Ricardian equivalence

Ricardian equivalence: A mere day before second quarter spending stats were released in late July of this year, the Hoover Institute’s John Taylor was a guest on PBS’s News Hour. He argued that the reason the U.S. recovery was weaker than some might have hoped for was due to less rapid growth in investment spending. Taylor argued that this drop in growth was due in turn to worries about high budget deficits: “And now the slowdown is because investment has slowed down, and people are getting nervous about the increased debt that has partly resulted from the stimulus.” (A very small part due to President Obama's stimulus package. According to the Heritage Foundation's Brian Riedl’s only 6% of it. His paper is available online). This argument that the impact of government spending on overall macroeconomic equilibrium is relatively weak because of the effects of budget deficits on expectations is referred to as Ricardian equivalence. With Ricardian equivalence higher deficits now create the fear that taxes will eventually increase. This lowers the net expected return to investment. It lowers expected real disposable income of consumers as well. According to this, bond financed increases in government spending provide no more stimulus than tax financed ones would because we are smart enough to realize that –at some point in the future- the piper must be paid. The day following Taylor’s appearance on PBS’s News Hour Q2 2010 (the second quarter of 2010) spending stats (real GDP figures) were released. They indicated a year over year increase in investment spending of 23%. So much for weakened investment spending. The stupidity of Ricardian equivalence: If one stops to consider what we must assume when we try to apply this general idea to the real world all sorts of logical problems present themselves. Will there not be a range of opinions about exactly when budget deficits will have become too burdensome to tolerate? Given this, will there not also be a range of opinions about when leaders who have the commitment and power to push through higher taxes will appear to save the day and put our financial house in order? Furthermore, won’t the confidence with which these opinions are held also differ widely? Finally, there is question of how much weight will be attached to any of this. Say that I am the owner of a profitable business who plans to retire soon. I plan to sell the business to someone else. I believe –perhaps with good reason- that the bulk of potential buyers are oblivious to the threat of higher future taxes and lower net income. I also do not care about the financial fate of future generations. I could care less about what impact the choices the government makes now might have on my descendants. My indifference towards those who follow is exemplified by the fact that I can’t help but roll my eyes when someone says that we do not inherit the planet from our ancestors we are borrowing from those who come after. All this said, I attach relatively little weight to the long distant prospect of higher taxes. It would seem that the question of how to interpret the impact of the increased spending from added road repair and the added amount left after taxes in my pay check from current tax cuts (or the reverse of these, spending cuts and tax increases now) would be much easier than trying to figure out than the following : (1) If we don’t get deficits under control by date x, what the consequences will be. (2) If the leadership needed to chart a course through such politically dangerous waters of tax increases and spending cuts will ever appear. (3) Whether I am the only one to be concerned about such things, whether or not those of us who are worried about such things are correct in our assessment of how bad the situation will become by date x and whether politically we will be able to do anything about it . (4) What the likely consequences of failure might be. (5) The question of whether balance or surpluses might be achieved not via raising taxes –which would affect me directly- but instead via cuts in spending. If I have faith in the self-correcting tendencies of the market would have at most an indirect and very temporary affect on my situation. Besides all of this there is something else that is key and is missing from the discussion. This is the question centers on the issue of how what the composition of increased spending and the mix of tax cuts. If the deficits that have emerged are the result of governments simply continuing to do what they need to (vis-à-vis things such as primary and secondary education, police and fire protection, road repairs and so on) in the face of temporarily lower revenues should I be that concerned? Why are we not considering what I would like to call the Rohatyn effect? Rohatyn in his 2009 book Bold Endeavors: How Our Government Built America, and Why It Must Rebuild Now argues that much of the prosperity of the U.S. economy is based on private sector investment made far more productive and profitable in the wake of government investment in things like education, infrastructure, and overall economy stability. Add to the list of complicating factors that a more nuanced view of Ricardian equivalence demands then one more item in honor of Mr. Rohatyn and his book. Increased government spending and tax cuts, if directed at areas that increase the long-run productive capacity of the country, while they may lead to larger deficits now, via growth in capacity and earnings (assuming that the effective demand is there), over the long-run will lead to lower deficits, balanced budgets or possibly even generate surpluses. As summarized in his survey of work done on Ricardian equivalence North Carolina State’s John Seater notes: Finite horizons, nonaltruistic or inoperative bequest motives, childless couples, liquidity constraints, and uncertainty all can lead to failure of Ricardian equivalence, and it seems virtually certain that some of these sources of nonequivalence are operative. It appears likely that the world is not Ricardian. (p. 155 – 156) Stupid or not, it seems to fit the facts?: Despite this, Seater goes on to argue that as implausible an explanation as Ricardian equivalence might be, that it somehow or the other fits the facts reasonably well. In short, the evidence that Seater has examined would suggest that fiscal stimulus has been relatively ineffective. Almost two years ago I tried to untangled the equally twisted knot of Barro’s objections to ARRA: that the evidence suggested that increased government spending was ineffective. Barro pointed spending multipliers for 1941-42, 1942-1943, and 1943-1944 that were either below or just barely above one. I again come back to the same point that I raised in my posting in response to this from almost two years ago: that as the federal government applies stimulus to the overall economy the effectiveness of this is weakened considerably if –at the same time- state and local governments are doing the opposite. They did in this period that Barro refers to and they certainly are now. As the federal government has increased spending and cut taxes, state and local governments have been increasing taxes and cutting spending to balance their budgets. According to the National Organization of State Budget Officers (NABSO), despite projected increases in state level spending and revenues over the course of fiscal year (FY) 2011 both will still be well below their 2008 levels. Not even adjusting for inflation, state spending will be 7.6% lower in FY 2011 than it was in 2008. In real terms, it would of course be lower still. In the case of revenues, NASBO estimates that they will still be 7.8% lower in nominal terms in 2011 when compared to 2008. Not only have state and local governments been a drag on recovery but it is also true that a fairly high fraction of the production being generated to satisfy growing spending on both investment goods (23%) and exports (14%) in the fourth quarter was being covered via increased imports. Over the same period that both investment spending and export spending grew so rapidly in real terms (from Q209 to Q210) import spending grew in real terms 17.2%. Christian Weller notes this in his piece “Recovery Continues Amid Worrisome Trade Deficit”: The story of U.S. imports is not all that complicated, and it is directly related to struggles in the manufacturing sector. U.S. businesses are now operating in an expanding economy where other businesses and consumers demand more of their products. Domestic businesses thus need to ramp up production to meet that demand. They need more inputs for this added production, and they often turn to overseas suppliers for these. Imports of industrial supplies, for instance, increased by 20.2 percent in the second quarter, and imports of capital goods such as aircrafts and computers rose by 51.7 percent. The lack of domestic manufacturing capacity to supply these goods thus lowers the momentum for economic growth. (emphasis added). Finally, the over 6.5% growth in hourly productivity of labor since the crisis began might also have something to do with what we are seeing in terms of employment, especially when couple with the drag import spending growth, state and local government tax increases, and cuts in state and local government spending. Putting so much faith in others’ rationality, why would economists continue to offer an explanation that it implausible simply because it would appear to fit the facts as some argue Ricardian equivalence does? Why especially when there are other, more straightforward explanations to offer? The dangers of Ricardian equivalence: For those who wish to dress others in the sack-cloth and ashes of austerity Ricardian equivalence does offer an explanation of why “fiscal responsibility” can’t wait and austerity is needed now even if an economy could be counted on to pop right back on its own. In honor of Ed Prescott, what I refer to as the “pop back” theory is the neoclassical argument that if only wages and other resource costs were to move down along with the general level of prices to a sufficient degree the economy would self-correct. “Fiscal responsibility” means simply balancing government budgets when deficits emerge. Even though in 2007 the federal government was running a budget deficit, in 2007 - according to the NASBO report already cited above- state budgets were overall in balance. Their budget woes emerged as their economies moved into recession and were largely due to the natural decline in tax revenues that followed from economic weakness. Budgets that might have been in balance when state economies were stronger and unemployment lower moved toward deficit. Shouldn’t such economies if they are left alone –if they do indeed adjusts or pop right back- see their revenue picture improve considerably once recovery has been achieved. In fact, all else being equal, budgets should be back in balance again once long-run full-employment equilibrium is restored. In such a situation, to argue for austerity in the midst of a crisis would seem unnecessary. It is tantamount to saying that you think that even more pressure should be placed on labor and other resource suppliers to adjust than they would have to anyway. Ricardian equivalence provides a very dangerous answer to this question. Given increased deficits and its negative impact on private spending, whether governments cut spending , raise taxes, or carry out some combination of the two now or do so later, spending at the present time will be depressed. Labor and other resource supplies will be asked to carry the heavy burden of adjustment no matter what. The heavy burden of adjustment might be due directly to austerity measures put into place now. Lacking the political moxie to do something now, given Ricardian equivalence, the burden will be no lighter anyway as private households and businesses, seeing that the future will bring with it higher taxes unless something is done, cut their own spending in anticipation. God forbid that you live in an economy whose political leaders are so foolish to add even further to current and future budget deficits via expansionary fiscal policy such as we have. Households and businesses will only see still higher taxes in their future and cut back even more in order to get themselves ready. Waiting means that the final day of reckoning is further delayed and an even higher toll would have to be later than has to be paid now. This would be all well and good if true but it's not. Austerity is attacking the symptoms and not getting at the causes of our present difficulties. In economics we have a situation akin to modern medicine (with all its strengths and limitations) being practiced alongside bloodletting and humorism. It's too bad.

Don't bet on economic forecasting does not mean that we should not bet on economists.

Justin Wolfers is a professor of business and public policy at Wharton and was guest on the American Public Media radio program Marketplace Tuesday the 21st. His commentary on the deplorable state of the economic forecasting “Don’t bet on economic forecasting” I think is fair. My concern is that in a world in which jokes such as you could lay all the economists in the world end to end and never reach a conclusion are so common what economists do well risks being lost in the shuffle. You may not need an economist to tell you which way the wind is going to blow. However, if you want to understand why the wind is blowing and what to do to better shelter yourself from it you just might need one. For more on this click here.

more on stimulus

I have put together a note on whether or not President Obama's stimulus package is having an effect on the economy. When you look at the June state level unemployment rates (just released earlier this week) and the numbers available on recovery.gov regarding how much stimulus money has been paid to each state it would appear to be that, in those states that have received, as of June 30, 2010, more than a paltry $200 per person in stimulus money, the answer offered to this very important question is yes, it would seem to be having an impact. Because of the charts and tables included I could not directly post this note to this blog. It can be found on Scrbd by clicking here.

when will the employment numbers improve?

The patient was quite ill and was in intensive care. She has been moved from ICU to another room in the hospital. She not ready to be released. However some of the doctors, nurses, and family members are worried about mounting bills so she is discharged from the hospital. With quite a bit of luck and family members able and willing to step in and do what the hospital's staff was doing the patient may recover. If not, having been released far too early, she ends up in the hospital again, far more ill than before. Who will accept the blame? The Great Recession began in December of 2007. However, real GDP (RGDP) hit its peak in the second quarter of 2008. At that time output per worker (crudely measured by the ratio of RGDP to nonfarm payroll employment) was $91,865.27. Between the second quarter of 2008 and the second quarter of 2009 total earnings fell by over $500 billion. Since QII 2009 we have been in recovery. Recovery notwithstanding, real income remains some $270 billion lower than it was two years ago. And what has happened to output per worker? Overall productivity has grown by more than 7%. Our employment problems are simply a matter of arithmetic and we have a long way to go before the U.S. economy can be said to have fully recovered. How far? To reach the level of real income we enjoyed two years ago requires another two quarters of economic growth like the one experienced during the first quarter of 2010. Even then, given that between Q2 2008 and Q1 2010 productivity has grown from $91,865.27 to $98,521.31 (i.e. seven percent), the U.S. economy will have to grow 7% more for the level of nonfarm payroll employment to return to where it was at before the Great Recession began. And with continued growth in productivity, population, and the labor force it will take more growth still to bring the unemployment rate back to where it was before the recession. The likelihood of sustained economic growth in the near term is shrinking by the day. Last year, New Yorker columnist Jame Suroweicki warned of the harm to recovery budget balancing state governments could bring in his Fifty Ways to Kill Recovery. Within the last week, New York Times reporter David Leonhardt in his article "Governments Move to Cut Spending, in 1930s Echo" points out that here in the States, in Europe, and elsewhere the hope is that as states pull away the support that they have given to their economies that private sector spending will step in to make up the difference. Assume that by some miracle this comes to pass. Then as Leonhardt points out, governments will be able to shore up their finances that much sooner. If, as is much more likely, the money released from government as it cuts its spending fails to circulate at anything approaching the speed that it has been circulating with state spending and spending is further drawn out of the economy via increased taxes, the risks of another Roosevelt recession grows and we should not expect to see a recovery in earnings or employment anytime soon. For the numbers used in this posting click here .

Walton and Rockoff

In Walton and Rockoff’s History of the American Economy they discuss the relative and absolute prosperity of America on the eve of the revolution. In year 2000 prices they estimate that real per capita income of free persons was in the $1,300 to $1,500 range. While they note that this meant that the standard of living for the average free colonial was less than half the official U.S. poverty level that “(N)evertheless we can safely guess that free colonials enjoyed surprisingly high standards for the world at that time” (Walton and Rockoff, p. 102). They go on to claim that “(E)ven today, relatively few countries generate the earnings of free Americans on the eve of the Revolution. In fact, more than one-half of the current world population lives in countries where the average income is below the level of free American’s income of more than 200 years ago. This is true of most of the people of the “Third World”, including India, Pakistan, Indonesia, and large parts of Africa and South America. Relatively speaking, free colonial Americans lived very well, both by today’s standards in many areas of the world and in comparison with the most advanced areas of the world in the late eighteenth century”. (Walton and Rockoff, p. 102). In short, while American were poor by contemporary American standards we were well ahead of where the majority of the world is even today and already close to the lead, in material terms over 200 years ago. There is a difference between less than half of contemporary poverty levels and well less than half: Adjusted for inflation, the poverty level for a single person in 2009/2010 in the U.S. was almost six times greater than $1,500 (http://aspe.hhs.gov/poverty/09poverty.shtml *) Even for a family of eight, the 2009/2010 poverty level comes to $3,735.82 a head or almost two and a half times the higher end of the range that Walton and Rockoff report. One –sixth of current poverty level to forty percent is indeed less than half, quite a bit less. {* I used a price index of 123.8349 to put the 2009 figures into comparable terms to the figures of $1,300 to $1,500 Walton and Rockoff report. I arrived at this figure by taking ratio of the GDP deflators for 2009 and 2000 (base year 2005) and then multiplying the result by 100. } Purchasing Power Parity Ratios and real per capita income: According to World Development Indicators (source: http://siteresources.worldbank.org/DATASTATISTICS/Resources/WDI08_section1_intro.pdf )in 2005 (the year the edition of Walton and Rockoff Iam quoting from was published) real per capita income in India was $2,222 , Indonesia it was $3,209 , and in Pakistan it was $2,184. Even for countries of Africa, such as Kenya ($1,375), Lesotho ($1,311) and Nigeria ($1,520) you find per capita income within the $1,300-$1,500 range . One must assume that Walton and Rockoff used earnings figures converted into dollars using local currency to USD (U.S. dollar) exchange rates. By failing to take into account the substantial differences in the cost of living between countries (typically far lower in economically poorer countries than in economically richer countries such as the U.S.) the level of earnings can be grossly underestimated. For example, the cost of living in India is only one-third that of the U.S. So when the Rs 32,596.74 earned by the average Indian in 2005 is converted into USD using an exchange rate of Rs44.27=1 USD it would appear that the average person in India only earned a little over $700 ($736.32 to be exact). This assumes that the cost of living is the same in the two countries. However, with one-third the cost of living in India the $764.32 actually goes slightly over three times farther or is closer to earning the $2,222. Poverty is still very real but the sting of poverty is somewhat less painful as it is offset by a lower cost of living. Focus on the fine lady. Ignore the boy in rags: The illustration (Walton and Rockoff, p. 104 ) used to further support the enviable prosperity of America in the late 18th century is in fact English artist W.P. Firth’s “The Crossing Sweeper” . http://en.wikipedia.org/wiki/The_Crossing_Sweeper which was painted in 1858 and meant to depict the sharp contrast between wealth and poverty in mid-19th century London. However, in Walton and Rockoff , the painting is meant to illustrate how far America had come from Jamestown’s mud huts to the eve of the Revolution. The fact that even if it were a painting of late 18th century America rather than mid -19th century England the shoeless boy is helping his family make ends meet et by sweeping the way clear for a fine lady as she crosses a dirt road would seem to support an alternative view. That alternative view is that at the eve of independence we were by today’s standards a poor country and. we had much more in common with contemporary economically developing countries than Walton and Rockoff would care to admit. Summary: Walton and Rockoff are not unusual in the approach they have taken. It is a variant to the idea that today’s economically dominant economies have been far ahead a very long time ago and, although relatively poor, were never quite so poor as the poorest sections of the world today. The fact is that in the admittedly broad terms of real per capita income it was not until the after the middle of the 19th century that we here in the U.S. approached a standard of living that placed us roughly on par with where the average Indonesian is today. Using the figure reported by Fogel in Without Consent or Contract for 1860 (see Table 1 p. 85) and the Economic History Assocation’s measuring worth website (http://www.measuringworth.com/ppowerus/ ) to convert the figures quoted in 1860 prices to a year 2000 base, the level of real per capita income we, as a nation enjoyed (the portion that was not enslaved), was a meager $3,080. This means that over six decades after the period Walton and Rockoff are discussing the average American had a standard of living still well below the per person poverty level, even the poverty level for a large family today. Note too that it would require only ten years of real economic growth at 3.3% a year for India to reach the point we were at in 1860, Pakistan a little over ten and a half years and Nigeria about 22 years. All three are in the admittedly very rough terms of real per capita income around where the average free American was at the end of the 18th century or in fact beyond that point.

a sense of proportion

Regardless of what one thinks about health care reform a sense of proportion is completely missing from this debate. The most current data we have for total earnings in the U.S. yield a figure of over $14 trillion. This means, even if we assume no growth in the U.S. economy over the next ten years, we will generate earnings of $140 trillion. The horrifically high figure of $1 trillion in additional spending over the next ten years for health care reform therefore represents well less than 1% of this total. Worthwhile or not, given the size of the U.S. economy 1 trillion dollars over ten years is NOT a lot of money. Also note that the Census department estimates that the average U.S. family spent about $6-$7 A DAY on food away from home in 2007. With over 121 million households this translates into $300 billion dollars spent in 2007 eating out. Not that I am suggesting this as a way to fund health care reform but I find it interesting that we could, by cutting how much we eat out by a third, we could easily handle annual costs of $100 billion a year. Finally, the burden of paying $100 billion more to improve access to healthcare works out to be about $328 per American. This means in my own case my family chipping in less than $1000 each year to help out. To paraphrase Vonnegut, we could have saved ourselves but we were too damn cheap.

employment and economic growth

Over the last year I have become quite disillusioned with National Public Radio. The quality of its reporting, especially on the financial crisis, has been awful. What is most disturbuing is that there appears to be no way communicate with reporters (other than in the comments section where the quality of comments ranges from ridiculous to excellent, where it is not clear the reporter ever reads these comments, and where one must drop everything to post a comment before the story is closed for comments). I listened to the piece by Scott Horsley "Jobs Shrink Faster than Stimulus Grows New Ones" on Morning Edition while getting ready for work today and have just finished listening to it again here in my office. I would rather direct my comments to Mr. Horsley but absent that here I go. (1) "Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that! " (Lewis Carroll) It is a simple matter of arithmetic. If the capacity to supply grows faster than demand, employment -measured crudely in number of people employed and more correctly in hours of work put in- will fall. The local candy bar factory installs new machinery that boosts output per hour's labor ten percent, currently employs 100 people (each working a forty hour work week and so collectively they are putting in four thousand hours a week at the factory), and each worker was previously able to produce 100 candy bars an hour. All else equal, a week's production will expand from 400,000 candy bars a week to 440,000; if the demand is there. However, what happens to hours needed if this new machinery is installed at precisely the wrong time and demand stagnates or worse yet, falls? Even if demand remains at 400,000 bars a day, we cut back production to adjust to demand and in so doing reduce the hours of labor required each week from 4000 to a little over 3,600 hours. This means four hundred fewer hours required and possible layoffs of 10 people. While in the U.S. final sales adjusted for inflation grew last quarter output per hour's worth of labor grew far more rapidly. Part of this growth in productivity is due to ill-timed introduction of new labor saving technology and, as one should expect, this resulted in job losses. If spending had failed to grow even the relatively sluggish amount that it grew in the second quarter of 2009 the job losses would have been even greater. (2) Sweeping, dusting, tightening bolts, and tidying up. Even absent growth in productivity of the sort just described, the employment numbers are bound to lag behind as the economy improves. Why? An answer is given in an excellent piece by Ed Sokalski posted to a website called Themorningcall.com August 26, 2009. Management, not sure of the depth or possible duration of a downturn and hesistant to lose valuable staff, is inclined to cut both staff and their hours by less than declining sales might warrant. * Management has retained core staff as much as possible for as long as possible. Management has cut production and suffered lost sales far greater than hours or employment have been cut. When the economy begins to recover how is management to tell that a recovery is indeed happening? Having little or no confidence that a recovery is taking place nor any confidence in how strong the recovery might be rather than making new hires employers maintain employment levels and increase hours of work offered. Staff stops cleaning up their file cabinets, sweeping the lobby and taking Friday afternoons off, and gets back to a more normal day-to-day routine of answering customers' calls, filling orders and the like. At the ground level, company sales and profits rise, bonus pay increases, the average number of hours worked each increases, and confidence increases. In the economy as a whole we see growth in real income despite stagnant or even rising unemployment rates. (3) Yet another reason for rising unemployment/sluggish job growth. In a one page article entitled "Fifty Ways to Kill Recovery" (published in the July 27th, 2009 issue of the New Yorker ) James Surowiecki explains how states and the Federal government are working at cross purposes. While spending in real terms at the federal level grew 2.6% over the second quarter of 2009 spending at the state and local levels grew a sluggish .9%. This was of course before many states and local governments started to budget for the coming year and in the name of fiscal responsibility slashed programs, cut positions, and such. One can imagine that at the end of October we shall see that levels of spending by states and local governments fell over the last quarter. So even as more federal stimulus money is entering into the economy all the time (let's say that it indeed is as high as the 157.5 billion that Mr. Horsely claims it to be). each dollar state and local governments cut cancels out the stimulus provided by increased federal spending. Note that 46,000 government jobs were lost between June and August of this year. As I mentioned in an earlier posting during the 1930s and 40s, as federal government spending was growing , state and local government spending was falling. Between 1939 and 1944 the overall level of state and local government spending fell. Part of what is going on now -at least arguably- is due to our making the same mistakes we did then. Absent the small part of the Economic Recovery and Reinvestment Act money that has already been injected into the economy that the economy would be less robust and showing far fewer signs of recovery than it at present is showing.

(4) One final note: $787 billion and confidence multipliers. Is $787 billion a lot? Nominal GDP in the U.S. in the second quater of this year was $14 trillion. Even if half the $787 billion ERRA money is spent by December 31st 2009 this is still only 2.8% of total nominal earnings for the year. It is interesting to note that China's 4 trillian yuan was so often characterized as being almost as large as our own stimulus package. Indeed the yuan figure given above converted into dollars using the yuan/dollar exchange rate of 7 or so yuan to a dollar translates into $570 billion. However, China's overall economy is still much smaller than our own (a little over about half as big as the U.S. economy with real GDP of about $8 trillion). Furthermore, given the tremendous differences in the cost of living between the U.S. and China (being much higher here), China's stimulus package is actually more akin to injecting over $2 trillion worth of stimulus.

In China's case one could argue that what signs of recovery there are (and there appears on the whole to be several such signs) are directly due to spending the Chinese government has injected or has helped to inject into its economy. In our case, I think it is well worth considering how much of what is going on is the direct result of fiscal and monetary stimulus (a modest amount of the former and a substantial bit of the latter) and how much of it has to do with restoration of confidence. Akerlof and Shiller in their book Animal Spirits develop a concept that they refer to as the confidence multiplier. Much like spending multipliers, which provide estimates of the change in equilibrium income that follow a unit increase in consumer spending, economic investment, government spending or export sales (say the unit being used is an inflation-adjusted billion dollar increase in spending), confidence multipliers provide an estimate of "... the change in income that results from a one-unit change in confidence..." (Akerlof and Shiller, p. 16). Of course, unlike spending multipliers, it is much more difficult to sensibly explain what might be meant by a one-unit change in confidence and much more challenging therefore to measure it.

*This is one reason why less skilled labor suffers disproportionately in downturns; last hired and first fired. The unemployment rate for the less educated adults stands well above the national average while the unemployment rate for those with more formal education, for example, stood at a little under half the overall rate of 9.7 in the month of August.

Our children and our granchildren.

Let's say that my roof leaks. By not fixing my leaky roof I am leaving my wife and daughter with less debt to pay off if something should happen to me. However, I also am leaving them with a far less valuable property. With low interest rates and qualified roofers able to work on very reasonable terms, is it really the right thing to leave the roof in its current state? Would I really be a good husband or father if instead of having the roof fixed I took out a somewhat smaller loan so that the three of us could go to Disney World instead? If I do this and something happens to me, all my wife and daughter are left with are memories of our trip and the loan to pay off. As any student who has passed a course in corporate finance can tell you, the internal rate of return on an investment is its gross return. Regardless of how expensive any project might appear to be initially, a positive internal rate of return or gross return means that over the life of the investment it is capable of being quite profitable. For example, a 2 billion dollar investment which adds on average $150 million to a company’s profits (either by lowering operating expenses or making it possible to increase revenues) each year over the next thirty years generates a gross return of about 6.3%. All else equal, if financing could be obtained at the rate that currently thirty year Treasury bonds are being sold, 3.5%, what would any savvy business manager do? Wouldn’t it be at least worth considering increasing overall profits, net of interest expense, by 2.8% a year? Of course in any well managed business there should be and will be debate about how confident management is in its estimates of cost savings and added revenues. There should also be a discussion of whether it might be advisable to wait to see if a clearer picture about what the future holds might emerge later on. Regardless of all of this, it would be exceedingly foolish to simply dismiss the proposed project out of hand as too expensive or to claim that years from now management of this company would be saddled with payments on the debt it has taken on today. Again as any student with a passing grade in corporate finance should be able to tell you, any project with a positive net return (gross return less interest expense) will yield a positive net present value; in other words it will generate more in benefits over time than it adds to costs. Now read the following passage carefully: Regardless of how expensive the stimulus package might appear to be initially, a positive internal rate of return or gross return means that over time it has the potential for making us far better off than we would be otherwise. For example, a nearly trillion dollar stimulus package which focuses on investment in education, energy efficiency, health care, and infrastructure may add billions to an economy’s earnings (either by lowering costs or expanding markets) each year for some time to come; perhaps generating a gross return of about 6.3%. All else equal, if financing could be obtained at the rate 3.5%, what would any savvy group of political leaders do? Wouldn’t it be at least worth considering increasing overall earnings, net of interest expense, by 2.8% a year? Of course there should be and will be debate about how confident those who have put forward the package are in the expected cost savings estimated and the market expansion anticipated. There should also be a discussion of whether it might be advisable to wait to see if a clearer picture about what the future holds might emerge later on. However, it would be exceedingly foolish to simply dismiss the package out of hand as too expensive or to claim that our children and our grandchildren would be saddled with payments on the debt taken on today. Again as any student with a passing grade in corporate finance should be able to tell you, any project with a positive net return (gross return less interest expense) will yield a positive net present value; in other words it will generate more in benefits over time than it adds to costs. As should be abundantly clear at the present moment, in times of uncertainty individual households or businesses are concerned with protecting themselves and their families. Therefore, they are hesitant to act, to take on risks until a clearer picture emerges and they have seen things improve. They are only too happy to join the crowd spending and generating sales, profits, financing and jobs once the crowd is big enough. As we all wait for others to move however no such forward movement is possible. What makes the government different is that while as business managers and adults running households are first concerned with the safety and security of those who have invested in their businesses and their families, the government is charged with acting in the public’s interest Investment in energy efficiency, education, health care, and infrastructure are all investments in which we can anticipate over the long-term to generate a substantial return net of the debt taken on now. If the money from the current stimulus package is spent wisely to employ the resources that the marked slowdown in private spending has made available to repair schools, to fix roads, to increase energy efficiency and so on we both stimulate total demand right now and expand our capacity to produce later on. It is true our children and our grandchildren will be paying down the debt we have taken on now. However if the money is spent wisely and employs otherwise idle resources productively our children and grandchildren will be paying this debt out of higher and more stable earnings; just like a private business that has takes on debt and invests the money profitably is able to do. Economically stronger and more efficient, future generations will have less need to struggle and borrow themselves if we do what needs to be done now.

Voodoo economics and Team Obama

Will Wilkinson (of the Cato Institute) in an editorial on Marketplace Morning Report points to Harvard's Robert Barro's opposition to the stimulus package. In an opinion piece published in the Wall Street Journal on 1/22/09, Barro explains why he views "Team Obama's" stimulus package as misguided. I have two comments to make about his piece . (1) What Barro characterizes as the flaw in Obama's stimulus package. "The theory (the simple Keynesian macroeconomic model) implicitly assumes that the government is better than the private market at marshaling idle resources to produce useful stuff. Unemployed labor and capital can be utilized at essentially zero social cost, but the private market is somehow unable to figure any of this out. In other words, there is something wrong with the price system". We may indeed appreciate the real opportunities there are in picking up dirt cheap shares of stock or in starting up a business when rents are so low and equipment can be had for a song (and finding workers who are willing to work for peanuts as well ). However as rational self-interested individuals we tend to fall back on the old adage "fools rush in ...." Individual consumers, creditors, and businesses will of course be happy to join the crowd but only once such a crowd forms. This is the problem. It is, at the very least arguably the case, that since Arrow and Hahn that significant advances in macroeconomics have come as we have worked on the implications of models with incomplete markets and where the agents in our models act strategically. The conclusion that emerges from this work is that, as Keynes argued, there is indeed something wrong with the price system. Barro seems to suggest that it is preposterous to suggest that our friend the marketplace can have any faults. However, to say that she has weaknesses does not imply that we do not respect her and do not think that, with help, she is better suited to the task than others would be. (2) Basic statistics. A sample of size one is a pretty slender thread to hand one's argument on. I took a look at the same numbers (in 2000 dollars rather than 1996) that Barro uses on government spending and changes in real GDP. Using the increase not just in federal defense spending but the increase in real federal spending overall and the same crude calculations Barro does I get a rough and ready expenditure multipliers of .56, .68, and 1.02 for 1941-42, 1942-1943, and 1943-1944. The point here is not to quibble about the numbers but to note four things. First, as federal government spending was growing over this period, state and local government spending was falling. Between 1939 and 1944 the overall level of state and local government spending fell by almost 40 billion dollars (on a base of real income much much smaller both in absolute and per capita terms than what America generates today). Just as it is hard to assess the impact of the medication a patient is taking for high blood pressure when the patient continues to work in a stressful job and smokes a pack of cigarettes a day, these changes in the level of state and local government spending almost certainly dampened the stimulative impact of increased government spending at the federal level. Second, using the same basic approach that Barro uses but simply averaging the ratio of changes in real income to real federal government spending from 1929 to this last year I get an average of over $7. In short, I could make the outlandish claim that over the last 79 years the evidence suggests that, on average, a dollar increase in federal governemt spending generates not just a free lunch but a veritable banquet of $7 increases in spending and earnings. To suggest this would be irresponsible in the extreme. Often, the increases and the drops in real income have had very little to do with the changes in government spending at the federal level of government. For example, in the 1990s we saw federal government spending fall as real income rose in the wake of the tech boom and expansionary monetary policy. And, of course, we saw real income fall sharply in the period 1929 to 1933 despite growth in real federal government spending. My third point is that if using the same method to calculate an expenditure multiplier for 1983-1984 as Barro has done for 1943-1944 we get an expenditure multiplier of nearly 24! The fact is that in an era in which the genius of free enterprise was being freed from the shackles of government regulation (the Reagan years) federal government spending adjusted for inflation increased at a rate that was 3.5 times faster than it had grown during the Eisenhower to Carter adminstrations (just as it has grown, rhetoric aside, at a rate 2.67 times faster 2000-2008 than it had 1952-1980 ). Finally what Barro argues in the very last paragraph of his piece is that in the face of what is going on now that the solution is to be found in cuts in marginal tax rates, eliminating the federal corporate income tax, and such. Entirely rational self-interested financiers, entrepreneurs, and consumers are playing the socially destructive game of waiting to see if things will improve. Whatever the merits of tax cuts in general might be what Barro recommends it akin to advising a poor farmer to pour fertilizer on dry and relatively barren soil. What is so foolhardy in suggesting that he break new ground and with a bit of manure, fertilizer, and irrigation added to this mix see what the land capable of ? Once moved to a better position to take advantage of opportunities, he is again on his own.

NPR's Adam Davidson strikes again

The following is a copy of a letter I am sending to NPR re Adam Davidson, NPR’s "expert" on Keynes. In a breezy conversation two weeks ago today with Morning Edition’s host Renee Montagne, reporter Adam Davidson managed to convey to listeners the notion that President Obama has founded his solution to our current economy crisis on the largely discredited theories of a long dead anti-semitic nutty snob of an Englishman who hated Americans, the French, and the working class: John Maynard Keynes. Google “Keynes: gay brit elitist hater of USA Jews working class” and it will lead you to a posting to the Planet Money Blog by Mr. Davidson dated January 14, 2009 (http://www.npr.org/blogs/money/2009/01/some_problems_with_keynes.html To not put too fine a point on things, taking over twice the listener’s time and with two more weeks to do his homework Mr. Davidson again failed miserably to improve on this grossly inaccurate characterization of someone who the late Milton Friedman –certainly not to be considered by any stretch of the imagination a Keynesian- referred to as a "brilliant scholar" and "one of the great economists of all time." (Milton Friedman, "Keynes's Political Legacy," in John Burton, ed., Keynes's General Theory: Fifty Years On (London: Institute of Economic Affairs, 1986), pp. 47-48, 52)) After Mr. Davidson’s piece ran on Morning Edition I wrote to question the accuracy of much of what Mr. Davidson claimed. I also noted that the sort of follow up that I think represents what we mean by the term “in-depth reporting” (and that NPR prides itself on) was woefully absent in the questions Ms. Montagne’s put to Davidson. I wouldn’t continue to bother with this but it is estimated that there are 20 million people who tune in to NPR each week and, as I mentioned above, I fear what we are to take from Mr. Davidson’s is that President Obama is grasping at straws and potentially leading us to Lord knows where. Anti-semitism: I would encourage Mr. Davidson to have a look at volume two of Skidelsky’s biography of Keynes. Pages 238-239 and 486-489. To focus on Keynes’s anti-semitism is akin to running a piece on Lincoln’s influence on Mr. Obama noting that Lincoln was a racist (Which he was. After several generations of helping build this country, Lincoln nonetheless supported the idea of “repatriating” African Americans once freed from slavery. He wrote to Horace Greely that if he could restore union without emancipating slaves he would gladly do so. And in Sept 1858, in his fourth debate with Douglas, Lincoln said that “there is a physical difference between the white and black races which I believe will forever forbid the two races living together on terms of social and political equality”) Americaphobe and anti-French snob: Perhaps Mr. Davidson would like to consider Keynes’s views on Americans and the French and how they were shaped by his experiences after World War I (see for example Skidelsky, pp 122-123) On the matter of Keynes’s hatred of the working class, I am at a complete loss to see where Mr. Davidson draws the conclusion that Keynes hated them. His mentor Alfred Marshall wrote eloquently of the inequities in English society as being one of the key factors that drew him to economics. And what led Keynes to the General Theory was a flat refusal to accept what was implicit in classical economics of his day and in conservative economics of our own; the notion that widespread unemployment was the fault of recalcitrant workers unwilling to face facts and adjust their pay downwards. Beyond this I would again invite Mr. Davidson to consult Skidelsky (volume 2 p. 526) or, better still, read Keynes’s “Economic Possibilities for our Grandchildren” Keynes’s theories discredited long ago: Since at the very least 1959, with the publication of Debreu’s Theory of Value it has been clear that Smith’s invisible hand is only as swift as we might like it to be if there are complete markets. While the main text is well beyond most mere mortals (economists and noneconomists alike) I would suggest that Mr. Davidson read carefully the first few pages of the introductory chapter to Magill and Quinzii’s Theory of Incomplete Markets (2002) and what they have to say about Keynes. One can easily rally a number of articles and books written in the last generation in which the classical resurgence of the 1970s and 1980s has been called into question. The vast majority of them focus on incompletely-formed or missing markets and the weaker efficiency of market economies when compared to the ideal case . In this growing literature many recognize the parallels of their new models to Keynes’s insights (as is the case in Magill and Quinzii) And the policy implications of this work are clear; between completely free markets and complete control we find reality where ignorance and uncertainty are a fact of life and in which the potential need for government intervention is there. To not risk giving Mr. Davidson too much to absorb I again recommend he have a look at Skildelsky volume two and the quote given on page 409 from one of Keynes’s students, A.F.W. Plumptre ( who studied with Keynes at Cambridge in 1920s.) Plumptre notes that in studying with Keynes it was clear that Keynes’s desire was to protect freedom and prevent communism by introducing government intervention in a timely manner on a sufficiently large enough scale. A much better story for NPR to focus on concerns the price we are paying for too little being done too late. We are constantly being asked to choose between two polar extremes that are of the economic equivalents of completely negligent parenting (laissez faire) and overly strict meddling parenting (socialism). In essence, what Keynes argued for was for political leadership (under the guidance of academics it is true, who else?) to seek out, as best as humanly possible, a point along the continuum between these two extremes in order to protect freedom and fortunes of individuals. As he noted on more than one occasion in any downturn those least able to bear the burden of adjustment are the ones who are expected to do the heavy lifting. (This is another important story that NPR is largely missing in its coverage of the current recession.) Just as good parenting requires intelligence, the exercise of good judgement, and a clear sense of duty to one’s children, good governance requires all these things. The fact that our leaders can fail, as so many of us often do as parents, does not excuse us from trying or give us the right to criticize any one so arrogant as to point out how difficult and important the task is.

Mr. Keynes

I find much to criticize in Adam Davidson’s conversation this morning with Renee Montagne (“Keynes' Economic Theories Back In Vogue”, Morning Edition , January 16, 2009). “Just Plain Nuts”: First it very difficult to find any support for the statement Mr. Davidson made that "Most of what Keynes wrote was just plain nuts" or that there is a consensus to this effect. It is in fact quite easy to find statements such as the following written by the late Milton Friedman some 20 years ago. Certainly not commonly thought of as an admirer of Keynes, Friedman referred to Keynes as a "brilliant scholar" and "one of the great economists of all time." He described The General Theory as a "great book," saying at the same time that he considered Keynes’s Tract on Monetary Reform as his best work. Friedman in this same piece further states that "I believe that Keynes's theory is the right kind of theory in its simplicity, its concentration on a few key magnitudes, its potential fruitfulness." (Milton Friedman, "Keynes's Political Legacy," in John Burton, ed., Keynes's General Theory: Fifty Years On (London: Institute of Economic Affairs, 1986), pp. 47-48, 52). “He wasn't worried about contradicting himself” As far as Keynes’s inconsistency, I would simply note that as an economist very well-schooled in orthodox economics, Keynes struggled to fit the rough-edged square shaped pegs of the real world into the smoothly carved round holes of orthodoxy. One can look at the evolution of Keynes's monetary theory (dating all the way back to a review article of American economist Irving Fisher's The Purchasing Power of Money in 1911) in this light with his two volume Treatise on Money (1930) , the General Theory(1936) and his article summarizing the General Theory that was published in the Quarterly Journal of Economics the following year (1937) as representing the culmination of those efforts. Over the course of this intellectual struggle his views of the proper role of government policy and his faith in the essentially self-adjusting nature of market economies changed radically. When because of this Keynes was accused of being inconsistent , of being the “rubberman” Keynes is famously quoted as having said that “When the facts change, I change my mind. What do you do, sir?” (when taken to task for having changed his position on monetary policy, as quoted in Lost Prophets: An Insider's History of the Modern Economists (1994) by Alfred L. Malabre, p. 220). “A prolific writer who owned a magazine and published his own books” Keynes’s books were not self-published as the statement “..and he published his own books’ would seem to imply nor did he own the Economic Journal although he served as its editor for years. Keynes as a snob, anti-semite, and so on: Unfortunately, among upper class Englishmen of Keynes’s day being a snob, anti-semitic or not particularly fond of the French would not I should imagine be uncommon. For example, do we have any evidence that Keynes was any guiltier of this than Churchill or the Queen Mum? Also I find the accusation hard to reconcile with what one finds pp. 485-488 on Robert Skidelsky’s John Maynard Keynes:The Economist as Savior, 1920-1937. Keynes’s homosexuality: Perhaps I am being unfair to Mr. Davidson but I think the lowest point of this four minute conversation with Renee Montaigne came when he discussed Keynes’s sexual orientation. Are we to conclude from this that not only what Keynes wrote was “just plain nuts” but so was he? Is a person’s sexual orientation an indicator of this? Bloomsbury was an island of tolerance and I do not know whether or not there is any evidence that Keynes, outside this wide circle of friends and acquaintances, openly flaunted his interest in persons of the same sex. Anyone interested in this matter should consult volume one of Skidelsky’s biography of Keynes. Also perhaps given his long and close relationship to wife, the Russian ballerina, Lydia Lopokova it might be more accurate to describe Keynes’s sexual orientation as bisexual rather than homesexual. What’s important to keep in mind: At root, what Keynes saw as the key failing of the orthodox economics of his day (and with the orthodoxy of our own day, they are one and the same) was the assumption that in response to any change introduced to the system (say, for example, a sharp drop in confidence) market economies would quickly tend to absorb the impact of these changes rather than amplify them. Before Keynes’s time, markets were thought capable of creating compensatory changes in some variables as disturbing changes take place in other parts of the system. For example, in response to the disturbing change of rising unemployment (caused perhaps by lower spending created by financial panic) the orthodox idea was that wages and prices would fall enough to compensate for lower demand. If markets were working properly no intervention was needed. However, as Keynes argued if the drop in spending (created by things such as a drop in the confidence of financial investors) created further drops in spending, rather than markets absorbing the impact of the disturbing changes they would amplify them. Badly bruised by the fall it would be unreasonable to expect any one entrepreneur or financial investor or group of same to be willing to get up without help. Most would, quite rationally be waiting for others to make the first move. The positive role government could play in breaking this deadlock is what Keynes identified. He also was clearly made the obvious point it is best not fall in the first place. Over the last several months of this crisis, I have repeatedly heard reporters on NPR draw attention the important role that restoration in confidence plays in our recovering from the mess we have collectively fallen into. What is missing in these discussions is Keynes’s insight that the dilemma we face in a market economy is that while we can all see that this is the solution to our difficulties is to be found in the restoration of confidence we are unable, acting in our self-interest, to do anything about it. For example, what sort of measurable effect has Warren Buffet’s efforts to swim against the tide made? Cooperative/collective action is needed; in short, government intervention. For a thoughtful and extended discussion of Keynes's relevance today see Tom Ashbrook's interview with Lord Robert Skidelsky December 18th 2008 On Point

Financial disasters

Within the field of geography there is an area of specialization referred to as disaster management. The basic concepts of disaster management involve: (1) prevention and mitigation, (2) preparedness and response and (3) recovery. The first involves preventing or at least minimizing the chances of a disaster, the second –recognizing that many disasters cannot be prevented- involves making sure that an area is ready with a set of plans in place to respond as effectively as possible while the third involves a careful consideration of the steps needed to help a region pick up the pieces and return to normal as quickly as possible. The current financial crisis can certainly be referred to as a disaster. In what follows I argue that what we have been doing over the last several years has been the financial equivalent of allowing and even encouraging the extensive building of huge but poorly constructed structures on a major fault, a major floodplain or a very cyclone prone area. One cannot reasonably expect experts to be able to predict with any precision just when the next major earthquake, flood or cyclone will occur in an area prone to such calamities but to actively encourage settlement in such places or to fail to have plans in place to deal with disaster when it, inevitably, occurs is extremely poor disaster management. How financiers are like poor Bangladeshi farmers: Driven by poverty and overpopulation poor Bangladeshi farmers settle in islands of rich fertile alluvial soil that form islands of farmland in the Sunderbans of Bangladesh. If they are spared from cyclones and flooding, it is possible to eke out a better living on these islands (or chars as they are called) than they could manage elsewhere. Of course, flooding and cyclones do occur but the choice made is taking one’s chances and making ends meet rather than starving . So farmers settle on chars hoping and praying that they are spared from disaster. Sometimes prayers are answered more often they are not. The Bangladeshi government can do little to control this settlement and, given its limited resources, can offer little in the way of alternatives to those who settle there. The U.S. financial sector -driven not by poverty and overpopulation but by an increasingly crowded and hence competitive environment- has settled in the financial equivalent of disaster prone areas of financial services such as the packaging and sale of mortgage backed securities and credit default swaps. In fact, through deregulation our government has encouraged settlement in these disaster zones. Disaster has struck with a clear recognition that it was simply a matter of time and we have, until this week, had no plan in place in terms of how to respond or how to recover from the inevitable. “Financial statesmanship”: On August 6th of this year an organization of major players in the financial services industry (a group called the counterparty risk management group project, CRMGP) issued their third report. This report was expressly directed to Secretary Paulson (as the report issued by the same group three years ago had been) and to Mario Daghi, governor of the Bank of Italy and chair of the Financial Stability Forum. To their credit, the CRMGP clearly has recognized that the root cause of our current difficulties is a lack of what they call “financial statesmanship”. They define financial statesmanship as requiring that management of individual firms look at the broader and longer run perspective of what ultimately would be better for the financial sector the world economy overall, and themselves rather than their own firms’ short run (real or imagined) profits and cash flow. Beyond this frank admission of short-sightedness what is amazing is that they clearly point to the dilemma that an individual firms faces if chooses to rise above the fray. As they put it “ …in a highly competitive marketplace it is very difficult for one or a few institutions to hold the line on best practices or to stand on the sidelines in the face of booming markets.” Although the CRMGP does not identify the dilemma as such, what individual financial firms face is a classic prisoners’ dilemma. Just as the guy who confesses first is potentially better off to the swift goes the race in financial markets. To move cautiously when you are not at all sure that others will be so wise means that the sort of returns earned may be far below one’s competitors’. Just as the prisoners’ dilemma provides support to the old adage that there is no honor among thieves what the CRMGP is drawing our attention to in their report is that, for good reasons, financial statesmanship is an exceedingly rare commodity. What I hasten to add is that, with the right expertise, you shuffle the deck and put most of us in the position of top management in the financial services industry and we would behave no differently. This dilemma is a problem inherent in financial markets. But what has happened here is that the ultimately self-defeating and potentially dangerous game has shifted from the risky trading of financial paper to first mergers and acquisitions and initial public offerings (which in hindsight seem tame in comparison) to the disaster prone territories of mortgage backed securities, credit default swaps, and such. It is natural enough to expect the quest for higher returns to have encouraged this movement but the level of competition and the ability to take on far greater risks have both grown largely thanks to less stringent regulation. Regulation has become far more relaxed: Among many recent changes to our regulatory environment in 2003 the current administration asserted the superior power of the federal government, through the SEC and other federal agencies, to regulate the financial sector, over the states. This is in keeping with the Bush administration’s later position that federal carbon emissions standards were binding and that states such as California could not set their own more stringent standards. With looser controls predatory lending became the order of the day as mortgage credit was given to many borrowers with little thought given to the credit history or actual earnings of the borrowers, the market value of the properties to be purchased with these mortgages or concern that the borrowers were aware of what risks were involved once the low or zero interest-principal only period of their mortgages expired, they had to “reset” and, for some reason, they could not refinance. Originators left it to the third parties buying mortgages to sort all of this out Those buying these mortgages pooled them with the hopes that the pooling would make risks of default insurable. Perhaps not coincidentally issuance of MBSs over the course of 2003 grew by some 48% over what it had been in 2002 (according to the Bond Market Association). As of 2006 the same organization estimates that the market value of MBSs outstanding stood at some $6.1 trillion (in comparison to about $8.5 trillion worth of U.S. Treasury debt held in government accounts and by the public in the same year). The magic of financial engineering: Take a MBS based on a collection of subprime mortgages. As an investment banker you buy 10 subprime mortgages to package together in a security. Because of a higher default risk, the individual subprime mortgages let's say yield 7% when prime mortgages only pay 5%. First by assuming that although the chances of default on any one subprime mortgage may be relatively high (say a one in ten chance) if the likelihood of any one borrower defaulting is independent of the others in the pool (which is an extremely naïve assumption for any one with even an elementary understanding of macroeconomics) the likelihood of default goes from a 1/10 chance if you held each mortgage individually to an infinitesimally small chance when you pool ten together. This pooling of risk is how insurance works. By pooling two such mortgages together you cut the odds of complete default not getting any of the money risked from a 10% chance to only 1 out of 100. Double the pool again to four and the odds of complete default falls to one in 10,000. The flip side of this is that the odds of at least half of the money at risk being paid back as you go from 1 subprime mortgage on its own ten mortgages collected in a pool goes from 90% to 99.98%. Of course, in an actual insurance policy the odds are capable of more or less exact estimation whereas the likelihood of default is not. Ignoring this simple fact, money is to be made by buying these mortgages up at discounted prices that reflect individual default risks and by pooling them, theoretically reducing the default risk in the way I have just described. Essentially a 2% profit in interest income on 10 mortgages is divided between the seller and the buyers of mortgage backed securities with the notion that the default risk has virtually disappeared and those involved are earning 2% more than previously the market would have paid for a “risk free” investment. Tranches, what makes MBSs toxic, credit default swaps, and counterparty risk: The idea behind tranches is that not all who might wish to invest in MBS share the same level of confidence. If more cautious one may invest in an upper tranche. If one is less cautious, in exchange for helping the issuing company shoulder part of the default risk, lower tranche investors receive a greater share of the total overall gain. The tradeoff is that in the event that a significant number of borrowers in the underlying pool of mortgages go into default those in the upper tranches have a prior claim on cash flow and are paid first. If all goes well then you get a bigger share of the total gain for simply being less risk averse. However, when there is not enough money flowing in because of higher than expected defaults those in the lower tranches lose out. When there is not enough coming in to pay those in the upper tranches out what otherwise would be paid to the lower ones, MBSs become toxic. (For a wonderful description of tranches, toxicity, and such click here, here or here) At least subconsciously, investors realized the tremendous risks inherent in all of this. To address this, credit default swaps were created. They offer to the buyer a form of insurance. However, unlike real insurance , CDSs are completely unregulated and, unlike real insurance, based on incalculable odds. You are concerned that the company issuing the MBSs you hold will not be able to pay back your initial investment. Let’s say that for 1 basis point on the $10 million of your money that is at risk in MBSs (i.e. for $100,000) I agree to cover the loss if the company issuing your MBS, based on this package of pooled subprime mortgages, goes into default. You rest easier, I have pocketed $100,000 and given GAAP (generally accepted accounting principles) having “insured” your investment you no longer have to mark to market the value of the MBSs you hold (even if they are falling in value). I may not have the $10 million to make good on my promise and so may in turn take out a credit default swap on this same MBS for ½ a basis point (i.e. $50,000) with another party. As a result, I have netted $50,000 profit but no longer have to worry about the fact that I don’t have the $10 million promised. If all goes well, all goes well. However, if defaults begin to increase or if the credit ratings of individual institutions along the chain are downgraded, clouds on the horizon gather and the chances of your losing everything grows. You begin to worry that at the same time the company issuing the MBS that you sold the CDS to me to cover the CDS you bought will not be honored because the seller of that credit default swap has gone into default as well. Driven into this fertile but dangerous area by increased competition and, at the very least, not discouraged from settling here by those in power you now realize that perhaps should have settled some place safer. There is no evacuation plan and no clear idea of how long the storms will last, if you will survive and, if you are lucky enough to pull through what the recovery effort will be. There is plenty of blame to go around. The more fundamental question is what lessons we will draw from what has just happened. Some links on the candidates' positions on the crisis: Senator Obama Senator McCain 1 Senator McCain 2 Senator McCain 3

Leadship, parenting, and differing views on economic policy

You have a friend. He is a parent. He obviously loves his kids. It is equally clear that he firmly believes his children can do no wrong. It looks to you as though serious problems are soon to arise. You say nothing because you know that your friend will not listen to anyone who might suggest that his children could have problems. Time passes and some of his kids have gotten into very serious trouble. Your friend minimizes the problems that are popping up. It is only when they have reached a crisis stage that he steps in. You must face the fact that your friend is a bad parent.

Your country has leaders who love their country. Listening to them it is clear that they firmly believe that businesses can do no wrong. It looks to you and others as though serious problems are soon to arise. You know that your leaders will not listen to anyone who might suggest that businesses (that are, after all, managed by rational intelligent people whose fortunes and reputations are at stake) could have problems. Time passes and some businesses have gotten into very serious trouble. You and others see your leaders minimizing these problems. It is only when they have reached a crisis stage that they step in. You must face the fact that your leaders are inept.

My point is that bad governance is much like bad parenting and good governance is much like good parenting. As a thoughtful parent you assume that your children will behave. At the same time you nonetheless carefully monitor their behavior and stand ready to step in sooner rather than later when difficulties arise. Business people are fond of saying that all that they want from government is to be left alone, much like many teenagers might wish their parents did not treat them like they were still children. But just like the supposedly adult teenager runs to Mom and Dad once they have run out of money or are stranded along the road because they forgot, yet again, to buy gas; businesses rush to government for help when crises emerge.

It isn't wrong that a parent helps in times of crisis. What is wrong is a parent refusing to recognize that the problems they must deal with would not be nearly as great and that both they and their kids would be happier and better off if they had simply kept a closer eye on what was going on. What is wrong is the refusal to recognize that one's children do need to be watched and do need to be disciplined. It isn't government stepping in to help in times of crisis that is the problem. It is the refusal of those in power to recognize that the problems they must deal with would not be nearly as great and that we would all be happier and better off if they had simply kept a closer eye on what was going on that is the problem. It is the refusal to recognize that business, especially financial concerns, need to be watched and need to be disciplined that it the problem. Unfortunately, the business community is populated by mature and intelligent people who collectively act like children. Bizarre and ill-conceived ideas like bond insurance (credit default swaps) or making relatively riskier investments in an increasingly competitve environment with wholely inadequate reserves have a way as sounding as sensible as tearing down the highway at 100 mph in your Mom's car or racking $200 in text messages on your cell phone does to all too many teenagers.

Following, among others, the late Arizona Senator, Barry Goldwater, conservatives are fond of saying the government that governs least is the one that governs best (although religious conservative tellingly leave out the second part of what Senator McCain's mentor quickly added to this: " and stays out of the imposible task of legislating morality")* what would you think of someone who told you that they firmly felt that the parent who parents least is the parent who parents best? The odds are quite high that the only intelligent thoughtful human being who would say such a thing would be a teenager. As an economist, I can explain in detail how, under the right circumstances, free and unfettered markets can yield better results than those produced by well meaning but inept government intervention. What is too often overlooked is just how idealized the right circumstances are. Especially relevant in the financial sphere is the need for the uncertainty we face to be only uncertain in the sense of rolling a six or getting heads. The great sin economists have committed is therefore a sin of omisson. We have failed to draw attention to that fact that in practice the uncertainty we face is of a mch more profound nature. By not emphasizing this, and the potential it creates for episodes like this past week, we become family counselors describing how children can theoretically grow and prosper without parents doing much more than paying the bills and keeping the car filled with gas. The kids (i.e. businesses) love us and everyone else, justifiably thinks we're awfully far off base.

Children need parental regulation just like markets need regulation. Government is a necessary evil but least does not mean zero. Nor does it necessarily mean, and this is a key thing to remember, that the oversight required is small. Just as in families there are parents who are too actively involved in their children's affairs, who are too ready to step in the second that problems arise or who are too domineering or just plain foolish there are examples of government intervention, regulation, and management of economic affairs that exhibit such traits too. Like good parenting, good governance is difficult. But simply because there is such a tremendous potential to fail does not in the slightest give us an excuse not to try.

When Sentor Obama this week pointed to the current crisis as providing the final verdict on the validity of the economic philosophy that has driven the economic policy (the philosophy that business can do no wrong and that the fundamentals are to be assumed sound until it is apparent to almost everyone else that they are not) of the current administration for the last eight years he was right. And when Sentor Obama says that Senator McCain is obviously not to blame in any meaningful way for the current crisis ( in humbler times, Senator McCain has freely noted that economic and financial policy is not his forte) he is of course correct. Most importantly, when Senator Obama notes that what is the root of our current difficulties is the economic philosophy that Senator McCain (at least until November 4th) claims to subscribe to, he was right as well.

On Thursday , Senator McCain has made a statement that was quite revealing. While viewing the damage left by flooding this summer in Cedar Rapids, Iowa he remarked that this is where he sees government playing a role, to step in, in the wake of disaster, to help people pick up the pieces. Viewing this as the sole role of government, to step in after disasters have occured begs the question about what government might do to minimize the likelihood of disasters in the first place. In the case of this summer's floods in Iowa, one might counter that floods are an act of God. However the significant loss of wetlands; to farming, to business development, and to new home construction over the years has led to a significant increase in the frequency and the severity of flooding in the midwest (see Postel, 2008). Just as the neglect of the more difficult to monitor and seemingly antibusiness prevention of the loss of wetlands might help control the severity and therefore the cost of floods when they do occur "needless government meddling" in financial markets (perhaps some time after Warren Buffet in 2002/2003 told us all that derivatives were financial WMDs and it was apparent that no one was really listening) might have helped control the severity and therefore the cost of this week's financial crisis.

*Government that governs least is a somewhat loose paraphrase of Thomas Paine's "Government, even in its best state, is but a necessary evil; in its worst state, an intolerable one."

Bailout of Freddie Mac and Fannie Mae

What does the move by Treasury secretary Paulson and OFHEO director Lockhart this weekend to put both Freddie Mac and Fannie Mae under conservatorship mean? What conservatorship means is that the federal government has agreed to absorb up to $100 billion in potential future losses of the two institutions. There are all sorts of ways that one could try to put this in some perspective: at one extreme you could characterize the decision as Paulson and Lockhart as tantamount to their promising that every man, woman, and child in America pay as much as $333 apiece for the excesses of Freddie and Fannie management (and that much of this could have been avoided if Congress, President Bush, officials in the Treasury, or at the FED had done something earlier to rein in these two institutions before they got to the point they are now.) At the opposite extreme you could argue that for less than what the typical American family spends in a month on cable services and cell phones we have, at the very least, bought some time for badly stressed financial markets and, at best, taken action that will help us move forward out of the liquidity crunch that world financial markets face. The fact of the matter is that we have been part of a massive run up in housing values that has been fueled by and which in turn has helped perpetuate a massive expansion in the volume of mortgage credit granted to the US population as a whole. With 20-20 hindsight it is easy to say that we should have known better. However I am not confident that we will ever learn. We should be thankful that the much ballyhooed fall in housing prices only really bites those of us unfortunate enough to have purchased homes since the end of 2005. Not to minimize in the slightest the plight of those who entered the housing market at precisely the wrong time, the decline in housing prices only began nationally in the Spring of 2007. For those of us who purchased homes at at any time prior to this the market value of our homes is still higher now than when we purchased them and for those of us who bought in the early to mid 1990s or earlier, just following national trends, the market value of our homes remain ridiculously inflated (on average over two times higher in value now than in the early to mid 1990s) SHOULD WE HAVE KNOWN BETTER? In today’s New York Times (NYT “Countdown to Inevitability”) former secretary of the Treasury under President Clinton, Lawrence Summers, is quoted as saying that he had expressed grave concerns about the explosive growth in Freddie Mac and Fannie Mae’s mortgage loan portfolio and the increased investment in subprime and other risky mortgages. The current administration is far less inclined to worry about decisions being taken when those decisions are being scrutinized by the market and so can perhaps be excused for being so slow to react. The point is that we are at present in a position where vis-à-vis the bailout there is really no other choice open to us. The more fundamental question is indeed how to avoid such crises in the future or more fundamental still, whether, we have the ability to avoid them. In form or another the principles of increasing risk first explicitly outlined in a paper published by Michal Kalecki over seventy year ago (M. Kalecki, “The Principles of Increasing Risk” Economica, November 1937), further developed by Hyman Minsky, and as of late, again the focus of our attention thanks to Nouriel Roubini suggests that part of the price we pay for a sophisticated financial system are these sorts of problems. At the same time, it would be foolhardy in the extreme to celebrate such episodes and to do nothing to prevent them from happening in the first place. At Freddie and Fannie we have seen mortgages or mortgage backed securities owned or guaranteed by the two grow by over a factor of 6 since 1990 and more than doubling since 2000 with an increasing share of these being subprime and Alt-A mortgages. The fine line between making credit as easily available as possible and being over-leveraged is what at root needs to be drawn, despite the fact that it is indeed a fine line. We should look to the specific statements made by both nominees regarding this issue of leverage and try to gauge how well either understands the inability of the market to discipline the financial sector seriously enough ex ante and gently enough ex post. For a bit more background on these two institutions click here.

more thoughts on social enterprises

There are four things that at root explain the persistent poverty that social enterprises seek to address: (1) loss aversion (2) credit constraints (3) what I refer to as contigent profitability and (4) high transactions costs. Poverty is both the cause and a consquences of each one of these. Consider first loss aversion. However much a gain in earnings might mean to a poor family, the fact of the matter is that if potential losses are substantial this family, because of its poverty, cannot afford to gamble. Loss aversion means that even if such a family were able to experiment (or even if the family concerned were otherwise quite comfortable with the notion of gambling) they would still sit back and wait, “leaving well enough alone”. Of course, the poverty of poor families also sharply limits their ability to act. By definition, one’s own resources are limited if one is poor and credit is not easily had as the fears of the poor are compounded by creditor's lack of faith in their ability to honor obligations. Contigent profitability is simply a term I have created that is meant to capture the fact that the expected payoffs of any undertaking are often dependent on a number of significant factors outside the invididual family’s control. For example, the less faith poor families have in job opportunities appearing after investing in education or the less confident they might be that a reliable supply of inputs would be available to continue to operate one's own business the less beneficial activity will take place. Even if the poor had no real reason to be particularly loss averse and even if credit were readily available on reasonable terms this would be true. Paul Polak in his book Out of Poverty discusses his organization IDE's (International Development Enterprises) first project. This project involved helping refugee blacksmiths in Somalia build and sell donkey carts to other Somali refugees. Absent Polak’s realizing that tires would frequently be in need of repair and his efforts to bring tire patch kits and lug wrenches (inexpensive lower quality ones) all the way from Nairobi back to Somalia , the initial efforts of blacksmiths would have been far less successful. (Polak, p. 65) In essence the complementary investment and activity of others, as it limits the size of potential losses and raises the potential payoff of any investment, tips the scales in favor of action rather than inaction. There is finally a myriad of things that together combine to create the fourth factor contributing to persistent poverty: high transaction costs. To begin with, individual transactions the poor carry out are small . This means that if, for some reason, a given trade is unsatisfactory there is a high chance that the costs to an injured party of making a legal case against the offender will often far outweigh the benefits. Also the very contingent nature of economic activity just discussed and the large number of individuals involved means that not only is the enforcment of contracts costly but so too would be writing-up such contracts . Add to all of this low levels of education and poor infrastructure and it should be easy to understand that high trasanction costs serve as barriers to the identification as well as the pursuit of opportunities. In essence social entrepreneurs are involved in trying to break the vicious circle that the preceding four factors create. This of course begs the question as to how social entrepreneurs addressing such questions differ from other non-profits or government agencies devoted to attacking the same problems. Some see the key difference as being due to better organization and the sharper focus on results that social entrepreneurs have. Some equate social entrepreneurship with being for-benefit organizations that are completely self-sufficient. What is curious about the field of social entrepreneurship is how wide the range of definitions in use is. This then means that what might pass muster as a social enterprise to some may not at all qualify if an alternative definition were to be employed. What one might consider social enterprise is to another a nonprofit or what is labelled by one person a for-profit with a charitable bent becomes in the eyes of another a social entrepreneur. An attempt at a definition: The word entrepreneur comes from the French entrependre meaning to undertake (as in to undertake a challenging task). A social entrepreneur then is an individual willing and able to undertake challenges (either the challenge of pursuing advantages of opportunities as they appear or warding off threats such as finding and continuing to attract resources and funding) with her principal goal being not her own gain but rather the benefits her efforts generate for others. In turn, broadly what seems to distinguish social enterprises from other non-profits are two things: While many other non-profits are focused on helping others they rely heavily on charitable donations and grants and operate in a very nonbusiness-like manner social enterprises are run more professionally and to some degree have the ability to generate earnings that defray operating expenses, help pay suppliers and help attract and retain qualified staff. Discussing an obviously important part of the social enterprise movement, microfinance institutions (MFIs), Jonathan Murdoch notes that while a substantial proportion of MFIs are self-sufficient in this sense (what he refers to as operationally sustainable) far fewer are financially sustainable. While operationally sustainable MFIs generate enough to revenues to cover their operating expenses they fail to generate enough revenue to act entirely independently. It is only the much rarer financially sustainable MFIs that could survive if they had to "...obtain all inputs (especially capital) at market, rather than concessional, rates (Murdoch, 1999, p. 1588) While the goal of financial sustainability is laudible as Wei-Skillern et al point out while in commerical capital markets "...the key motivation for all players involved is most often to build a profitable company and to earn an attractive return on investment" the motivation is varied in the case of those funding social enterprises (Wei-Skillern et al, p. 13) They go on to note social enterprises "...rarely, if ever, atain breakeven without some form of donor support" (p. 13) It is enough to be business-like in managing operations and to be, if possible, concerned with operational sustainablity. It is often nothing short of impossible to pay staff competitive salaries and benefits and at the same time pay investors an adequate return on their investment and remain at the same time true to the social enterprise's orginal mission.

Nonetheless, Boschee and McClurg define social enterprises and social entrepreneurship in terms of self-sufficiency. As they put it self-sufficiency "...can be achieved only by relying completely on earned income, and is the ultimate goal of the most ambitious social entrepreneurs" (Boschee and McClurg, 2003, p. 3, emphasis added) As Murdoch suggests however by such a definition it is well nigh impossible to find real world examples of social enterprises. It sets a standard that few social enterprises will ever be able to attain.

On its website the Social Enterprise Alliance notes that in 2002 commercial revenue ("service fees, registratrions, dues and subscriptions, and other program fees, as well as income from special events and sales of products") has risen from 48.1% of nonprofit revenue overall in 1982 to 57.6% in 2002. These figures are not adjusted for inflation where inflation eats away over half of the seemingly impressive 219% growth in nonprofit revenues. And when adjusted for inflation the figures represent at most decent growth in earned income. This growth has taken place alongside relatively weak growth in the total earnings of nonprofits. While the U.S. economy grew at an average annual rate of 3.36% in real terms between 1982 and 2002 the total revenue of nonprofits grew only 2.75% a year in real terms while earned income (if commercial revenue and earned income are synonmous which is not entirely clear from the SEA's website) grew at an average annual rate of 3.68%. In short, as overall funding for nonprofits lagged behind the general growth of the U.S. economy a few additional scraps were thrown in the direction of nonprofits in general to make up for the significantly lower growth in government support for nonprofits (1.72% a year in real terms or put another way a little over half the growth in real incomes overall between 1982 and 2002).

A key catalyst to growth of social enterprises and the increased focus on earned income has therefore been the fact that tighter government budgets have forced many social organizations to become far more self-sufficient than they might otherwise be. It also reflects the sad fact is that more than being a desirable goal for social enterprises the complete self-sufficiency that McClurg and Boschee call for reflects the outsourcing of public service to private sector. Part of the rise of social enterprise is then borne of necessity converting some non-profits into social enterprises simply because of a lack of funding.

All the while the mountain of poverty grows in absolute terms. The many social enterprises that have sprung up are to be admired and applauded for their accomplishments. However what many of these enterprises have been able to accomplish is tantomount to moving small sections of earth from this ever growing mountain of poverty. Looked at from the ground level those who have given so much of their time and effort are justifiably proud. This in no way however means that such undertakings represent a key solution to the dilemma of world poverty. As Jonathan Murdoch in his work on MFIs has suggested in fact the more operationally sustainable MFIs -taken here as a subspecies of social enterprises- have succeeded by addressing not the needs of the poorest of the poor but small merchants and shop keepers who are relatively speaking better off. It is indeed striking to see the Mexican MFI Compartamos frankly admit this and to draw the connection between its move from nonprofit to profit status as in no small degree due to this and that it's mission does not nor can it include addressing the needs of the poorest of Mexico's poor (see the following).

There are, of course, social enterprises that as Alan Folwer notes he would prefer to refer to as integrated complementary organizations. In these the business generates a suplus that then is not plowed back into the original venture nor turned over to shareholders but rather it directed toward a social program of some sort. Staff is hired, funding is raised through bank loans and bonds, advertising is carried out and after all the bills are paid the net revenue goes toward supporting some social program or perhaps a variety of social programs. BRAC through a variety of enterprises such as its retail outlet Aarong provides employment opportunities to the poor, an outlet for their products, and provides revenue that helps fund BRAC's other activities. Newman's Own "shameless exploitation in pursuit of the common good" would be another example of a business that operates at least in a sense at a financially sustainable level and uses the profits earned for social programs rather than to provide a return to shareholders. To their credit the fact that this presents practical difficulties in equity markets is something the Grameen Foundation recognizes.