Value of KiwiRail (updated)

This news story tells us that

The value of KiwiRail - a central plank in Labour's election billboards - has taken a $242 million knock just three months after it was bought.

This to me raises two questions; one general, one specific.

The general question has to do with Why does the government own a asset like KiwiRail at all? What should a government own and what shouldn't it own. When is privatisation efficient, when is nationalisation efficient? The specific is, Why has KiwiRail lost so much value so quickly?

As to the second question I really have not idea, other than this is the true value of the firm and the government just paid too much for it. This does not mean that government is ownership is bad as such, it may just mean the government negotiated a bad deal. The first point is relevant to the, is government ownership good or bad question.

On this first point, as a general guide, Hart, Shleifer and Vishny ("The Proper Scope of Government: Theory and an Application to Prisons", Quarterly Journal of Economics, 112(4): 1127-61, November 1997) argue that the case for government provision of goods or services is generally stronger when non-contractible cost reductions have large deleterious effects on quality, when quality innovations are unimportant and when corruption in government procurement is a severe problem. It has been argued that the case for government production is strong in such services as the conduct of foreign policy, police and armed forces. The case can also be made reasonably persuasively for the case of prisons. The case for private sector provision is stronger when quality reducing cost reduction can be controlled through contract or competition, when quality innovations are important and when patronage and powerful unions are a severe problem inside the government.

Its not clear that the government's interventions have been in areas where the Hart, Shleifer and Vishny arguments would suggest the government should be involved. Rail or banking, for example, are not a areas where cost reduction come at the expense of quality, where innovation is unimportant or where there are any problem with government procurement. So why have the government owning KiwiRail or Kiwibank? Also government involvement in Air New Zealand is hard to justify on these grounds. As noted above, the case for private sector provision is stronger when quality reducing cost reduction can be controlled through competition, and the airline industry is very competitive, when quality innovations are important, and we want a high quality and innovative airline industry, and when patronage and powerful unions are a severe problem inside the government, which are things we wish to avoid with an airline. Here private provision makes sense.

The Hart, Shleifer and Vishny argument applies to contracting out as well as outright privatisation. A question that arises therefore is, Why would private ownership ever be more efficient than public? As to why private provision is superior, there are two results that need to be explained. Williamson's well known idea of selective intervention and the Fundamental Theorem of Privatization by Sappington and Stiglitz. (Sappington, David E. M. and Stiglitz, Joseph E. (1987). 'Privatization, Information and Incentives'. Journal of Policy Analysis and Management, 6(4): 567-82.) These tell us that there should be no differences in efficiency between a privatised and a nationalised firm. Thus any explanation of the relative efficiency between the two must explain why these ideas cannot be applied.

The first notion, of selective intervention, argues that the government can reach the same level of productive efficiency as the private sector by mimicking the private owner. If the government organises the firm in exactly the same way as a private owner would, if it gives the same incentive schemes to managers and workers, and if it deviates from such a policy only if there is the possibility of doing something strictly better than a private owner, then a nationalised firm should produce at least as efficiently as a privatised one. Think about what the SOE model was all about.

The second idea is concerned with allocative efficiency and says that a public firm will choose a socially more efficient production level because the government cases about social welfare and internalizes externalities, whereas a private owners just maximizes private profits. However, this argument implicitly assumes that the government cannot regulate the firm. Sappington and Stiglitz suggest a privatization and regulation procedure that perfectly overcomes the problem of different objective functions. The government could auction a contract that entitles the private owner to receive a payment for the firm's output that exactly equals its social valuation. Thus, the owner fully internalizes social welfare and chooses a socially efficient production level. Furthermore, if the bidding process is competitive, the government will extract all the rents form the contract through the auction ex ante even if it doesn't know the cost function of the firm.

At this point the argument tells us that efficiency should be the same for both private and state firms. Why then does the empirical evidence tell us otherwise? Well, both arguments are based on the implicit assumption that it is possible to write a comprehensive contract for the entire horizon of the firm - otherwise the involved commitment problems could not be overcome. To illustrate this point, consider again the auction suggested by Sappington and Stiglitz. For such an auction to work, the government must be able to commit at the stage of privatization to actually pay the social valuation of output to the private owner in the (possibly distant) future. That is, it must be possible to specify unambiguously in a contract the social benefit of production for all possible state of world such that this agreement can be enforced by the courts. Otherwise, the private owner will rationally expect that once she has made a relationship specific investment the government will exploit the fact that investment costs are sunk and will expropriate her quasi-rents; therefore she will not invest efficiently. However, if comprehensive contracts are feasible, it is not surprising that there is no difference in efficiency, since it is well known that any organizational mode can be copied by any other organizational mode through a comprehensive contract. Therefore, if there is any difference, it must be due to the fact that only incomplete contracts are feasible at the stage of privatization.

A simple example is the paper by Klaus Schmidt, "The Costs and Benefits of Privatization: An Incomplete Contracts Approach". (The Journal of Law, Economics & Organization, 12(1): 1-24, 1996.) The intuition is roughly as follows: Suppose the manager of the firm has to make a private investment in cost reduction before production takes place. For example, he may have to expend effort to restructure the firm and to organize production more efficiently. Assume also that the manager derives some private benefit from a higher production level, either because he is an "empire builder" or because he is afraid of the firm being liquidated, in which case he loses his job and his reputation may be damaged. To improve the manager's incentives, the government may want to commit ex ante to a subsidy scheme that punishes the manager if costs are high by cutting back production or even closing down the firm. However, under nationalization this commitment is not credible. If the government could observe the cost function - and it can in this case -, it would always choose a production level that is ex post efficient, thus forgiving high costs and paying more subsidies than announced ex ante. Anticipating this, the manager has little incentive to save costs because he faces a "soft budget constraint". Under privatization, however, the government is not informed about the costs of the firm whereas the private owner is. It is shown that the optimal subsidy scheme under incomplete information distorts production below the socially efficient level if costs are high. Furthermore, there is a positive probability that the firm will be liquidated, even though this is inefficient ex post. Thus, under privatization allocative efficiency is clearly lower than under nationalization. The more surprising result is that productive efficiency may be enhanced. The manager faces a harder budget constraint because he rationally foresees that subsidies will be cut back if costs turn out to be high. Thus he has a stronger incentive to invest in cost reduction to avoid the low production level or possible liquidation. To summarize, there is a trade-off between a less efficient production level (lower allocative efficiency) and better incentives for the manager to save costs (higher productive efficiency).

This article makes a very strong assumption about the role of government. The government is modelled as a benevolent, fully rational, and unitary decision maker. There are no conflicts of interest between politicians, ministries, and regulatory agencies; no rent-seeking lobbyists trying to get subsidies; and no self-interested politicians struggling for power, bribes or a larger share of the electoral vote. This assumption is clearly unrealistic. therefore the main result of the paper should be seen as an existence theorem: It shows that privatization can be can be strictly superior to nationalization even in the best of all words for government. Thus, even if it were possible to fix all the deficiencies of the political system a case for privatization could still be made.

The empirical evidence shows us that private ownership is by and large superior to state ownership, Nellis ("Privatization—A Summary Assessment", Center for Global Development Working Paper Number 87 March, 2006.) for example, summaries this evidence as

The vast majority of economic studies praise privatization's positive impact at the level of the firm, as well as its positive macroeconomic and welfare contributions. Moreover, contrary to popular conception, privatization has not contributed to maldistribution of income or increased poverty - at least in the best-studied Latin American cases. In sum, the technical picture is generally positive.

We also have an understanding as to why this is the case. The thing that is hard to understand therefore is, Why is state ownership so common? It would appear to have little to do with sound economics.

Update: The Inquiring Mind warns us that a Black Hole sighted in Wellington

Interesting blog bits

1. The visible hand in economics has Credit crunch jokes.
2. Gary Becker asks "Does the Free Market Corrode Moral Character?"
3. Richard Posner comments on Does the Free Market Corrode Moral Character?
4. Arnold Kling has his Anti-Democratic Thought for the Day.
5. Thomas Sowell on Ego and Mouth.
6. Freakonomics on The Iraqi Housing Boom.
7. Luc Laeven on The cost of resolving financial crises.

   A new IMF database, which covers the universe of systemic banking crises from 1970 to 2007, shows that the average fiscal cost was about 15% of GDP, or three times the US’s $700 billion. This column points out that quick action often lowers the ultimate cost. Moreover wishful thinking teamed with regulatory forbearance and bank liquidity plans often raises the cost by delaying vital, but politically painful, government action.

How will the financial crisis affect the economics profession?

Or so asks Tyler Cowen over at Marginal Revolution. He answers

I believe that demand for economics classes will rise, as it often does in economically troubled times. Some of this will be "shaman demand" rather than "knowledge demand." The consulting incomes of finance economists will fall and fewer talented people will go into finance. Speaking fees will fall since fewer economists will give talks at hedge funds. The relative status of macroeconomists will rise and the relative status of microeconomists will fall. Economists will gain in fame and lose in income.

At the EconLog Arnold Kling thinks

[...] that macroeconomics has suffered a crash. As recently as six months ago, the consensus was that it was sufficient for monetary policy to engage in inflation targeting or to follow a Taylor rule. Now, Brad DeLong refers to this view contemptuously as "Greenspanism."

If you look closely, you will find that there is no consensus now. Olivier Blanchard's triumphal history of the last thirty years of economics is exactly wrong.

What will emerge? What the public wants is a theory of control. That is, the demand is for a theory that includes ways for policymakers to control booms and busts. To satisfy that demand, my guess is that the economics profession will put most of its effort into rationalizing or tinkering with the consensus. The leaders of the profession have too much invested in New Keynesianism to be able to back away or acknowledge that it has been refuted.

I would not be surprised to see unorthodox theories of control gain traction. Perhaps, to justify current policy trends, a theory that socialized investment is necessary for stability.

To me. the logical thing for the economics profession to do is admit that we are nowhere near understanding what is happening. However, taking that position will not get you invited to panels.

I think that there are two questions. First, what are the generic causes and consequences of bubbles? Second, why did the specific bubble in real estate and mortgage finance occur? The first question is harder. But I would say that 99 percent of the economics profession cannot even correctly answer the second.

I'm not sure that Tyler is right when he writes that relative status of macroeconomists will rise and the relative status of microeconomists will fall. The current mess has highlighted just how many problems there are with macro, and that won't help its status. It could however bring people into the subject since it's clear there are big questions that need to be answered. Arnold's two questions are a good place to start.

Tullock doesn't vote

Who would have guessed?!

Here is a great little video from the PBS in the US featuring Gordon Tullock - Eric Crampton's favourite economist - on why he doesn't vote and why you shouldn't either. Take note New Zealand voters.

(HT: Marginal Revolution)

Key's economic understanding

Over at Kiwiblog David Farrar writes

John Key, if he wins the election, may be the most economically literate Prime Minister New Zealand has had in recent decades. I think he will have a far greater understanding of business and the economy, than most people realise. Why do I say this?

A good question. I have to say given what I have heard of Nationals economic polices I could not vote for them. Why?

To take a couple of examples. First, Nationals redundancy package. I have to ask why do we have such a scheme? Why do we want to treat unemployment during a recession and unemployment outside of a recession differently? (Vote buying aside, of course). Secondly, National's plan for more of the Cullen fund to flow into domestic investment projects. Not good. Such an idea has to reduce the return to the fund. If investment in New Zealand made the highest return, then we wouldn't need to legislate a 40% local investment rule, as the Cullen Fund managers would already have invested that amount here anyway. As a result, by "forcing" the fund to keep 40% here, we are reducing the return on our investment. Also what will the extra Cullen Fund investment do to the local market? Will this extra government investment just crowd out private investment, both from within New Zealand and from overseas. So the total amount of investment in New Zealand may not change much at all. And then there is the issue of what happens if politicians start to take an even more hands on approach to the fund. The last thing we need is for investment decisions to be made, not for good economic reasons, but purely for party political reasons. In addition as Matt Nolan has noted

Someone might say that “we are making job, and we’re making money” but they would be practically illiterate - just like the buy NZ made campaign. “Employment” and “domestic production” are not a positive externality. If we are investing money overseas and getting more goods back in return, then we are effectively getting “something” for “nothing” - what is wrong with that.

My colleague Eric worries that 40% Superfund investment in New Zealand seriously exposes the fund to the risk of correlated shocks. To wit: the government must use tax funds to pay superannuitants when the returns from the Superfund aren’t enough to cover obligations. If the Superfund is invested broadly, shocks to New Zealand’s tax revenues should be relatively uncorrelated with shocks to the Superfund’s returns, barring global shocks about which not much at all can be done. But if the Superfund has supernormal investments in New Zealand securities, shocks to Superfund returns are likely to hit precisely when tax revenues are at a low ebb, exposing the fisc to serious downside risk.

Thirdly there is National's approach to infrastructure investment. I have argued here that infrastructure is a loose term covering a collection of very different industries and assets and, importantly, that the government does not have a major role to play in many of them. There is also Matt Burgess's guest post as to why National's plan to spend $1.5 billion building fibre to the homes of 75% New Zealanders is not a good idea. I agree with Matt on this issue. Lastly there is National Party's decision not to move any state-owned enterprises to the private sector in, at least, its first term. I again I think is a mistake. The evidence we have on state ownership of business shows that in most cases private ownership is more efficient. Nellis (2006) for example, summaries this experience as

The vast majority of economic studies praise privatization's positive impact at the level of the firm, as well as its positive macroeconomic and welfare contributions. Moreover, contrary to popular conception, privatization has not contributed to maldistribution of income or increased poverty - at least in the best-studied Latin American cases. In sum, the technical picture is generally positive.

These are just four issues, but they are important ones where I think National has got it wrong. My view would be that good economics is not driving National's economic policy, vote buying is. And that is the worst possible basis for government policy of any kind.

So a dilemma, who to vote for? Perhaps the only thing worse that National's stated policies are Labour (and their coalition partners) policies over the last nine years. So voting Labour is out. What of Act? Their policies are the most sound, but a candidate vote is wasted vote anywhere outside Epsom. A party vote could help.

This does raise a question for me. Are bad economic policies necessary to be elected? Is Key right to put forward bad economic policies since he has come to the realisation that voters, unfortunately, like bad policies? If we take Caplan's "Myth of the Rational Voter" seriously then this could be the optimal approach to an election. Then we have to hope Key is lying as to his true intentions. If not, then neither of the major parties are worth voting for. Perhaps then the issue should be decided upon who the major parties are most likely to go into coalition with in the hope a coalition partner can mitigate the worst excesses of its major partner.

• John Nellis (2006) "Privatization—A Summary Assessment", Center for Global Development Working Paper Number 87 March.

Eric's handy excel spreadsheet

On the iPredict blog Eric Crampton writes

I've uploaded my handy excel spreadsheet that works out what the price of PM.National would be if the prices in the underlying markets are correct and if my bold simplifying assumptions aren't too bold. Though the spreadsheet contains much that is apocryphal, or at least wildly inaccurate, if the calculations show a big gap between the calculated price and the current market price, there's likely an arbitrage opportunity playing around somewhere in the prices. Either in the prices in the underlying markets, or in the PM markets themselves.

Be warned: the file is 24 MB, mostly because I cribbed somebody else's Sainte-Lague spreadsheet and because my Excel coding skills are padawan-level at best, I copied those sheets four times over to work out the seat shares in four relevant cases: Act returns (or doesn't) and NZ First returns (or doesn't).

All very useful if you want to make money trading on election stocks on iPredict.

Comparative advantage explained

Steve Horwitz has been serving as the "professor" at the Fraser Institute's "Ask the Professor" monthly column/blog for the last several months. The November essay is now up and the topic is "Comparative Advantage." This seems to be a topic people find difficult to understand so hopefully this short explanation will help.

(HT: The Austrian Economists)

Minimum wages

There is a new book out on the effects of the minimum wage, Minimum Wages by David Neumark and William L. Wascher, MIT Press, 2008.

David Neumark is Professor of Economics at the University of California, Irvine. He is also a Research Associate at the National Bureau of Economic Research, a Senior Fellow at the Public Policy Institute of California, and a Research Fellow at the Institute for the Study of Labor. William L. Wascher is Associate Director in the Division of Research and Statistics at the Federal Reserve Board.

Minimum wages exist in more than one hundred countries all around the world. The United States passed a federal minimum wage law in 1938, in New Zealand the minimum wage was introudced in 1894, and has increased the minimum wage and its coverage at irregular intervals ever since; in addition, as of the beginning of 2008, thirty-two states and the District of Columbia had established a minimum wage higher than the federal level, and numerous other local jurisdictions had in place "living wage" laws. Over the years, the minimum wage has been popular with the public, controversial in the political arena, and the subject of vigorous debate among economists over its costs and benefits.

In this book, David Neumark and William Wascher offer a comprehensive overview of the evidence on the economic effects of minimum wages. Synthesizing nearly two decades of their own research and reviewing other research that touches on the same questions, Neumark and Wascher discuss the effects of minimum wages on employment and hours, the acquisition of skills, the wage and income distributions, longer-term labour market outcomes, prices, and the aggregate economy.

Based on their reading of the evidence, Neumark and Wascher argue that minimum wages do not achieve the main goals set forth by their supporters. They reduce employment opportunities for less-skilled workers and tend to reduce their earnings; they are not an effective means of reducing poverty; and they appear to have adverse longer-term effects on wages and earnings, in part by reducing the acquisition of human capital. The authors argue that policymakers should instead look for other tools to raise the wages of low-skill workers and to provide poor families with an acceptable standard of living.

Stalin as a rational dictator

Stalin's mass killings are often viewed as the acts of a deranged dictator. But according to Konstantin Sonin of the New Economic School in Moscow, such violence may have reflected the Soviet leader's rational efforts to avoid losing power. In this interview with Romesh Vaitilingam, from VoxEU.org, Sonin discusses his research and its implications for thinking about modern day dictators.

Block versus Caplan (updated)

Over at the lewrockwell.com Walter Block has posted an exchange of emails between him and Bryan Caplan on Fractional Reserve Banking.

The present debate got started when Block read that Caplan had characterized Murray Rothbard's position on fractional reserve banking as "crazy." Adding insult to injury, Caplan denoted Rothbard's position as too easy of a target to hit out against. These claims upset Block who then emailed Caplan.

Now read on .....

Update: Arnold Kling writes on Fractional Reserve Banking from a Modern Finance Perspective.

Cool interviews!

The Liberty Fund has put online several interviews from its Intellectual Portrait Series. Of particular interest - to me anyway:

• Armen Alchian, interviewed by Dan Benjamin
• Ronald Coase, interviewed by Richard Epstein
• Israel Kirzner, interviewed by Tibor Machan
• Friedrich August von Hayek
• Milton Friedman, interviewed by Gary S. Becker

and lots more. Enjoy!

(HT: Organizations and Markets)

Selgin interview

From the Mises Economics Blog comes this audio interview of George Selgin by Jeffrey Tucker. George Selgin is author of Good Money: Birmingham Button Makers, the Royal Mint, and the Beginnings of Modern Coinage, 1775-1821.

This book is about the true and remarkable story of private coinage and banking in Britain in the early years of the Industrial Revolution (1775-1850). Making money was a business in demand. The needs of business for small denominations were changing. Merchants needed small denomination coins in copper and silver. The Royal Mint couldn't be bothered. It made coins to serve the elites, not the new and burgeoning working class. Free enterprise stepped in with a new industry that truly saved the day—before the Crown cruelly stamped it out and ended one of the most beautiful experiences with private money in world history.

Interesting blog bits

1. Anna Schwartz Tearing Into the Fed and Treasury Plans.
2. Not PC on "Salvationist zeal" too blinding for rational thought?
3. A brief interview Russell Roberts about The Price of Everything from Reason.tv.
4. Don Boudreaux on Franklin Delano Bush.
5. Bryan Caplan on Left versus Right: What's the Big Deal?
6. Frederic Sautet on Is Barack Obama a Socialist?
7. Mark J. Perry on UK Retailer Tesco Now Grammatically Correct.

Quote of the day

Edward L. Glaeser in Psychology and the Market writes,

The real case for laissez-faire is not that the individual is perfect, but that the state will do worse than the private individual, and the strength of this case has always relied more on the fallibility of the state than on the perfection of markets. Adam Smith's case for laissez-faire was grounded in the unarguable historical fact that governments often pursue policies that impoverish and slaughter their own citizenry. Human beings surely make mistakes about their own welfare, but the welfare losses created by these errors are surely second order relative to the welfare losses created by governments which not only make errors, but also pursue objectives far from welfare maximization. Individuals may procrastinate and foolishly invest, but they tend not to voluntarily enroll in concentration camps.

Don't just do something

Russ Roberts has a new piece in the Wall Street Journal, Don't Just Do Something. Stand There. In a posting on his blog Cafe Hayek, Roberts writes

Bob Higgs claims that "regime uncertainty," the uncertainty about the rules of the game, is what made the New Deal so ineffective. Because business didn't know what the government was going to do next, people were hesitant to invest and take risk in the 1930s. It's possible but it's very hard to measure. Maybe investors were discouraged by the lack of opportunities in the economy or some other reason.

At the end of last week, the government announced that insurance companies were next to be bailed out. It became clear that firms were lining up making the claim that they too deserved government help. The effect that Higgs had written about feels palpable right now. When you know the government can save your company and your bottom line, you start spending an increasing amount of time on that possibility rather than trying to actually turn things around or look for private suitors. When you're not sure about the rules of the game, risk-taking and investing becomes much more uncertain than usual

He then points to his WSJ article in which he argues that government policy appears to be making things worse, now there's a surprise, and that doing nothing, at least for a while, is probably a better option. But, as is obvious to most people, governments have a problem with credible commitment. Doing nothing cannot be guaranteed to last for very long. Action, almost any action, is seen as good by politicians, no matter what the outcome. Action its self is a good thing, the outcome is of secondary importance. Activity is the politician's substitute for achievement. Just look at the proposals from both Labour and National to deal with the effect of the financial crisis here in New Zealand. And unfortunately, in the US context, neither presidential candidate has a commitment even to the principle that doing nothing might be the best policy. Such a principle might make a commitment to inaction, at least partially, credible. But even though the commitment to do nothing might be only temporary, Roberts argues, it still would be useful for alternative strategies to the current one to emerge and generate a consensus as to whether such alternatives might be preferable to the current scattershot approach of doing one thing today and something else tomorrow. Such uncertainty has to affect the calculus of risk-taking.

Halloween: economist version

(HT: Greg Mankiw)

Zimbabwe's inflation rate

According to Steve H. Hanke's new Hyperinflation Index (HHIZ) at the Cato Institute, Zimbabwe's annual inflation is 10.2 quadrillion percent!

The index was set at 1.00 on the 5th of January 2007. As at the 24th October 2008 the index is at 48,500,000,000,000,000.00 which gives an annual inflation rate of 10,200,000,000,000,000%.

Wackonomics

Walter E. Williams takes on the job of explaining Wackonomics. Williams writes

For the U.S. Congress, news media, pundits and much of the American public, a lot of economic phenomena can be explained by what people want, human greed and what seems plausible. I'm going to name this branch of economic "science" wackonomics and apply it to some of today's observations and issues.

His best example is

Wackonomics isn't just practiced by the uninitiated. This year's Nobel Laureate, Princeton University Professor Paul Krugman, after the terrorist attack on the World Trade Center, gave one rendition of wackonomics in his column "After the Horror," New York Times (9/14/01). Krugman wrote, "Ghastly as it may seem to say this, the terror attack -- like the original day of infamy, which brought an end to the Great Depression -- could do some economic good." He went on to point out how rebuilding the destruction in New York and Washington, D. C., would stimulate the economy through business investment and job creation. For practitioners of non-wackonomics, this reasoning doesn't even pass the smell test. If Professor Krugman's vision is correct, and extending his logic, the terrorists would have made an even larger contribution to our economic well-being had they been able to fly a plane into the White House and destroyed buildings in other cities.

Broken window fallacy anyone? Such thinking is not just found in the US, how often here have you seen someone here write that greed is to blame for high oil prices or high CEOs salaries or that things like earthquakes are good for the economy? But Williams also points out that wackonomics isn't all bad,

Wackonomics isn't all bad. There's an upside to it. It spares people the bother of having to understand the complexities of the world.

Our next government? (updated x2)

Eric Crampton has an interesting piece on the iPredict blog discussing Our next government? Eric writes

The markets today are saying 70% National, 30% Labour as next PM. Let's have a look at the underlying numbers.

At high bid for each party, assuming that Peters does not return to Parliament, Hide takes Epsom, Dunne and Anderton return to Parliament and the Maori Party take 6 electorates, we're looking at a 123 seat Parliament arrayed as follows:

GRN: 9
PRG: 1
LAB: 45
MAO: 6
UF: 1
NAT: 57
ACT: 4

62 seats are needed for a majority. National + Act + UF are at 62; Labour + Green + Progressive + Maori are at 61.

He goes on to look at bit deeper,

The markets also are saying there's a 17% chance that National's true vote share will be above 50%. If National's price is normally distributed around the true mean, though, that means there's also a 17% chance that National's true vote share will be below 43.3%. Again, we can take the combination of the prices in VOTE.NATIONAL and MAJORITY.NAT to work out the standard deviation of VOTE.NATIONAL: it's currently at 3.5. Let's assume that the standard deviation of VOTE.LABOUR is the same. We'll benchmark minor party vote share standard deviation by that of NZ First, which we can work out from the combination of VOTE.NZFIRST, TAURANGA.PETERS and MP.PETERS. At current prices, that suggests that the minor party standard deviation is 1.15.

Ok. National's coalition's expected vote share is 50.65%, getting it 61 seats plus Dunne. While the vote share point estimate is 50.65, the standard deviation will be the sum of the standard deviations of the underlying components: 3.5 + 1.15 = 4.65. National's seat share is then expected to be 62, with standard deviation 5.58 seats (as 1% of the vote gets you 1.2 seats).

Labour's coalition's expected vote share is 49.37%, getting it 59 seats plus 1 Maori overhang plus 1 Anderton. The standard deviation will be (as a rough cut) the same as that for National's coalition because we don't need to worry as much about the variance of the Maori party vote if they're set anyway for overhang, so we're really only worried about variance in Green and Labour. So, 4.65. Labour's seat share is then expected to be 61, with standard deviation 5.58 seats.

Now, what's the probability that the realized seat share for the National coalition really lies above the realized seat share for the Labour coalition? A cheap way of checking this is just to check the probability that National lies at 61 seats or less. Our standard normal table tells us the chances of this are 42.86% as only 7.14% of the distribution lies between 62 and 61 seats.

So, National's chances of getting more seats than Labour look more like 57% than like 70%. And those chances get much worse in the 26% probability case that Peters returns to Parliament. I'm not going to bother working them out at this point though.

Don't you just love economists and statisitics?! But what this says is that either Eric has gotten his calculation very wrong or the iPredict market has gotten something wrong. If it is the latter then there is money to be made. Go to it!

Update: Eric has added the following post to the iPredict blog,

Our next government redux

One of the advantages of being at Canterbury in October is that Sir Clive [Granger]comes to visit. Sir Clive won the Nobel a couple of years back for his work in economic forecasting and economic statistics. So I asked him if I'd screwed up anything major in the post below. He said the overall technique should be reasonable for what we're trying to do here, but that I'd made a minor error: the correct probability of National forming the next government, at the current prices in the vote share market, is 60.6%, not 57%. I'd made the rather silly error of adding up the standard deviations rather than adding up the variances.

So we have four options.
1. The prices in the PM markets are wrong
2. The prices in the VS markets are wrong
3. The underlying distributions are highly skewed rather than symmetrical.
4. The Maori party is more likely to go with National than NZ First is likely to make it into Parliament.

We've eliminated 3a, which was the "Eric's completely screwed this up" option as I now have the Sir Clive seal of approval. And you're not going to do better than that in New Zealand currently.

I'm complementing my positions in the PM markets with the appropriate inverse positions in the VS markets as a quasi-arbitrage.

Update 2: Eric comments on And so is solved the mystery of the inconsistent prices

Beware political saviours

Economist Stephen Kirchner writing in The Australian tells us to Beware political saviours. He makes a nice point that I'm sure most public choice economists would also make,

Scottish Enlightenment philosopher David Hume noted as long ago as 1741: "Avarice, or the desire of gain, is a universal passion which operates at all times, in all places and upon all persons." One cannot explain episodic phenomena such as financial crises with reference to a constant such as human nature or rationality.

The principal mistake the critics of free markets make is to assume that self-interest, greed and irrationality affect only private sector decision-makers. Politicians and regulators are just as prone to self-interested behaviour and do not become saints by virtue of elected or unelected office. The public sector and regulators are populated by the same species that is found in the private sector and financial markets. We should always be suspicious of claims to superior moral virtue coming from politicians.

Well said that man.

Norman Barry

This posting by Peter Boettke at the Austrian Economists blog alerted me to the sad news of the death of the political philosopher Norman Barry on the 21 October 2008.

Barry had been Professor of Social and Political Theory at Buckingham since 1984. He was a graduate of the University of Exeter. Professor Barry lectured in Politics at Queen's University of Belfast and at Birmingham Polytechnic (now the University of Central England) before being appointed as a Reader in Politics at the University of Buckingham in 1982. His books include Hayek's Social and Economic Philosophy (1979), An Introduction to Modern Political Theory (1981), The Morality of Business Enterprise (1991), Classical Liberalism in an Age of Post-Communism (1996) and Business Ethics (1998). He was also a visiting scholar at the Centre for Social Philosophy and Policy, Bowling Green State University, Ohio, and at the Liberty Fund, Indianapolis. He was a member of the Advisory Council of the Institute of Economic Affairs, London; the Institute for the Study of Civil Society, London; and the David Hume Institute, Edinburgh.

He came to New Zealand in 1997 to give the Sir Ronald Trotter Lecture on the topic of Business, Ethics and the Modern Economy. See here for a copy. He was a great defender of the classical liberal view of politics and of Austrian Economics.

You can watch a 40-minute video interview with Barry below.

See a nifty 1982 review essay on the history of the idea of spontaneous order from Barry here.

(HT: Reason Magazine)

Interesting blog bits

1. Robert Higgs points out that Every Crisis Becomes a Carnival of Opportunism.
2. Richard Posner on The Controversy over the Milton Friedman Institute.
3. Gary Becker gives some Observations on the Milton Friedman Institute at the University of Chicago.
4. The Visible hand in economics on Private prisons: National’s policy and “the proper scope of government”.
5. Arnold Kling on Central Bankers and History.
6. Greg Mankiw on The Best Book Promo of All Time
7. The Visible hand in economics on Providing a “capital injection” for households?

Energy independence

"Energy independence" is one of those ideas that just doesn't go away, no matter how long you send explaining to people why it's crazy. Just look at the current US presidential campaign where both McCain and Obama think it's a good idea. To see why it's not such a good idea read David Henderson at the EconLog blog. He writes

One issue that has arisen in this campaign is the issue of "energy independence." Both McCain and Obama believe that moving towards energy independence is a good idea. But, as I pointed out in this month's The Freeman, it's not. Energy independence is no more desirable than coffee independence, banana independence, or car independence. The case for free trade does not break down just because the good being exchanged is important, as oil is. It doesn't generally make sense, if your goal is the wellbeing of country A's citizens, for country A's government to impose tariffs or import quotas on a product from other countries. Even if we put the moral arguments against coercion aside, and even if we nationalistically care only about Americans (I don't care only about Americans), the gains to the domestic producers from reducing trade are less than the losses to domestic consumers. I won't repeat that argument here because you can go to The Freeman to read it.

The Freeman article he refers to above is available here. Read it and the rest of Henderson's blog posting.

Effects of minimum wages

The Economic Logician comments on work by Natalya Y. Shelkova of the University of Connecticut on the effects of the minimum wage.

A controversy has been raging for many years about whether minimum wages increase or decrease employment of the low waged. But the effects of the minimum wage on other wages has not been so well studied. The idea behind the minimum wage is, I would assume, to raise the lowest wages to a level that makes them "living wages". What about the other wages? The Economic Logician writes

Natalya Shelkova suggests that the workers with productivities not much higher that the minimum wages get their wage depressed to the minimum wage. The reason is that the minimum wage acts like a coordination device for employers who thus implicitly collude to offer lower wages. Empirically, she shows that this happens more in states that follow the federal minimum wage, as well as at times where the minimum wages has not been changed for a long time. This implies that introducing a minimum wage reduces wages, at least for those who had wages reasonably close to this new minimum. However, increasing an existing minimum wage raises wages.

EconTalk this week

Mike Munger of Duke University talks with Russ Roberts at EconTalk about the often-vilified middleman--someone who buys cheap, sells dear and does nothing to improve the product. Munger explains the economic function of arbitrage using a classic article about how prices emerged in a POW camp during World War II. Munger then applies the analysis to the financial crisis.

The great escape

Having outlined Greg Mankiw's view, see here, of what got us into the 1930s depression, I now take a look at Robert Higg's view of what got us out. Higgs writes in a column, Our Economic Past ~ The Great Escape from the Great Depression, in "The Freeman: Ideas on Liberty" - October 2008, Vol. 58 No. 8, that

With regard to the Great Escape, economists have also reached substantial agreement, but unfortunately they have come to agree on an interpretation that is almost completely wrong.

It is wrong factually because it places the Great Escape in the early 1940s, around the time the United States became a declared belligerent in World War II, whereas the economy did not return to what we may properly describe as prosperity until after the war. Economists have misconstrued the specious “wartime prosperity” as the real thing, but diverting nearly 40 percent of the total labor force into military-related employment and producing mountains of guns and ammunition do not create genuine, sustainable prosperity, as people would discover if they tried to operate an economy on this basis for more than a brief period. The true Great Escape did not occur until 1946.

He goes on to say

After the war most of the wartime economic controls were discontinued, more than 10 million men were mustered out of the armed forces, and the released warriors and civilian war workers quickly found private employment or left the labor force for home or school. The unemployment rate in 1947, when the transition was nearly complete, was less than 4 percent.

The standard interpretation of the transition after 1945 emphasizes that during the war people had accumulated enormous amounts of bonds and bank deposits, and afterward these financial holdings were “released” to finance consumer spending, especially for durable goods whose production had been prohibited or greatly diminished during the war. This interpretation, however, makes no sense: the bonds one man sold another bought, leaving the economy’s overall holdings unchanged. Similarly, the money one man spent by drawing down his bank account reappeared in the sellers’ bank accounts, leaving the economy’s overall bank deposits unchanged. In fact, holdings of liquid assets did not decline at all after the war. People financed their spending for consumer goods by reducing their saving rate.

Nor did people attempt to reduce their holdings of liquid assets by decreasing their demand for cash balances—equivalently, by increasing the average dollar’s “velocity of expenditure.” Velocity actually fell slightly during the immediate postwar years (because, some economists have conjectured, people still expected postwar deflation).

Nor did consumers reduce their holdings of government bonds. Although the amount of outstanding government debt declined between 1945 and 1948, this occurred almost entirely because of reductions in the holdings of commercial banks and corporations other than banks and insurance companies.

What then drove the postwar business expansion?

While consumers were financing their postwar spending binge simply by reducing their saving rate, which had risen to extraordinary heights during the war, businesses financed their postwar investment surge by selling government securities acquired during the war; by retaining more of their current earnings, in part because business taxes were reduced substantially after 1945; and by entering the capital markets, where stocks and bonds could be sold on very attractive terms. Even greater business expansion was prevented mainly by lack of materials, rather than by lack of desire to invest or lack of financial resources—to the great astonishment of the elite Keynesian economists, who had forecast that a severe postwar depression would occur when the government reduced its purchases of war-related goods and services.

Higgs goes on to argue here, as he has before, that the Keynesians policy makers of the time had failed completely to understand that the prewar depression had persisted for so long in large part because of "regime uncertainty". During the Second New Deal, the period 1935 to 1938, the Roosevelt administration had created extreme apprehension in the minds of investors and businessmen about the security of their private property rights, and thus had discouraged these people from making the large volume of long-term investments necessary for the economy's full recovery and for its sustained long-run growth. By the time that World War 2 ended, Roosevelt was dead and the most zealous advisers and administrators of the Second New Deal had left government service altogether or had been placed in less influential positions. This resulted in a considerably more auspicious view being taken of the future security of private property rights than had been true before the war. This change in outlook was sufficient to induce a great deal of long-term private investment for the first time since 1929. Higgs writes

Because “regime uncertainty,” which had dominated the later 1930s, no longer cast such a dark shadow over business and investment, the economy finally recovered from the Great Depression and the economic hardships of the war years, even as it simultaneously reallocated about 40 percent of the labor force from war-related uses to civilian uses.

Higgs ends by noting

The year 1946, when civilian output increased by about 30 percent, was the most glorious single year in the entire history of the U.S. economy. By 1948, real output was back on its long-run growth trend, and during the decades that followed, the economy was spared the sort of deep and long debacle that a congeries of wrongheaded government policies had caused during the 1930s.

Mankiw on what caused the depression of the 1930s

In his latest article in the New York Times, But Have We Learned Enough?, Gregory Mankiw gives us an outline of his view of what caused the depression of the 1930s. He writes,

The Depression began, to a large extent, as a garden-variety downturn. The 1920s were a boom decade, and as it came to a close the Federal Reserve tried to rein in what might have been called the irrational exuberance of the era.

In 1928, the Fed maneuvered to drive up interest rates. So interest-sensitive sectors like construction slowed.

But things took a bad turn after the crash of October 1929. Lower stock prices made households poorer and discouraged consumer spending, which then made up three-quarters of the economy. (Today it’s about two-thirds.)

According to the economic historian Christina D. Romer, a professor at the University of California, Berkeley, the great volatility of stock prices at the time also increased consumers’ feelings of uncertainty, inducing them to put off purchases until the uncertainty was resolved. Spending on consumer durable goods like autos dropped precipitously in 1930.

Next came a series of bank panics. From 1930 to 1933, more than 9,000 banks were shuttered, imposing losses on depositors and shareholders of about $2.5 billion. As a share of the economy, that would be the equivalent of $340 billion today.

The banking panics put downward pressure on economic activity in two ways. First, they put fear into the hearts of depositors. Many people concluded that cash in their mattresses was wiser than accounts at local banks.

As they withdrew their funds, the banking system’s normal lending and money creation went into reverse. The money supply collapsed, resulting in a 24 percent drop in the consumer price index from 1929 to 1933. This deflation pushed up the real burden of households’ debts.

Second, the disappearance of so many banks made credit hard to come by. Small businesses often rely on established relationships with local bankers when they need loans, either to tide them over in tough times or for business expansion. With so many of those relationships interrupted at the same time, the economy’s ability to channel financial resources toward their best use was seriously impaired.

But the big question is What does this have to do with the situation we face today? Mankiw sees parallels. But Anna Schwartz, co-author with Milton Friedman of "A Monetary History of the United States" thinks not much. In a recent interview she said

Today's crisis isn't a replay of the problem in the 1930s, but our central bankers have responded by using the tools they should have used then. They are fighting the last war. The result, she argues, has been failure. "I don't see that they've achieved what they should have been trying to achieve. So my verdict on this present Fed leadership is that they have not really done their job."

Schwartz and Friedman argued in "A Monetary History," that in the 1930s the US was faced with a liquidity crisis in the banking sector. As banks failed, depositors became alarmed that they'd lose their money if their bank, too, failed. So bank runs began, and these became self-reinforcing. If borrowers had left their money in the banks, the banks would have been fine. But they didn't and importantly the Fed just sat by and did nothing, so bank after bank failed. And that only motivated depositors to withdraw funds from banks that were not in distress. This just deepened the crisis and causing still more failures. But

"that's not what's going on in the market now," Ms. Schwartz says. Today, the banks have a problem on the asset side of their ledgers -- "all these exotic securities that the market does not know how to value."

So the history of the Great Depression may not be a good guide to what needs to be done today. The problems of the two time periods are different and thus the solutions need to be different. The government's justification for the current activism in terms of monetary policy just doesn't meet the historical test.

OECD ladder too steep for NZ to climb

Dr Trinh Le of the New Zealand Institute of Economic Research has an interesting piece in the National Business Review of October 24 2008. Her article is entitled OECD ladder too steep for NZ to climb, a title which right now seems all too true.

Le points out that

In 2007, New Zealand’s GDP averaged $US26,600 per capita in purchasing power parity terms, ranking 22 out of 30 OECD countries.

and

Over 2000-2007, New Zealand’s real GDP per capita grew at 2.1% per year, while the average growth rate for the rest of the OECD was 2.4% (or 1.8% if weighted by population).

If each country continued to grow at its average growth rate for the period 2000-2007, New Zealand would only reach the middle rung of the OECD ladder in 2170.

In the last three years, New Zealand’s growth performance was poorer than the rest of the OECD (1.5% vs 3.0% per year). If these growth rates were sustained, New Zealand would drop to 24th place in 2010 and continue to fall further later on.

Assuming that other countries maintain their average performance of the period 2000-2007, New Zealand’s GDP per capita will need to grow at 4.6% per year in the next decade to reach the top half of the OECD. That would mean an average growth rate of 5.9% in total GDP, assuming a population growth rate of 1.27% (average rate for 2000-2007).

A growth rate in GDP per capita of 7.4% is required for the goal to be achieved in five years. Since 1970, there has not been a single year when New Zealand recorded growth of at least 7.4%, let alone five years in a row. The highest average rates over 5- and 10-year periods were respectively 2.9% (1992-1997) and 2.6% (1992-2000).

But may be the worst thing that Le points out in our growth in labour productivity. The graph below comes from the NBR article.With labour productivity heading in that direction we are very unlikely to be able to improve our growth rate to the level required to move up the OECD ladder.

Why is growth so bad? A number of policies have contributed to this outcome.

Interest-free student loans, raising the top marginal tax rate and not indexing tax brackets to inflation, high effective marginal tax rates (through Working for Families), the Employment Relations Act, KiwiSaver, re-nationalisation of ACC and the railways, the Emissions Trading Scheme, and increasing government spending and regulation are some of the many growth-retarding policies that have been introduced in the last nine years.

Le ends her article by noting

Getting back to the top half of the OECD is a commendable goal, but its achievement is highly unlikely under current policy settings. It would be a good thing if the need for substantial changes to policy settings informed public debate during this general election period.

Looking at the election campaign so far I don't see any evidence that such debate is taking place. I have yet to see what I would call pro-growth policies have any of the parties.

Don Boudreaux on changing times

Donald J. Boudreaux writes in the Pittsburgh Tribune-Review on Changing times. He says,

All in all, the past 30 years have been satisfying ones for friends of free markets.

Has this period suddenly come to a close? Is the subprime-market meltdown sparking another era of intervention along the lines of the New Deal?

Newspapers, magazines, and the broadcast media are full of pundits predicting this outcome (and eager to applaud it when it happens). These pundits might well prove to be prescient. Conventional wisdom already holds that this financial mess is a result of unfettered free markets. The fact that markets have become freer over the past 30 years is now distorted into the myth that these years were marked by the reign of laissez-faire capitalism.

Joe Six-Pack can be forgiven if he now thinks that, for the past few decades, commissioners and staff at the Securities and Exchange Commission, the Commodities Futures Trading Commission, the Department of Justice, along with bank regulators at the Fed, have all been on permanent administrative leave -- vacationing on some far-off island with every last tax collector.

Of course, the economy hasn't been remotely close to laissez faire. Yet the belief that it has been -- the belief that government intervention cannot possibly have played a role in this mess because there's been no government intervention -- is fast discrediting markets. With equal speed, this mistaken belief is rejuvenating Americans' faith in command-and-control regulations.

One lesson I draw from this frightening state of affairs is that even the most obvious falsehood stands a good chance of being widely believed if it is repeated often enough. The claim that the U.S. economy of late has been one of laissez faire has become a mantra. And it's now taken as fact.

Another lesson is that we champions of free markets and individual liberty became too complacent. "Of course the virtues of markets are widely appreciated," we proclaimed confidently. "Airlines are deregulated and the Iron Curtain lies in rubble!"

Well, now that the Dow has shed 40 percent of its peak value and people who expected to retire at the age of 55 fear that they must wait until they're 60 or 65, the virtues of markets are lost amid the panic of market adjustments.

"Enough already with laissez faire!" people cry.

"Give us regulations that will protect us from bankers offering exceptionally attractive credit terms. Spend lots of money buying up worthless assets so that their prices make them appear to be the equal of gold. Create new bureaucracies. Have government set CEOs' pay and buy the banks!"

That people so readily indict the market and plead for government intervention is a sure sign that those of us whose job it is to make a compelling case for free markets have failed.

It's tempting to blame the general public for their economic ignorance. But succumbing to this temptation solves nothing. If public understanding of the market is shallow (as it certainly is), the fault lies first and foremost with people like me [Boudreaux is chairman of the Department of Economics at George Mason University] -- people who accept the responsibility for explaining the many merits of markets to a general audience.

We must do better. Making the invisible hand of the market visible -- and showing that, even when it's a bit unsteady, the invisible hand is always more reliable and less bossy than is the visible fist of government -- must become an even higher priority for people who care about the kind of society we will bequeath to our children.

Boudreaux is right that the public understanding of the market, and economics, in general is shallow but I'm not sure how much difference even the likes of Don Boudreaux can make. Bryan Caplan in his book The Myth of the Rational Voter: Why Democracies Choose Bad Policies lists an "antimarket bias" as one of the four systematic biases about economics that people hold. Such a basis is common place and long held in face of all the effects of economists to educate the general audience. As Caplan writes

Antimarket bias is not a temporary, culturally specific aberration. It is deeply rooted patten of human thinking that has frustrated economists for generation."

You only have to look at the standard of economic debate in either the US or New Zealand election campaigns to see the very low standard it meets. Politicians play to beliefs like the "antimarket bias" to get votes. Voters could demand more from their elected representatives, but they don't. As Caplan's book makes clear, Boudreaux has a hell of a battle on his hands to change this, but I do wish him luck.

Public policies against global warming: don’t forget the supply side

In this audio from VoxEU.org, Hans-Werner Sinn talks to Romesh Vaitilingam about Public policies against global warming: don’t forget the supply side. Sinn argues that public policy discussion of climate change has focused only on the reduction of demand for fossil fuel, neglecting the supply side.

Hans-Werner Sinn is Professor of Economics and Public Finance at the University of Munich, President of Ifo Institute for Economic Research and Director of CES.

Four myths about the financial crisis

At the Federal Reserve Bank of Minneapolis three economists - V.V. Chari, Lawrence Christiano, and Patrick J. Kehoe - set out to look at Four Myths about the Financial Crisis of 2008.

The myths

1. Bank lending to nonfinancial corporations and individuals has declined sharply.
2. Interbank lending is essentially nonexistent.
3. Commercial paper issuance by nonfinancial corporations has declined sharply and rates have risen to unprecedented levels.
4. Banks play a large role in channeling funds from savers to borrowers.

What do they find? Basically that each of these myths is refuted by financial data, that is available to those who want it, from the Federal Reserve. Its a short paper, so it doesn't take long to read the whole thing. The abstract reads

The United States is indisputably undergoing a financial crisis. Here we examine four claims about the way the financial crisis is affecting the economy as a whole and argue that all four claims are myths. Conventional analyses of the financial crisis focus on interest rate spreads. We argue that such analyses may lead to mistaken inferences about the real costs of borrowing and argue that, during financial crises, variations in the levels of nominal interest rates might lead to better inferences about variations in the real costs of borrowing.

The Free Exchange blog attacks this piece here and Mark Thomas attacks it here. Alex Tabarrok attacks the attackers here.

Why are hedge funds not blowing up all over the place?

At Freakonomics Steven D. Levitt asks Why Are Hedge Funds Not Blowing Up All Over the Place? He writes

There are many things I do not understand about the financial crisis, but the one thing that currently puzzles me the most is how there have not been dozens of huge hedge-fund failures over the last few months.

Levitt goes on to give two reasons why we have not yet seen massive hedge-fund failures,

The first is that most hedge funds have “lock up” periods, so that investors can only get their money out with a lag of a few months or maybe up to a year.

The second reason that hedge funds might not yet be blowing up is that they are nearly unregulated, so they don’t face “mark to market” rules or required capital ratios. So these hedge funds could be in terrible shape, but might be able to hide that fact — at least until the redemptions hit.

From this he makes a prediction that,

the next few months will see a string of huge hedge-fund failures, which will lead hedge-fund investors to pull their cash out of hedge funds en masse, triggering further hedge-fund blow ups.

A testable hypothesis. Time will gives us the answer.

The State of Macro (updated)

Over at the visible hand in economics we are referred to a posting at EconLog in which Arnold Kling rips into economists. Kling is unhappy with the state of current macro but not everyone argees. Olivier J. Blanchard in a recent NBER working paper looks at The State of Macro.

Blanchard argues that for a long while after the explosion of macroeconomics in the 1970s, the field looked like a battlefield (still does to me!). He goes on to say that over time however, largely because facts do not go away, a largely shared vision both of fluctuations and of methodology has emerged. But he adds not everything is fine. Like all revolutions, this one has come with the destruction of some knowledge, and suffers from extremism and herding. In his view, however, none of this deadly. The general state of macro is good.

The first section of his paper sets the stage with a brief review of the past. The second section argues that there has been broad convergence in vision, and the third reviews the specifics. The fourth focuses on convergence in methodology. The last looks at current challenges.

Update: Arnold Kling responds to Blanchard here. He opens by saying

I'll excerpt more below, and try not to get personal about an economist who for thirty years has embodied everything I despise about macro. Back then, he was insufferably smug and I was childishly rebellious. Not much has changed.

New iPredict stocks

I'm a bit late on this, but better late than never I guess. iPredict has nine new stocks on offer to do with results in three electorate races.

1. Epsom: Hide vs Worth
2. Mangere: Field vs Sio
3. Tauranga: Bridges vs Peters

Epsom:

EPSOM.WORTH - This contract pays $1.00 if Richard Worth wins the Epsom electorate in the 2008 New Zealand General Election, $0 otherwise.

EPSOM.HIDE - This stock pays $1.00 if Rodney Hide wins the Epsom electorate in the 2008 New Zealand General Election, $0 otherwise.

EPSOM.OTHER - This contract pays $1.00 if both EPSOM.HIDE and EPSOM.WORTH contracts close at $0. Otherwise this contract closes at $0.

Mangere:

MANGERE.SIO - This stock pays $1.00 if Su'a William Sio wins the Mangere electorate in the 2008 New Zealand General Election, $0 otherwise.

MANGERE.FIELD - This stock pays $1.00 if Taito Phillip Field wins the Mangere electorate in the 2008 New Zealand General Election, $0 otherwise.

MANGERE.OTHER - This contract pays $1.00 if both MANGERE.FIELD and MANGERE.SIO contracts close at $0. Otherwise this contract closes at $0.

Tauranga:

TAURANGA.PETERS - This stock pays $1.00 if Winston Peters wins the Tauranga electorate in the 2008 New Zealand General Election, $0 otherwise.

TAURANGA.BRIDGES - This stock pays $1.00 if Simon Bridges wins the Tauranga electorate in the 2008 New Zealand General Election, $0 otherwise.

TAURANGA.OTHER - This contract pays $1.00 if both TAURANGA.PETERS and TAURANGA.BRIDGES contracts close at $0. Otherwise this contract closes at $0.

Politicians v's faith-healers

At Cafe Hayek Don Boudreaux gives us his view of politicians,

The general lesson here is that politicians are akin to faith-healers. Both pose as wizards; they use enchanting words to push crackpot potions. The faith-healer dupes his customers into believing that he will suspend medical reality; the politician dupes voters into believing that he will suspend economic reality. Both are frauds.

If only voters realised this fact.

Kling on banking

Arnold Kling writes about his Thoughts on Banking and Thoughts on Banking: An Example. With regard to the first posting he writes

This post returns to the deep topic of banking theory. I am very unhappy with the state of banking theory in economics. People make very strong empirical claims about what they call the risk-taking process based on shallow thinking about that process. I think that Mencius Moldbug is giving the wrong answer, but at least he is asking the right question, which is more than I can say for, well, just about the entire economics profession.

This stuff is for the macro geeks among us.

Myron Scholes on financial innovation and failure

When debating the notion that more regulation would repair the finance industry and keep us out of trouble in the future Nobel laureate Myron Scholes, one of the fathers of modern finance, makes an interesting point:

Economic theory suggests that financial innovation must lead to failures. And, in particular, since successful innovations are hard to predict, the infrastructure necessary to support innovation needs to lag the innovations themselves, which increases the probability that controls will be insufficient at times to prevent breakdowns in governance mechanisms. Failures, however, do not lead to the conclusion that re-regulation will succeed in stemming future failures. Or that society will be better off with fewer freedoms. Although governments are able to regulate organisational forms, they are unable to regulate the services provided by competing entities, many yet to be born. Organisational forms change with financial innovations. Although functions of finance remain static and are similar in Africa, Asia, Europe and the United States, their provision is dynamic as entities attempt to profit by providing services at lower cost and greater benefit than competing alternatives.

At the Free Exchange blog they comment

Looking at the recent and explosive growth of some financial derivatives, I wonder if something Schumpeterian occurred in financial innovation. Perhaps too much was invested in these products, thanks to an incomplete understanding of them and the risks they posed. Schumpeter predicts that such investment, in any industry, inevitably leads to a contraction. On the other hand, innovation is ultimately the only sustainable driver of long-term growth. It also, by definition, causes market fluctuations. Policies aimed at undermining innovation hinder an industry's ability to compete globally.

May be more regulation could help prevent another crisis, but it may also kill the goose that lays the golden egg.

Butler on Adam Smith

In this short video from the Institute of Economic Affairs in London, Eamonn Butler, author of Adam Smith: A Primer, talks about Adam Smith and the nature and importance of his ideas.

Butler on the finanical crisis

Eamonn Butler writing in the The Australian, on the 21 October, points out that there is No such thing as a free lunch. He writes

WITH turmoil in the world's markets, politicians and commentators have been demanding more regulation and control of the financial sector. Kevin Rudd even says it was caused by extreme capitalism. Their reaction is predictable, but entirely wrong.

This crisis was not caused by capitalism being fatally flawed. It was caused by politicians forcing the banks to give out bad loans, monetary authorities flooding the West with cheap credit and regulators being asleep at the wheel.

Indeed, one can date its origin precisely, to October 12, 1977, when US president Jimmy Carter signed the anti-redlining law. Before then, lenders generally denied loans to people in poor neighbourhoods, believing that the local mix of low incomes and a weak housing market would lead to many people defaulting. But the politicians - with good intent - wanted to make home ownership available to all Americans. So lenders were forced into giving out risky mortgages, what we call sub-prime loans.

By 1985, this torrent of bad business had nearly bankrupted the US's savings and loan institutions. So the government took on their bad debt and encouraged them to consolidate, unwittingly making them too big to be allowed to fail.

Meanwhile, several other problems worried the monetary authorities. In 1987, the US stock market plummeted, fearing that other lenders could collapse. There have been other successive crises. Asia's markets sank. Mexico, Argentina and even Russia defaulted on their loans. Over-valued dotcom stocks crashed. Then there was 9/11. Each time, Western authorities responded by flooding the markets with cash.

After 9/11, the Federal Reserve took US interest rates down from 6.25 per cent to just 1 per cent, fearing this blow to investor confidence could sink the markets. But, again, its action boosted the wrong market by sustaining the credit bubble.

With loans six times cheaper, mortgage applications soared.

Lenders, awash with the Fed's cash, happily issued more sub-prime loans. With more people buying homes, house prices soared. Buying a house seemed a certain money-maker, so more people got more loans and bought more houses, continuing the spiral.

In London, that other great financial centre, a decade of government overspending saw public debt soaring. Private debt and house prices soared even faster.

So for 10 years, economies boomed, the champagne flowed and everyone had a great party. But it was financed by fake money, printed by the authorities solely to keep the party going. When the realisation broke, the long party turned into the inevitable hangover we suffer today.

The regulators, meanwhile, were unconscious on the floor. The US mortgage institutions, Fannie Mae and Freddie Mac, had 200 regulators on their case but still went bust for $US5 trillion. These semi-governmental companies allowed investors to believe the bad mortgages were guaranteed by government, causing credit rating agencies to give their dodgy bonds high scores.

Mortgage lenders repackaged these bad debts across the world, but nobody cried foul. Institutions were lending 30 times their asset base. Though the Bank of England knew that the huge mortgage lender Northern Rock was failing, the 2500 staff of Britain's financial regulator seemed to do nothing until it collapsed six months later. Even then, they had no coherent plan.

When the government is persuading the casino to hand out free chips and the regulators are standing drinks at the bar, you shouldn't be surprised if the customers place a few risky bets. It's the management, not the system, that deserves our scorn for breaking the basic rules of economics: there ain't no such thing as a free lunch.

Any sustainable solution has to get finance back to those basics. But the bailout package includes so many treats for special interests that it could save the culprits without helping the victims.

But it's a big world out there. China, the world's fourth biggest economy, continues to grow at nearly 10 per cent. India and other emerging economies are expanding, too. Even with the West in recession, world growth next year will probably be near 4 per cent. That's pretty good.

Western capitalism has been dealt a severe blow by inept politicians and officials. But global capitalism continues to pull hundreds of millions of people out of poverty. It's a great system. Let's not break it.

Eamonn Butler is director of the Adam Smith Institute, a free market think tank in London, and author of the excellent Adam Smith: A Primer (2007, IEA, London).

EconTalk this week

Clay Shirky, author of Here Comes Everybody: The Power of Organizing Without Organizations, talks about the economics of organizations with EconTalk host Russ Roberts. The conversation centers on Shirky's book. Topics include Coase on the theory of the firm, the power of sharing information on the internet, the economics of altruism, and the creation of Wikipedia.

An international perspective on the US bailout

The current credit crisis in the US has prompted many calls for some form of regulation to prevent such an event from ever happening again. In a new column at VoxEU.org Romain Rancière, Aaron Tornell and Frank Westermann defend a financial system that engenders systemic risk. Economies that risk occasional credit crises enjoy higher long-run growth, and the cost of the US bailout is well within historical norms. Not your standard view of the situation.

The column, An international perspective on the US bailout, opens by noting

As the US economy is hit by the financial crisis and associated bailout costs, it is useful to take an international perspective on current events. In the last three decades, many developing countries have also experienced financial crises and large bailouts. Yet, the growth gains brought by financial liberalisation and deregulation have, in most cases, far more than offset the output and bailout costs of crises. Importantly, financial liberalisation by itself did not generate crises – government meddling and implicit bailout guarantees were often involved. In many ways, the US story is not so different.

Rancière, Tornell and Westermann go on to point out that many commentators point to financial deregulation as a key cause of the crisis. In Rancière, Tornell and Westermann's view the facts suggest otherwise.

• First, the size of the bailout is within historical and international norms.
• Second, financial liberalisation and deregulation policies along with financial innovation have largely contributed to the impressive growth performance of the US economy relatively to EU countries. The development of new financial instruments has helped finance the IT revolution and the large-scale increase in home ownership. Both factors have been powerful engines of US growth.
• Third, policy interventions, such as the effort by some in the administration and Congress to induce Fannie Mae and Freddie Mac to move into the subprime mortgage market, have largely paved the road to the financial crisis the US faces today.

One question to ask is How big is the bailout compared to others? Rancière, Tornell and Westermann note

The $700 billion bailout bill is equivalent to 5% of GDP. Adding to it the cost of other rescues – Bear Stearns, Freddie Mac and Fannie Mae, AIG – the total bailout costs could go up to $1,400 billion, which is around 10% of GDP.

But they put this into perspective by pointing out that

• Mexico incurred bailout costs of 18% of GDP following the 1994 Tequila crisis.
• In the aftermath of the 1997-98 Asian crisis, the bailout price tag was 18% of GDP in Thailand and a whopping 27% in South Korea.
• Somewhat lower costs, although of the same order of magnitude, were incurred by Scandinavian countries in the banking crises of the late 1980s. 11% in Finland (1991), 8% in Norway (1987), and 4% in Sweden (1990).
• Lastly, the 1980s savings and loans debacle in the US had a cumulative fiscal cost for the taxpayer of 2.6% of GDP.

They also explain the costs of the bailout that taxpayers are now facing can be seen as an ex post payback for years of easy access to finance in the US economy.

The implicit bailout guarantees against systemic crises have supported a high growth path for the economy – albeit a risky one. In effect, the guarantees act as an investment subsidy that leads investors to (1) lend more and (2) at cheaper interest rates. This results in greater investment and growth in financially constrained sectors – such as housing, small businesses, internet infrastructure, and so on. Investors are willing to do so because they know that if a systemic crisis were to take place, the government will make sure they get repaid (at least partially).

Such effects from a bailout scheme only occur when there is a systemic insolvency risk. This is simply because a bailout is not forthcoming if an isolated default occurs, it will only be granted when a systemic crisis hits because it is only under the threat of generalised bankruptcies and a financial meltdown that would the US Congress would agree to a bailout plan.

Thus, an investor will be willing to take on insolvency risk only if many others do the same. When a majority of investors load on insolvency risk, they feel safe (because of the bailout guarantee). No wonder many financial firms end up with huge leverage and loaded with risky assets. In the Tequila and Asian crises the risky bet was the so-called currency mismatch, in which banks funded themselves in dollars and lent in domestic currency. In the US, it took the form of toxic mortgage-related assets. There are no innocent souls here. Borrowers, intermediaries, investors and regulators understood the bargain. At the end, the bailout guarantee scheme has succeeded in inducing more investment by financially constrained agents in real estate and small businesses.

Now what of the positive side of risk-taking in the long run. Rancière, Tornell and Westermann say

Perhaps the financial sector lent excessively, leading to overinvestment in the housing sector today and the IT sector in the late 1990s. But the bottom line remains that risk-taking has positive consequences in the long run even if it implies that crises will happen from time to time. Over history, the countries that have experienced (rare) crises are the ones that have grown the fastest. In those countries, investors and businesses take on more risks and as a result have greater investment and growth. Compare Thailand's high-but-jumpy growth path with India's slow-but-steady growth path before it implemented liberalisation a few years ago. Over the last 25 years, Thailand grew 32% more than India in terms of per-capita income despite a major financial crisis. Similarly, easier access to finance and risk-taking explains, in part, why the US economy has strongly outperformed those of France and Germany in the last decades.

Many people are arguing for a rolling back of financial liberalisation and for a return of the "good old days" of strict regulation. But if Rancière, Tornell and Westermann are right then maybe this is not the right response to the current situation.

Rancière, Tornell and Westermann conclude

Today's bailout price seems high. But is it that much relative to the higher growth the US has enjoyed in specific sectors and overall? Let's wait for the final price tag. Other countries' experiences tell us that financial liberalisation – and some of its consequences – is not such a bad idea after all. They also teach us the importance of quickly jump-starting the lending engine so as to avoid a growth collapse and for the regulatory agencies to refrain from killing the natural risk-taking process that accompanies the resumption of credit growth.

White on Krugman

The latest issue of the The Freeman: Ideas on Liberty (October 2008, Vol. 58 No. 8) has an interesting article in which Lawrence H. White rebuts Paul Krugman's view that the subprime crisis is the result of too little regulation. See The Subprime Crisis Shows That Government Intervenes Too Little in Financial Markets? It Just Ain’t So! (pdf). White is the F.A. Hayek Professor of Economic History at University of Missouri - St. Louis.

More on the current financial problems

Brian M. Carney of the Wall Street Journal has report of a recent interview he did with Anna Schwartz. As Carney points out

Most people now living have never seen a credit crunch like the one we are currently enduring. Ms. Schwartz, 92 years old, is one of the exceptions. She's not only old enough to remember the period from 1929 to 1933, she may know more about monetary history and banking than anyone alive. She co-authored, with Milton Friedman, "A Monetary History of the United States" (1963). It's the definitive account of how misguided monetary policy turned the stock-market crash of 1929 into the Great Depression.

In addition there is a nice piece by Jeff Miron at CNN.com on Why this bailout is as bad as the last one. Warren E. Buffett says Buy American. I Am. Kenneth Arrow comments on a Risky business

The root of this financial crisis is the tension between wanting to spread risk and not understanding its consequences

Cool heads needed

In a recent piece in the Dominion Post Roger Kerr makes the point that Cool Heads Needed in Economic Turmoil. Kerr writes that there are some things that are clear about the current crisis,

First, it will pass. Defensive actions by governments and market adjustments will pave the way for recovery, probably within a year or two. A repeat of the 1930s Great Depression is highly unlikely.

Second, market-based economic systems will not be abandoned. They involve risk and can be volatile, but their wealth-creating abilities are unsurpassed.

Third, just as in the 1930s depression, the stagflation of the 1970s and the Asian economic crises of the 1990s, many of the current problems are government-made. Governments and businesses need to learn from their mistakes.

He goes on the explain that many acts of folly precipitated the meltdown in the US financial sector,

Prime exhibits include the easy money policies of the Federal Reserve after the dotcom crash, which helped fuel the house price boom; the government sponsorship of Freddie Mac and Fannie Mac, the giant mortgage underwriters that failed; the legislation and political pressure that encouraged banks to lend to unqualified borrowers in the name of ‘affordable housing’; land supply restrictions; mark-to-market accounting rules; non-recourse lending regulations; and more.

Later he notes that

Once the default avalanche was triggered, authorities in the United States, Europe and elsewhere had little option other than to act to protect their financial systems, [...]

This is not so clear to me. As Jeff Miron has recently put it

It is time for the government to do the one thing it does well: nothing at all.

Or as Miron entitled a previous column on the US financial problems, Bankruptcy, not bailout, is the right answer.

When looking at the US governments approach to protect their financial system Miron argues that the government bailouts of banks will hide problems and spread inefficiency. He writes

If banks were fundamentally sound but temporarily in need of cash, they could sell stock on their own to private investors. Few investors now want bank stock, however, because they cannot tell which banks are merely illiquid -- short of cash for new loans because their assets are temporarily sellable only at fire-sale prices -- and which are fundamentally insolvent -- short of cash and holding assets whose fundamental values are less than the bank's liabilities.

This lack of transparency is a crucial impediment to new investment, and therefore to new lending.

Government injection of cash, however, does little to improve transparency. A bank with complicated, depreciated assets is in much the same position after the government gives it cash as it was before, since outside investors will still have limited information about the solvency of any individual bank.

Perhaps the new cash will spur the sale of bad assets, or nudge banks to reveal their balance sheets, but that is far from obvious. Banks, moreover, might remain cautious even with this increased liquidity simply because of uncertainty about the economy. Thus it is hard to know whether cash injections will actually spur bank lending.

The great Anna Schwartz also sees the problem as one of lack of transparency. This from a recent report of an interview with Schwartz by Brian M. Carney in the Wall Street Journal,

This is not due to a lack of money available to lend, Ms. Schwartz says, but to a lack of faith in the ability of borrowers to repay their debts. "The Fed," she argues, "has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible."

So even though the Fed has flooded the credit markets with cash, spreads haven't budged because banks don't know who is still solvent and who is not. This uncertainty, says Ms. Schwartz, is "the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue."

Miron goes on to say

In any event, government ownership of banks has frightening long-term implications, whether or not it alleviates the credit crunch.

Government ownership means that political forces will determine who wins and who loses in the banking sector. The government, for example, will push banks to aid borrowers with poor credit histories, to subsidize politically connected industries, and to lend in the districts of powerful members of Congress. All of this is horrible for economic efficiency.

Government pressure will be difficult for banks to resist, since the government can both threaten to withdraw its ownership stake or promise further injections whenever it wants to modify bank behavior. Banks will respond by accommodating government objectives in exchange for continued financial support. This is crony capitalism, pure and simple.

Government ownership of banks will not be a temporary expedient. Politicians can swear they will unwind the government's position once "economic conditions improve," but no one can enforce this promise. The temptation to use banks as a political tool will be permanent, not temporary, so government ownership will continue for decades, or forever.

Worse yet, government ownership of banks sets a precedent for ownership in every industry that suffers economic hardship. Some might argue that banking is "essential," but many industries -- autos, steel, computers or agriculture -- will make similar claims when it is their turn to demand a bailout. Thus banking will be only the first victim in an enormous expansion of the government's role. This again will have disastrous consequences for economic efficiency.

But in Miron's view this is not the worst of it,

The injection means that banks get cash, and they get it now. This benefits current stockholders and bondholders, which is why stocks have jumped on news of the injections.

The government, however, gets stock that might end up being worthless, since some banks will fail anyway. The government gets stock that may never trade in a market or have its value determined by fundamentals. The government gets stock that it cannot sell for years, if ever, without generating turbulence in asset markets as investors interpret the government's decisions or position themselves to profit from them.

Government purchase of bank stock, therefore, is a transfer from taxpayers to people who took huge risks and lost. The United States, and the world, got into the current mess by trying to insure away risk, which everyone should have known was a fool's errand. Thus bailing out risk-taking -- or providing new guarantees for loans and deposits -- will generate even greater problems down the line.

Thus the US efforts to protect their financial system may well not work and similar efforts in many other countries share at least some of the problems of the US approach. But more importantly, doing nothing at all, as Miron puts it, was an option and if the actions countries have taken don't work hindsight may make it seem the optimal action (or inaction!).

Should this surprise us? I would argue no. As I tried to argue here and here the history of the Great Depression tells us that government efforts to deal with a crisis do, by and large, little good and in fact can make matters worse.

So Roger Kerr is correct to say cool heads are need right now, but I would argue that such heads may be saying, do nothing.

Dixit: why Paul Krugman got the Nobel Prize

In this article, Why Krugman got the Nobel Prize: Economics, not polemics, at VoxEU.org Avinash Dixit, University Professor of Economics at Princeton University and the 2008 President of the American Economic Association argues that economics got Krugman the prize. He notes that Paul Krugman the columnist offers strong views, attracting adulation and hatred. His newspaper-reading fans delight in his Nobel Prize; his foes are shocked and dismayed. Both are mistaken. His prize has nothing to do with his popular writing. In this piece Dixit explains that the prize celebrates Krugman’s achievements in science, not in the policy arena. This column clarifies exactly what those achievements are.