynamic and innovative private capital markets have brought the nation unparalleled prosperity. Fundamentally weakening those markets in order to calm short-run disruptions is desperately short-sighted.

For these reasons we ask Congress not to rush, to hold appropriate hearings, and to carefully consider the right course of action, and to wisely determine the future of the financial industry and the U.S. economy for years to come.

And it's signed by some serious people.

Update: At Marginal Revolution Alex Tabarrok writes "An excellent Open Letter on the Bailout signed by many economists." At Freakonomics Justin Wolfers comments on Economists on the Bailout. Wolfers writes "Why do I call this the consensus view? Well, the letter was signed by over 100 (and growing!) of the leading economists I know — including folks who have very different views about just what got us here — who vote left, right, overseas, or not at all."

Interesting blog bits

1. The visible hand in economics on PSA: Just more misleading statistics.
2. Barry Eichengreen on Anatomy of the financial crisis.

   The crisis solution depends upon its causes. Here one of the world’s leading international macroeconomists explains how the world got into this mess.

3. Greg Mankiw on More Capital for the Financial System
4. Lans Bovenberg and Herman Vollebergh on Auction greenhouse emission rights with targeted compensation.

   The EU plans to auction permits for the next phase of emissions trading, rather than giving them away for free as in the past. This column explains why the new scheme is a significantly better policy and proposes compensation measures to redress the complaints of industries opposed to the new climate change policy. Harmonised EU action may be required.

5. Arnold Kling on Delusions on Both Sides.
6. Carpe Diem on the fact that in the Great Depression: Not A Single Canadian Bank Failed.
7. Radley Balko on U.S. Government Veers Away From Capitalism.
8. The visible hand in economics asks Is free trade solely of benefit to farmers/exporters?

Steel/money policy

When thinking about the current financial turmoil Don Boudreaux points out, as only he can, that it is a Good Thing We Have No 'Steel Policy'.

Suppose Uncle Sam were the monopoly supplier of steel in the same way that he is the monopoly supplier of money. A (largely) independent board of Very Smart People meets monthly to determine the nation's steel supply. If this board gets matters correct, the resulting price of steel prompts producers and consumers to use steel wisely. But if the board guesses wrongly and, say, increases the steel supply too much, the market will overuse steel. Products that would have been better made with aluminum or plastic, or not made at all, will instead be made with steel. And production plans made in anticipation of a continuing 'easy steel' policy will be disrupted if the board changes course.

Unless this steel board gets things right with superhuman regularity, the structure of the economy will be become grossly distorted over time. In addition, producers and investors will be forever anxious about upcoming decisions of the steel board.

We avoid this fate because steel is supplied by markets, with competitive producers and consumers adjusting daily to new information about changing opportunities and costs of using and manufacturing steel. No one worries about getting the steel supply right, for markets do that job remarkably well.

Unfortunately, the same isn't true for money. Its supply is determined consciously by a board. Unable to know and adjust to changes in people's demand for money - and subject always to political pressures to grease the economy with the snake oil of easy money - the Federal Reserve distorts the economy with its inevitably mistaken decisions on the supply of money. Asset bubbles are part of the price we pay for this primitive way of supplying money.

What's the alternative? Free banking of course. Markets can supply money in just the same way as they supply steel, and experience, see for example Scotland and Canada in the 19th century, shows that they will in fact do so when given the opportunity.

New iPredict stocks

iPredict has three new stocks on offer:

1. Benson.Pope - will pay out $1 if David Benson-Pope stands as a non Labour candidate in the 2008 general election. Has launched at 80 cents.
2. US.Obama08 - will pay out of $1 if Obama is elected President. Will be launched at 49.5 cents.
3. US.McCain08 - will pay out of $1 if McCain is elected President. Will be launched at 49.5 cents.

Numbers 2 and 3 will launch at 6pm tonight.

Selfishness as a good thing

At the Economic Logic blog they are discussing a paper by Ernst Fehr, Karla Hoff and Mayuresh Kshetramade on Spite and Development. The Economic Logician writes,

In a recent article, Ernst Fehr, Karla Hoff and Mayuresh Kshetramade give an example of a situation where society would be better off if people were selfish: spiteful preferences. This happens when somebody desires to reduce another's payoff only to increase one's relative payoff, and doing so hurts oneself. Society would be better off if this person would just be selfish and not commit such acts of spite.

Two points here: first, we need to define what selfishness is. If it maximizing private utility, then if it is relative outcome that are relevant to one's preferences, then this is what we ought to accept as utility. Where it become problematic for society is if such preferences are widespread and people enter into spite tournaments and mutually hurt each other. But even if there is only one spiteful person, his actions exert a negative externality onto others that needs to be redressed.

Second, how widespread is such behavior? The authors of the article argue it is more widespread than you may think. They conducted experiments in India with a game where cooperation is a Nash equilibrium. They find that between 61 and 73 percent of players punish cooperators, and this is more prevalent among higher castes.

If this turns out to be right it can't be good news for development. If people are willing to hurt themselves to prevent others from beoming richer then everyone ends up staying poor.

Lessons on trade, protectionism, and mercantilism

Gene Callahan has a nice story about effects of trade, protectionism, and mercantilism at the Mises.org website. See The Nation That Lost Its Jobs, But Got Them Back.

(HT: Carpe Diem)

Reform of the Common Agricultural Policy

At the Adam Smith Institute Blog Tim Worstall gives us his personal view of how reform of the EU's Common Agricultural Policy should take place,

As a purely personal opinion reform of the Common Agricultural Policy should be achieved by burning the entire structure to the ground and ploughing the intellectual landscape that produced it with salt: the selling of the administering population into bondage would perhaps be a step too far in this age.

Let us not be too hasty. This idea has much to recommend it. In fact we could extend it to include many more (all?) bureaucrats.

The value of political connections

In highly politicised economies, where government intervention is common place and many areas of the economy are tightly regulated, rents are unavoidably created, and political connections are an important element of any effort to capture a part of these rents. Thus firms wishing to prosper will develop close connections to the government and its bureaucracy. Heavily interventionist governments are able to favour well connected firms via the granting of contracts, import licences, loans on favourable terms, access to production inputs or in some other way such as privileged access to foreign exchange. In non-politicised, free market economies political connections are worth a lot less because government interventions are minimal and thus the available rents are minimal.

For the case of Nazi Germany, a recent article at VoxEU.org shows just how much more valuable where politically connected firms. Hans-Joachim Voth discusses the value added of political connections in his column, Paying the piper, reaping the returns.

He starts by considering how to define what being "connected" to the Nazis means. He writes

Earlier academic work had focused mainly on the actions of managers. We broadened our definition of “connection”, by also analysing supervisory board members. Boards were particularly important in German public companies. Banks, for example, exercised power over affiliated companies through seats on supervisory boards. Any knowledgeable observer of the German corporate scene would have examined board composition to assess the political and economic positioning of a firm. An essential part of the work was to pin down supervisory board membership at the time of the takeover, which we did by analysing contemporary German sources.

In total, we found that 119 firms had connections with the Nazi party prior to January 1933. We counted leading businessmen as connected if they did one of three things:

1. contributed funds to the Nazi party;
2. signed an appeal in the fall of 1932, directed to the German President Paul von Hindenburg, to make Hitler chancellor;
3. contributed to two organisations designed to ’teach the Nazis economics’ – the Keppler Kreis and the Arbeitsstelle Schacht.

One question I have here is, over what period did these connections develop? Also how did the connectedness of the businesses change, if at all, between the Hitler government and those which went before? Business, in particular large businesses, are likely to want to be close to any government. Were businesses "connected" to multiple parties at this time?

To measure the value of political connections Voth and Thomas Ferguson

... decided to look at what the financial markets saw when the Nazi party suddenly came to power (Ferguson and Voth 2005). Instead of having to assess the importance of every interaction between individuals, stock markets have the beauty that people have to put their money where their belief is. If the Nazi party’s rise to power made a big difference to the value of a firm that had given early support to the party, chances are that these contacts mattered.

Voth outlines their method of measuring performance as,

To measure performance, we collected the monthly stock price of 789 firms listed on the Berlin stock exchange. Prices were collected for the 10th of every month, from the day the exchanges opened again after the financial crisis of 1931 to May 1933.

We also collected information on the sector in which firms operated, the dividends they paid, their capital structure, and the overall market capitalisation. We defined 10 January 1933 as the last date before some investors may have suspected that the Nazi party might enter office. Some important meetings had already taken place by this date, but very few would have confidently predicted that on January 30th, Adolf Hitler would be German chancellor. As late as December 31st, many journalists who wrote “the year in review” columns had predicted that the Nazi wave had reached the high-water mark and would be receding.

So, just how big was the Nazi premium? Voth writes

Firms connected with the Nazi party outperformed unaffiliated firms massively. Their share prices rose by 7.2% between January and March 1933 (43% annualised), compared to 0.2% (1.2% annualised) for unaffiliated firms. The politically induced change was equivalent to 5.8% of total market capitalisation. This is a high number by international standards. Johnson and Mitton (2003) estimate that revaluation of political connections in Malaysia during the East Asian crisis wiped 5.8% of share values. While comparable in magnitude, it took 12 months for this change to occur.

Affiliated firms did better, no matter their mode of connection with the party. The return differential favouring connected firms existed for both small and large firms, for firms in nine out of eleven sectors, and for those with high and low dividend yields. We also examined if expected rearmament was to blame for the value of connections, using lists of potential defence contractors compiled by the German armed forces (Hansen 1978). Our finding persists.

One thing Ferguson and Voth can't explain is why connections paid so well. Voth wrties

Around the globe, politically connected firms are more valuable (Faccio 2006). Nazi Germany was no different, but the sheer magnitude of the connection premium is astounding. Why did early connections with the party pay off as handsomely as they did? We do not know if loyalty was rewarded with additional contracts, loans on favourable terms, or in some other way such as privileged access to foreign exchange.

One interesting point Voth does make is,

What is clear is that not enough firms sought to affiliate with the Nazis prior to January 1933 to drive the expected benefit – as seen by stock market investors – down to zero. This means that either many firms expected the benefits from association to be low (the Nazi party’s rise to power may have been a genuine surprise), or that they would not contemplate giving support for a variety of political reasons.

All this suggests that the stock market in Nazi Germany realised the value of political connections to the Nazi Party. Firms which "bet on Hitler" did well. I wonder if what this tells us is that investors expected a very interventionist government with an associated high level of rents becoming available and that those firms closely associated with the Nazi Party where more valuable simply because they were in a better position to expropriate those rents.

• Ferguson, Thomas and Hans-Joachim Voth, “Betting on Hitler – The Value of Political Connections in Nazi Germany,” April 2005, CEPR Discussion Paper 5021, and Quarterly Journal of Economics123 (1) (2008), 101-137.
• Hansen, Ernst Willi, Reichswehr und Industrie: Rüstungswirtschaftliche Zusammenarbeit und wirtschaftliche Mobilmachungsvorbereitungen 1923–1932 (Boppard am Rhein: Boldt, 1978)
• Johnson, Simon, and Todd Mitton, “Cronyism and Capital Controls: Evidence from Malaysia,” Journal of Financial Economics, 67 (2) (2003), 351–382.

Is Paulson wrong? (updated x2)

The short answer is yes, at least according to Luigi Zingales, the Robert C. McCormack Professor of Entrepreneurship and Finance at the Graduate School of Business in the University of Chicago. Over at Marginal Revolution, Tyler Cowen points us to this piece, Why Paulson is wrong?, by Zingales. Zingales writes

The decisions that will be made this weekend matter not just to the prospects of the U.S. economy in the year to come; they will shape the type of capitalism we will live in for the next fifty years. Do we want to live in a system where profits are private, but losses are socialized? Where taxpayer money is used to prop up failed firms? Or do we want to live in a system where people are held responsible for their decisions, where imprudent behavior is penalized and prudent behavior rewarded? For somebody like me who believes strongly in the free market system, the most serious risk of the current situation is that the interest of few financiers will undermine the fundamental workings of the capitalist system. The time has come to save capitalism from the capitalists.

His way of dealing with the current problems?

As during the Great Depression and in many debt restructurings, it makes sense in the current contingency to mandate a partial debt forgiveness or a debt-for-equity swap in the financial sector. It has the benefit of being a well-tested strategy in the private sector and it leaves the taxpayers out of the picture. But if it is so simple, why no expert has mentioned it?

The major players in the financial sector do not like it. It is much more appealing for the financial industry to be bailed out at taxpayers’ expense than to bear their share of pain. Forcing a debt-for-equity swap or a debt forgiveness would be no greater a violation of private property rights than a massive bailout, but it faces much stronger political opposition. The appeal of the Paulson solution is that it taxes the many and benefits the few.

Update: A copy of the Zingales article is now available at VoxEU.org.

Update 2: Others think that Paulson is wrong as well. Mike Mandel summarises for Business Week's Economics Unbound blog.

Civil war in poor countries

Torsten Persson, director of the Institute for International Economic Studies in Stockholm, talks with Romesh Vaitilingam, in an audio from VoxEU.org, about his research, preliminary findings of which suggest that rising commodity prices increase the chances of civil war breaking out in poor countries.

The return to education

Something that is obvious to us all is that a good deal of the direct cost of education is in many countries subsidised by governments. The question is why. A standard answer to that question is that education generates external returns for society. A new column at VoxEU.org argues that there is in fact little evidence of such returns. If there are reasons to subsidise education, they don't include economic externalities.

Steven Yamarik begins his column, entitled What does state-level data tell us about the social value of education? by noting that

The most commonly-cited economic rationale for public investment in education is positive productivity spillovers from education. The individual student attends school in order to raise his or her earnings potential and possibly to directly increase his or her current utility. The increase in individual earnings due to educational attainment is called the private return to schooling. However, the knowledge gained by an individual can spread or "spillover" to others and thus increase aggregate productivity. The increase in income generated from the spillover is called the external return, while the sum of the private and external returns is the social return to schooling.

Since at least the work of James Heckman and Peter Klenow, one approach used to determine the size of the human capital externality is to compare the estimates of the private and social return to schooling. Yamarik explains,

Mincerian wage equations at different levels of aggregation can be used to estimate the two returns to schooling. At the microeconomic level, the Mincerian wage equation predicts that the log of earnings depends positively upon years of schooling, labour force experience, and experience squared. The coefficient in front of years of schooling is interpreted as the private return to schooling. At the macroeconomic level, the macro-Mincerian equation predicts that the log of aggregate income is positively related to physical capital, average years of schooling, and average labour force experience. By aggregating individual characteristics, the macro-Mincerian equation can capture externalities associated with schooling and thus provide estimates of the social return to schooling. Lastly, by including both individual and macroeconomic factors, the augmented micro-Mincerian equation can uniquely identify the private return to schooling and the external return to schooling. The sum of the two is the estimate for the social return to schooling.

Yamarik argues that data from the states of the US provide an opportune laboratory for testing for externalities in schooling. He notes three positives for the use of this data,

First, the educational structure and curriculum are more similar across US states than across countries. Second, state-level and individual schooling data are uniformly collected by the federal government. Third, US states share similar institutional and political backgrounds, while countries do not. As a result, state-level estimates of the return to schooling are less likely to suffer from bias introduced by measurement error, omitted variables, and parameter heterogeneity.

His summary of the results of recent work is,

Labour economists have estimated the micro-Mincerian wage equation using different time periods, samples, and econometric techniques. For the US, the private return to schooling ranges from 4% to 16% with a consensus estimate around 10%.

The recent construction of state-level physical and human capital stock data has provided the opportunity to apply the macro-Mincerian model to US states. Chad Turner and his co-authors estimated a social return of 12% to 15%, while I estimated a slightly lower social return of 9% to 13%. The closeness of the estimates of the social return to the private return suggests that US schooling generates little to no external return.

Researchers using the augmented micro-Mincerian equation find little evidence for the presence of external returns. These researchers match individual earnings and education data to city-level or state-level characteristics. An early study by James Rauch estimated an external return of 3% to 5%. However, more recent work by Daron Acemoglu and Joshua Angrist, Jeremy Rudd, Antonio Ciccone and Giovanni Peri, and Fabian Lange and Robert Topel find no statistically significant external return.

The conclusion that follows from this is not governments should automatically stop subsidising education but that the reasons for any subsidy must be the non-pecuniary externalities that can be generated from schooling. In Yamarik view there are three such externalities,

First, increased knowledge can make a person more interesting (and even more attractive) and thus raise the utility of others. Second, Lance Lochner and Enrico Moretti show that schooling reduces criminal activity and generates a substantial social effect. Third, Milton Friedman has argued that education enables individuals to participate more efficiently in the political process.

Some economic journalism is just bad

The following comes from a NZPA report, NZ current account deficit worsens, found on the Yahoo!Xtra website. The reports says,

New Zealand's current account deficit worsened to $3.91 billion in the June quarter, Statistics New Zealand (SNZ) said today.

Worsened? This seems to imply that the deficit is a bad thing, why? Another way of saying exactly the same thing is to say, "The surplus on the capital account just got larger", what is bad about that?

The report goes on

The current account, also known as the balance of payments, measures all of New Zealand's transactions with the outside world.

Wrong! The current account is NOT also known as the balance of payments. The current account is part of the balance of payments. The BoP can not be in deficit or surplus as it is by construction always zero. The surplus/deficit on the current account is offset by the deficit/surplus on the capital account.

I do wish someone would teach journalists in this country some very basic economics.