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There is an increasing tendency among pundits to note that one insurance company controls most of the insurance plans in a state. This company is almost invariably WellPoint. In fact, WellPoint is the largest insurance provider in the US. However, identifying them as WellPoint, I think, does readers a disservice.

How many people have heard of WellPoint? I am guessing not many. How is this possible when so many people have them as their insurer?

It’s because most of us know them as Blue Cross Blue Shield. WellPoint, among other companies, licenses the Blue Cross Blue Shield brand.

This is important because I think most people have a good sense for what Blue Cross Blue Shield is and how they do business. If we are going to evaluate potential monopoly-like practices then reputation is important. My sense is that in many states most customers are happy with Blue Cross Blue Shield. At least in North Carolina many providers hate it. That’s because BCBSNC uses its market position to enact monopsony power. That is, like Wal-Mart BCBSNC puts enormous downward pressure on suppliers.

This means that BCBSNC plans tend to be much cheaper than the competition. This supplier squeeze might also be why BCBSNC is so opposed to a public option – the public option is trying to crowd in on their competitive advantage.

Educated people in developed countries are typically aghast when anyone suggests that you might want to risk destruction of entire nations just to save a little cash. As an economist I would say this results from their low marginal valuation of income. A person in the developing might say that they don’t really know the value of a dollar.

In any case, I don’t think it’s helpful to bore or more likely enrage my readers with a cold, quantitative comparison of the value of statistical life across counties. So instead, let’s look at some of the things money can buy:

Would you risk your life for these things? How about this:

And perhaps most meaningful to me personally:

When this is what economic growth means to you — when this is what GDP means to you — $2.5 Trillion (5% of world GDP) takes on a somewhat different meaning.

So, the economic question is not whether risking climate change is worth giving up your HUMMER. It’s whether it’s worth giving up these little girls’ school. Remember that developing world GDP will also be reduced by carbon emission restrictions.

You might instantly retort that you want both. You want to reduce the risk of economic destruction AND buy these things for children in developing countries. But, unless you’re going to give everything you have to raise them out of poverty the question has to be would they rather have a reduction in climate change or even more schools and even more housing. Perhaps you are giving to them now, but you could still give more if we took the proceeds from forgoing Waxman-Markey and sent them all there.

I don’t think that has to be an academic question, either. Climate Change and Human Development Assistance is an idea whose time has come.

Should we worry a lot about low income singles? My general predisposition when discussing and designing tax policy is that we have limited resources with which to address inequality and we should devote the bulk of those resources to families. Perhaps, we can give a little here or a little there to single people but I am not overly concerned.


For one, single people have vastly more options. Working two jobs as a single person is not that big of a deal. Working while going to community college isn’t terribly hard either. More over many “poor” singles are poor because they are choosing to devote a lot of their time towards advancing their education.

Being a single parent, however, changes everything. Now options collapse. It’s not just about depriving yourself of sleep or fun, it’s about caring for a child. This is vastly more difficult situation and it deserves vastly more of our attention.

Two, my general view is that a struggling single person likely has deeper issues. If a person really has trouble making it as a single then they are probably suffering from some mental, emotional or physical disability. These issues need to be addressed directly. Patching them with tax subsidies is probably not a long term solution. Moreover, chances are this person is having trouble holding down a job, so tax subsidies are probably of limited use anyway.

These are my baseline views. What do you think?

Today’s chart by Conor Clarke shows the percentage of single workers who are offered employer based health insurance and the percentage which take advantage of that insurance. The chart is broken down by tax bracket.

I wanted to take a look at the numbers for married workers and workers filing as head of household (single parent). Again, the groups are broken down by tax bracket.

These numbers are a bit more intuitive. Health coverage rises rapidly with tax bracket. It then levels off. The 35% bracket has more people with coverage than offered. I assume this is because most of these are two earner households and in some cases only one spouse was offered insurance but both individuals are on that plan.

Lack of employer coverage is mostly an income story. The difference between marginal tax rates doesn’t seem to explain much. Its mostly that those in the very low income groups choose not to take advantage of care. Perhaps this means that a simple health care subsidy will better achieve the goals of universal care than massive reform.

I am also trying to piece together who exactly the “above 35% group” is. I am guessing high income parents with kids in college. This means not only do they face their marginal income tax rate of 35% but an additional effective rate because of a loss in federal aid.

I applaud Mike at Rortybomb, among others, for being able to take John Carney’s criticisms of CRA lending seriously when Carney says

Banks making CRA loans initially expected that defaults would be higher due to lax lending standards. When they discovered the low-income borrowers had an unexpected propensity to pay their mortgages. After years of data poured in showing that borrowers were paying mortgages despite high LTVs, low down payments and unconventional income measures, bankers began to believe that many of the traditional measure of credit worthiness were overly conservative.

So here is Carney’s story

1) Government suggests that low income borrowers are being unfairly overlooked and pushes banks to extend loans to them under the CRA

2) Banks extend those loans and to the banks’ surprise the loans are good



To be fair to Carney he suggests that the CRA data was misleading. Other financial institutions looked at these good CRA loans and thought, hey why not throw out all the rules. In this way CRA surved as the seed of the crisis.

I am doubtful about this part of the story. I think the spread more has to do with widespread increases in risk taking in all credit products. This risk taking was the result of innovations in the way loans were cut-up and sold. However, lets assume that Carney is right. How is that the fault of the policy? The policy says “banks try to do X because we think it’s not as bad as you think.” It turns out not to be as bad as the banks think. This is an amazing success, given the hubris involved in the government suggesting loans to banks. (As a side note Ben Bernanke had a first-mover disadvantage theory as to why such a policy might work.)

The fact that other financial institutions, in attempt to maximize profits, incorrectly used existing data is not the fault of the policy that created the data. At its core the problem is that profit-maximizing institutions engaged in practices which increased aggregate risk. I still suspect that in a world where there was only one subprime lender things would have turned out much better for that institution. Perhaps not on net profitable, but not a wild risk.

My own conjecture is that when one lender engages in this type of lending it increases the risks to other lenders because it distorts home prices both on the way up and on the way down. That is, subprime and other exotic lending leads to over-valued homes, which in turn leads to loans that are larger than the long term equity in the house. Subprime and exotic loans also increase the risk of foreclosure which artificially depresses home values and restricts the ability of troubled borrowers to refinance. In short, each individual lender contributed slightly to a bubble that increased risk for all lenders.

I know Mike and others have a less charitable view. Hopefully a detailed post-mortem can figure out who’s right but so far I have seen no compelling evidence in favor of the CRA theory.

In response to Greg Mankiw’s skepticism on the public option Free Exchange writes

Mr Mankiw is assuming that the public option would use its market power to force down the price of services in a manner that would discourage potential doctors and nurses. But that doesn’t have to be the case. A dominant public option might restrict the services available to subscribing patients to those justified by a standard cost-benefit analysis. In other words, it might create a fragmented market in which the government offers affordable but restrictive coverage, while private firms compete based on the market niche left to them—a willingness to cover all treatments at a higher premium level.

Is this likely?

That is, will a public plan actually reduce the services that patients consume? There are two major pieces of evidence that I see:

1) The history of government restricting patient access to care in the United States is not good. That is, when the government gets involved it is usually to expand access to services. Conventional wisdom is that here in North Carolina, Medicaid will pay for services that are denied by the State Employees Health Plan. I have not independently verified this, but everyone I have talked with seems to think it is true. This does not bode well for a government run plan that seeks to restrict patient options

2) The history of government restricting patient access to care in the rest of the Anglophone world is pretty good. I am thinking particularly of Canada and the UK. Despite incessant complaints about the options available both single payer systems seem to be pretty good at squeezing down on costs.


I am not sure which model would dominate in a US with a public option. My intuition leans toward the first. However, once a public option is implemented deficit hawks will be pushing for benefits to be limited. This adds some momentum towards cutting costs. On the other side, though, patient advocates will be pushing for more coverage.

Perhaps, the Free Exchange scenario could be implemented if the law ensures that that the public option cannot be the only option that an employer offers. Or, that the firm can do so only after paying a fee. This keeps private health insurance alive and it allows deficit hawks to say “if you really want more care just buy the private version.” I am still doubtful, however, that this will satisfy patient advocates.

In the comments, Mike asks

How does this square with something like Coase’s Invariance Theorem? It will matter short run, for the principles themselves short-term profit, how they get their permits. But once given, the market should move them around to the optimal allocation, no? How much work does market power and rent-seeking have to do to overhaul this?

Simply put the invariance version of “Coase’s” theorem is not correct. The same outcome will not prevail regardless of distribution. The general objection is that the distribution of permits affects wealth, but it also affects market power.

I put Coase’s in quotation marks because there are some suggestions that Coase himself did not approve of the common statement of his proposition. His original piece begins with a description of a world of perfect competition and zero transactions costs. He then adds transactions cost. To my recollection he makes no mention of the role of market power.

The long run raises some interesting implications. In the first case, one firm having monopoly power in the permit market and raising the price, you have an increased incentive for other firms to invest in pollution reduction technology. So, in the long run higher prices lead to less demand for permits. There still must be some efficiency loss but it will be reduced. Optimally, the holder of the permits would use the calculus of variations to figure the time path of permit sales. In practice, I am guessing they would try to assess the investment strategy of other firms and adjust their permits sales accordingly.

The monopoly power case, however, is mostly academic. I don’t see it as a real danger. What is a danger is creating a special interest lobby invested in keeping the value of permits high and its allocation of permits free.

In this case the problem is more difficult. It is the long run interest of the firm receiving free permits to prevent innovations from coming to market. How well they can do this, and trying to model their lobbying power is complex. My sense is that based on current agricultural and resource lobbying efforts, the firms will have some degree of success.

It should be noted that the stakes are probably high. As the number of permits decreases and as GDP rises the price of permits will rise quickly. There are huge incentives for firms to try to maintain those rights. There is also an intuitive political argument. Failing to give away these permits will impose huge costs of these firms. The idea that the government is going to drive a company out of business always drums up lots of political opposition.

Conor Clarke asks:

A cap and trade bill that gives all the permits to Donald Trump will be just as effective in reducing emissions as a bill that auctions off all of the permits and uses the revenue to fund an across the board payroll tax cut.

I thought this point was expressed very eloquently and at greater length last month by Harvard’s Robert Stavins. So here’s a question: has anything been added to the bill since then that would reduce its effectiveness?

I am not sure what was added when but there are a few things I can say.

First, even in a basic market framework, Conor and Robert Stavins are not technically correct. The distribution of permits does influence the effectiveness of the cap. If permits are distributed into too few hands, some firm or group firms could establish market power and artificially constrict the supply. Similar to the way the concentration of oil reserves in Saudi Arabia allows OPEC to artificially constrict supply.

Ok you say, but that doesn’t sound like a bad thing from an environmentalist’s point of view. The less pollution there is the better. Well, less pollution might not be better as far as society as whole is concerned but we don’t need to argue that. Realizing that pollution permits might be artificially restricted by polluting firms, themselves, reminds us that they are a property right and as such could give rise to my second point.

There will be rent seeking among the recipients of pollution permits. In particular, those who are currently receiving free permits will see it in their interest to maintain their supply of free permits and to maximize the value of those permits. Maximizing the value of permits implies minimizing the alternatives to purchasing permits. The most significant alternatives are new green energy sources and technology which allows fossil fuel produces to capture and sequester their carbon. Giving away permits, therefore, creates a special interest group that will always be opposed to advancing green technology.

While fossil fuel producers might have always been opposed to government investment in competing sources of energy, giving away permits provides them with an incentive to oppose technology which makes their own production greener.

If consumers value green products in and of themselves and there is a feasible technology which could allow fossil fuel producers to produce much lower net emissions then it is conceivable that this version of Waxman-Markey could wind up accelerating climate change. In other words, Waxman-Markey could create special interest groups that stand in the way of green technology that consumer pressure would have brought to market anyway.

The distribution of pollution permits matters because permits are property rights and they carry with them all of the baggage of property rights.

John Taylor debated Paul Krugman on GPS, Fareed Zakria’s insightful Sunday talk show. Krugman gave his usual song and dance about inadequate stimulus and the need for radical healthcare reform. I was more interested in what John Taylor had to say.

Taylor is prominent macro-economists known for, among other things, the Taylor Rule. He gained attention in the current debate when he suggested that the credit crisis was essentially caused by the Fed and brought to a head by the fumbling of Paulson and Bernanke in the wake of Lehman’s collapse. While I didn’t find his argument compelling Taylor’s original paper was carefully reasoned and flush with empirical observations.

His performance on GPS, however, left me confused. He seemed to be unaware of basic facts surrounding the case he was making. He argued that instead of the stimulus Barack Obama should have implemented his making-work-pay tax credit, seemingly unaware that the same credit was in fact a major part of the stimulus.

Perhaps, most baffling, though, was Taylor’s defense of the notion that the stimulus was driving up interest rates. He pointed to recent increases in the ten year Treasury rate and said that

We’ve seen some sign of interest rates increasing, to some extent because of people talking about the debt increase . . . That is certainly what I look at. [There is] more and more concern about the debt — public opinion polls — those are the people who are doing the investing

You don’t have to be an efficient markets proponent to think that this is a rather large bullet to bite. Taylor seems to be suggesting that because there is more talk about the debt on cable news and thus more awareness among the general public, there is lower demand for Treasury bonds. The problem with this analysis is that the future debt is not news.

It may be rising as a political issue but the trajectory of health care spending and hence the overall debt has been clear for at least a decade.

Is Taylor seriously arguing that major Treasury investors are just now realizing this because it’s become a political football? Would he likewise be arguing that the recent fall in the ten year rate represents a public once again distracted from the nation’s impending financial crisis?

This argument seems too weak for an economist of Taylor’s reputation.

Taylor went on to say that the worsening of the crisis is the result of Bernanke and Paulson scaring people by suggesting the financial situation was worse than it was. This would seem to be at odds with Taylor’s original argument that it was Bernanke and Paulson failure to calm the markets that lead to the crisis. It also seems deeply implausible.

Again one has to assume that Wachovia’s rumored inability to sell commercial paper at even 3000 basis points was water off a ducks back to major investors, but seeing hearing Bernanke and Paulson suggest that major congressional action was needed was enough to freak them out.

The online debate doesn’t seem to make much of it, but this is where Manzi had me

[Conor Clarke] then shows a chart making the point, basically, that 1% is a small fraction of 100%. But of course, this cuts both ways. We hear constantly about the existential threat posed by global warming – Cities underwater! Drought! Famine! Think about his graphic. The expected benefits don’t even outweigh these costs. That ought to make you stop and think.

If the costs are so low and Waxman-Markey still can’t pass cost-benefit analysis then this has got to give you pause. For one, it signals that the issue is not urgent and if it’s not urgent then perhaps we can take some time to forge a better solution.

More importantly, however, Waxman-Markey proponents are forced to invoke some measure of hyper risk aversion, typically the precautionary principle. Now we could have a debate over the merits of high levels of risk aversion or the precautionary principle in general but I think it’s moot.

It’s moot because the precautionary principle cuts both ways. Perhaps, we should be afraid that our estimates of the damages from global warming are way off. Yet, than shouldn’t we also be afraid that our estimates of the costs of Waxman-Markey are way off. Shouldn’t we be afraid that we’ve miscalculated the probability that future legislators and emitters will collude to use Waxman-Markey as a way of keeping new entrants out the energy industry and to hold back new technologies.

For example, suppose that a new technology allows carbon to be sequestered and it does so very cheaply. This represents a major breakthrough but it also represents a threat to the holders of carbon permits. Once an industry has convinced congress to steadily issue it free carbon emission permits, the industry has a valuable asset. Sequestration technology threatens that asset. So now the coal industry, perhaps, has a vested interest in preventing cheap sequestration from coming to market.

If we’re going to throw out our expected value estimates for adverse consequences then we face a paralyzing array of potential disasters. I don’t see a particular reason to favor one set over the other. We have to anchor our estimates on something. Or, perhaps I should say, we all do anchor our estimates on something. The question is whether that something is a conscious rational analysis of the probability estimates and expected costs, or whether the anchor is an unconscious appeal to the threats that we have read and heard the most about.

We have read and heard the most about the dangers in ignoring the threat of global warming, but that doesn’t mean it’s the greatest threat we face. Doing the wrong thing could have just as disastrous effects, for climate change, as doing nothing at all.

Tyler Cowen, Felix Salmon and Free Exchange discuss the enjoyment of surfing the web and its implications for GDP


The traditional gauge of economic success is profit, but over time we’ll find that such statistics as measures of GDP tell us less and less about broader efforts to improve human well-being. Much of the Web’s value is experienced at the personal level and does not show up in productivity numbers. Buying $2 worth of bananas boosts GDP; having $20 worth of fun on the Web does not. And this effect is a big one. Each day more enjoyment, more social connection, and, indeed, more contemplation are produced on the Web than had been imagined even 10 years ago. But how do we measure those things?


This is not necessarily new. Having $20 worth of fun by reading a library book, or running down a hill, or visiting the Tate Gallery, doesn’t boost GDP much either. So I guess my question for Tyler is this: are you saying that the web has increased the amount of fun that people can have without spending money, or at least has increased the nation’s aggregate fun-to-spending ratio? Are you saying that the correlation between aggregate fun and GDP used to be stronger than it is now, thanks to the advent of the web? And if so, are you implying that policymakers should be concentrating on new aggregates, such as some kind of Gross National Happiness measure, since GDP is proving an increasingly bad proxy for such things?


. . . now we have millions of people using internet applications that were often developed on a voluntary basis and which are provided without charge to share content which was also developed on a voluntary basis and is provided without charge, and which is, in many cases, taking market share from established, for-profit institutions. There’s nothing wrong with that—it’s progress—but it does suggest that economic data misses some important things. This may be especially problematic where productivity increases are concerned. If freeware boosts the productivity of free content providers allowing consumers to more effectively utilise their favourite free web applications, what are the effects on employment and productivity?


This is an even more fundamental problem than what Felix presents. Forget all of the free stuff that people can enjoy, GDP is simply not welfare, even for market based goods. Pardon me while I go through some transparent example, I think will be worth it.

Suppose I have an economy with two sectors that each use half of the workforce. One sector produces fish and the other produces beaded jewelry. (An economists mind always goes to desert islands when constructing these examples.) Both fish and necklaces cost $1 and the economy produce 1000 of each per year. The two sectors are equal in size and equal in their contribution to GDP.

Does that mean that they each make people equally well off? Do necklaces add as much to quality of life as food? Probably not. More likely the supply and demand graphs for each sector look like this.

GDP is the same


Welfare or the total benefit to society each market is quite different.

A steeper demand curve or a shallower supply curve can produce huge welfare gains at relatively small GDP gains. Indeed, some of the goods like running down a hill or reading new material posted to the web have a supply curve so shallow that they are provided at nearly zero cost. This is why they show up with such a disparity between GDP and welfare. This isn’t limited to free goods, however, my classic example is water. How much better is your life because of clean water vs. how much of your income do you devote to water cleansing.

The household savings rate continues to soar, reaching 6.9% in May.

In our current times this is a mixed blessing. On the one hand it means that the unsustainable rise in US consumer debt is coming to an end. This had to happen for international trade flows to stabilize and the world economy to regain balance. Remember that trade flows and international lending are mirror images of one another.

If we are spending beyond our means then that implies we are buying more than we produce. If we are buying more than we are producing where does the extra stuff come from? It must come from abroad. Thus borrowing from abroad and importing are linked. We send the Chinese US bonds and they send us Chinese goods.

The extreme interdependency between the US and China presented risks for both country. The US was at risk for sudden interest rate moves if the Chinese appetite or ability to purchase US debt declined. China was equally at risk for a massive recession should the US stop serving as its primary consumer. As that interdependency winds down, both economies will be safer.

At the same time, however, rising savings means that smaller fraction of consumer’s incomes are going towards purchasing US goods as well. Without increased demand it’s hard to see where a sustained recovery will come from. For know we have some boost from the stimulus. That is temporary. The change in spending habits is likely to be more permanent. The question remains, now that the US shopper is giving his or her credit a break who will be the consumer of last resort?

Derek Thompson doesn’t like Hardee’s ads.

Along with their sibling chain Carl’s Jr, Hardee’s is a decently profitable company (especially in the recession) that still has to shout to be heard over its more beefy brothers McDonald’s, BK and Wendy’s. Except instead of yelling, they’re making balls jokes and asking reality stars to roll around in the sand with their burgers. Strategic marketing! Let’s watch and cry.

I’m not sure I agree. While it’s true that just having a scantily clad woman in the ad with no direct relationship to the product probably doesn’t work, I think Hardee’s ads are effective.

Let me ask you this, who doesn’t know that Hardees has a thickburger and that it’s supposed to have a lot of meat? I think that’s the message they are trying to get across.

The semi-nude women are of course to get men to watch but they also draw a weird contrast in that Hardee’s food is clearly not intended to appeal to women let alone those whose career depends on their figure.

As for pure shock, I don’t know what makes some work and others not.  I still remember the Superbowl ads but I never once went there. However, I did go to the website to find out what they were selling. I didn’t catch it the first time through.

Conor Clarke revives the height tax debate with some new charts from Deaton and Arora.

More from Conor:

A height tax sounds horrible and absurd, but it would actually be pretty darn efficient: You would get the benefit of taxing something strongly correlated with a higher income, without the drawback of distorting incentives or decreasing effort. You can change how hard you work; you can’t really change your height.

I share Greg’s moral intuition that a height tax would be, somehow, wrong. But the more I see data like this, the more I think it might be a good (if utterly impractical) idea.


My sense is that the height tax strikes people as wrong in part because of what I jokingly named Karl’s Law.

Given equal size tax bases the economic inefficiency of a tax is inversely proportional to how much people hate it.

That is, people hate taxes that they cannot avoid. Yet, taxes which can’t be avoided are the most efficient. There is a sense that people are being punished for something that they cannot help. The larger question perhaps is whether or not this part of moral intuition is something that should guide tax policy or something that should be used to deflect criticisms of lump-sum taxes.

My fellow economists love to point out the flaws in common intuition through the use of careful reason. My sense, however, is that we should tread carefully. If something appeals widely to intuition then that is a signal that it is reflecting an important underlying preference. At the very least we should try to understand what that preference is, so that we can assuage the public’s fear.

New Claims for Unemployment Insurance in today at 627,000, pulling the four week moving average up to 617,250.

We can’t seem to break-out into a clear recovery pattern. Each week I am expecting a little bit better number that rolls in. In a traditional recession what we see is a sharp turnaround in new claims once the recovery has begun. The economy has natural job creating mechanisms and so to sustain a recession those have to be overwhelmed by newly unemployed workers.

What we can say is that there appears to stabilization. This is similar to the last two recessions that we had.

No clear drop off but stabilization. My working theory is that this change represents the dominance of service jobs for which layoffs are a much more permanent affair. In a factory setting workers may simply be sent home for a few weeks while the plant works off inventory and then recalled. As soon as the overall inventory glut in the economy is worked off factories will stop these plant shutdowns and the new claims will collapse.

For a service economy a new claim represents a worker who really was let go. That decision didn’t come ways for management and was a long time in the making. It will take a while before we work through all of the layoffs that were planned back in January and February.

Typically, I feel annoyed when these things happen because they distract from important policy discussions. I am not much of a sentimentalist and I find inconvenient that policy and the vulgarity of electoral politics are forced comingle. Nonetheless, I found Mark Sanford’s press conference unusually compelling.

Unless he is an Academy Award worthy actor, this is a man clearly struggling intensely with deep personal issues. I wish him and his family the best of luck as they deal with this difficult situation.

I have long wondered whether the upper echelon of business could really be modeled as a competitive market. There are so few buyers and sellers and a really high degree of firm specific assets. Making matters worse, everything is done by committee at the top. This revelation by Jack Welch published by the Economist only reinforces those suspicions.

This columnist once heard Mr Welch tell a chief executives’ boot-camp that the key was to have the compensation committee chaired by someone older and richer than you, who would not be threatened by the idea of your getting rich too. Under no circumstances, he said (the very thought clearly evoking feelings of disgust), should the committee be chaired by “anyone from the public sector or a professor”.

HT: Salmon

From Hilzoy via Sullivan

But within orthodox Shi’a theology, [the Ayatollahs] are not supposed to have guardianship over whole countries. The idea that they should was an innovation of Ayatollah Khomeini’s, and in theology, innovation is generally not seen as a good

Just a note: In Islam the term innovator refers to heretics.

In a series of posts Will Wilkinson worries that we’re excited about the Iranian uprising for all the wrong reasons.

Is that what we get if the Mousavi-Rafsanjani axis comes to power? A more liberal and democratic Iran? I honestly don’t know, and I don’t think many people do. I do know that these guys are deeply embedded in the larger status quo power structure, have had power before, and their records don’t look so good. They may well represent improvement, but I don’t honestly know that. As far as I know, the outpouring of desire for change that we see so clearly on YouTube is being exploited by one faction of the Iranian ruling class to depose another.

Anyone who believed the election of Mousavi was going to signal a significant change in Iran was, I believe, kidding themselves. I supported the Mousavi campaign because the enemy of my enemy is my friend. Or, more accurately and convolutedly, the enemy of the foil of my rival is my friend. That is, Ahmadinejad provided a convenient target for those who wanted to escalate war with Iran.

He was obviously a bit off his rocker, though I think much of it is an act. More importantly, however, he maintained popular support with jingoistic rhetoric about the United States and Israel. This in turn provided ammunition for those in the US who maintain support with jingoistic rhetoric regarding Iran. This bilateral escalation in nationalism seemed to be exactly the kind of thing that had gone horribly, horribly wrong before.

Since the election things have changed. The mass protests Mousavi has inspired have come to take on a life of their own and while it is difficult to see where all of this is headed, real change is now a possibility. I don’t mean a complete replacement of the Islamic Republic with some form of liberal democracy, but a serious moderation. The powers of the elected officials may be expanded and the Supreme Leader subjected to more oversight by the Assembly of Experts. These are steps in the right direction.

We should not be democratic fundamentalists and insist that a universal suffrage, completely open and free election is the only thing worth having. Let us not forget that 45 years ago the United States did not have universal suffrage. There were many things about the United States before integration that were brutal and repressive but it was a great democracy nonetheless.

Felix Salmon has a nifty chart on Credit Cards, showing that for-profit banks really are pulling a bait-and-switch.

As you can see the for-profit banks offer a lower introductory rate but a much higher penalty rate. This is a point I’ve tried to make repeatedly offline. This is not a secret within the banking world. Indeed, when I first went to work as a management consultant for a major US bank I ordered a training CD that was called something like “retail banking for numbskulls” or some other obvious takeoff.

The guide stated in clear language that the credit card business was dependent on those customers who didn’t make their payments on time. The other forms of lending did best if customers paid their bills on time and in full. I will note that this was emphasized as especially important for mortgages. Not so with credit cards. The ideal credit card customer was someone who was always behind but never fully defaulted on the debt. This kind of customer was incredibly profitable.

Durable Goods orders tend lead the overall economy. Consumers start buying big ticket items when they feel more secure about there job prospects and businesses invest in capital goods when it looks like sales are turning around.

What had looked like a slow down in the rate of decline is just barely beginning to look like a rebound. If so this portends good things ahead. Keep in mind, however, the durables goods series is rather noisy and this could easily be a blip.

Maybe it’s just me but I find it hilarious that CNN has the possibly sea changing revolution in Iran listed alongside Jon and Kate.

Correct me if I am wrong but what I have gleaned from the supermarket headlines is this: Jon and Kate got famous for having a bunch of kids. Kate turned out to be a real so-and-so. Jon cheated on her with some college chick. Is there really more to this story? I didn’t have the intestinal fortitude to click the link.

New orders for long-lasting U.S. manufactured goods rose by a much stronger-than-expected 1.8 percent in May, Commerce Department data on Wednesday showed, providing further evidence that the battered economy was finding its feet.

Analysts polled by Reuters had forecast durable goods orders would decline 0.6 percent last month. May’s increase, the third gain in 4 months, followed a revised 1.8 percent gain in April, previously reported as a 1.7 percent rise.

Perhaps most importantly, orders for non-defense capital goods were up. We think of this as a proxy for business investment spending. Typically, investment doesn’t pick up until the recovery is well on its way. Charts and details to come.

On their blogging heads video Noah Scheiber and Megan McArdle seem to agree that Citigroup’s size and complexity were a key problem preventing regulators from nationalizing the bank.

I am not so sure. I think lack of clear regulatory authority to wind Citi down is the real issue. Why?

Because if the Fed has clear authority to do it then it doesn’t have to involve Congress and it is when Congress gets involved that things really go boom. Lots of commentators mention that the government would have to “run Citi.” Well, no not really. Most shareholders don’t take an activist role in running the corporations that they own. The government doesn’t have to either.

The problem with nationalization is not that the government has to run Citi but that the government gets to run Citi if it wants. That is, when you go to Congress to ask for money Congress is now fully aware that they can ask you for favors that benefit their constituents or use you as a whipping boy to pull in more votes.

Cutting Congress out of the loop is key and it would allow the Fed to take care of the problem quietly. Even if it took months, that’s fine as long as creditors know that they will definitely get their money back. Indeed, since the Fed is going to guarantee everyone anyway and since they have the printing press they could simply cash out the short term creditors much the way the FDIC cashes out depositors. With this structure a failing Citigroup is much less of systemic problem.

Greg Mankiw wonders why he was kicked off the jury for a medical malpractice case when the only thing the court knew about his was his name, address and occupation.

Why does being a professor of economics at Harvard make one an undesirable juror in such a case? And does this say anything about the judicial system or the need for medical malpractice reform? I am not at all sure about the answers, but the experience did raise some intriguing questions.

There are two straightforward answers. One, someone knew who Greg Mankiw was and decided that his previously written opinions were not in the interest of their side.

Two, they were concerned that occupation was Economics Professor at Harvard. The lawyers would probably rightfully conclude that Greg would have unusual sway over the deliberations. Not many people are willing to question a Harvard professor and economists are particularly intimidating.

There is also the third possibility which I imagine Greg is imagining, that an economist would see through the attempt of one side or another to crank up the emotional quotient. Though I think this is less likely that the other two.

Facebook is really beginning to creep me out. It has suggested friends that I didn’t know anyone knew I was acquainted with. I don’t know what algorithms they have that figured this one out but it is a serious blow to any sense of slyness that I might have had. Next Facebook is going to have “people you might have causally flirted with at a bar.”

Ryan gives me a little blog love.

For those of you who like what I’m doing here, I’ll let you know that Ryan’s encouragement is the reason I’m blogging.

Free Exchange points to an interesting post by Alex Tabarrok on Quality Adjusted Life Years. Here Tabarrok asserts that if you want to get serious about cutting health care costs you have to get serious about defining a cut-off for the how much you are willing to pay for life. This kind of exercise appeals to me and it is just the thing that would serve as a lynch pin of backroom modeling.

More generally, when people say we should cut “wasteful” health spending they should specify what they think a QALY is worth.  Politicians who say that they can balance the budget by elminating “health care waste” are selling the same line as politicians who say that they can balance the budget by elminating “government waste.”  In particular, it’s naive to think that we can save a lot of money by eliminating spending with 0 QALY.  More reasonably, we can eliminate spending with high costs per QALY.  For example, dialysis for the sickest patients (top 10%) costs more than $240,000 per QALY and some heart pumps costs more than $500,000 per QALY.  

I would say it a bit different though. Rather that calling a heart pump too expensive, I would point out just how many lives could be saved on some other procedure. For example, find the procedure with the median cost per additional year of life. Then just base all other procedures on that one. Such as “For the medical resources of one heart pump I could get 18 life saving angioplasties. Should 18 people really have to die so that one can live?” This type of argument is a lot more compelling to non-nerds.

I do have some problems with his reasoning though. For one thing, maybe, maybe the marginal QALY is worth $300K but the average certainly isn’t. Most people don’t make anything near 300K a year and you can’t value something at more than you have to pay for it. My guess is that a lot of people on $70K dialysis wouldn’t be there unless someone else was footing the bill.

Second, there seems to be some evidence that some procedures actually subtract life years. The New Yorker article quoted in Free Exchange does an excellent job of elucidating how that works. One of the real problems is that Americans really, really trust their doctors and the weight of the evidence suggests that those doctors really, really don’t deserve that trust.

I gave the doctors around the table a scenario. A forty-year-old woman comes in with chest pain after a fight with her husband. An EKG is normal. The chest pain goes away. She has no family history of heart disease. What did McAllen doctors do fifteen years ago?

Send her home, they said. Maybe get a stress test to confirm that there’s no issue, but even that might be overkill.

And today? Today, the cardiologist said, she would get a stress test, an echocardiogram, a mobile Holter monitor, and maybe even a cardiac catheterization.

“Oh, she’s definitely getting a cath,” the internist said, laughing grimly

Megan McArdle replicates the meme that in order for carbon reduction to work Americans really have to hurt. Now it could be true that meaningful carbon reduction is painful, however, it’s not necessarily true. It’s an empirical question. Yet here, McArdle appears to be questioning the empirics based on the notion that change must be distinctly unpleasant.

But the real question, I think, is whether the low cost is a feature or a bug.  The only way a bill is going to have an impact is if it causes real financial pain to American households–enough to get them to change their behavior.  Waxman-Markey obviously is not going to do that.  And indeed, the projections of its effect on global warming are entirely negligible.

There is no necessary reason for this. There are clearly some fairly easy ways to save some carbon, like getting a timer on your home AC unit. I don’t have one because frankly then I would have to think about which one to get and order it and that’s a lot of work and I have a reasonably high Beta.

However, I could be persuaded to do so by a “holy $#%^” inducing power bill. This would save some carbon and would have little net costs. I am paying somewhat more for power, though there may be significant savings from this timer deal. The government, however, is capturing those extra costs and rebating it back to me and my neighbors. So the real cost is ordering this timer, which is not that high. Given that my current cost for carbon is zero, however, it’s a lot higher than that.

So I don’t know how many of these low hanging fruit measures there are but I don’t see a reason to discount them off the bat.


Responding to Bill Easterly’s claim that poverty is not a human rights violation Wilkinson engages in a fair bit of intellectual gymnastics to conclude that the basic problem is that we have states (as in independent nations, for my more financial minded readers) at all. This is unnecessary. The argument against poverty alleviation as a human seems clear and compelling to me. I think Wilkinson begins to veer off track when he says.

There is a human right to property, I believe. But the definition of legitimate property rights and the criteria for identifying their violation are also vague. I don’t think that means we should not recognize property rights.

In many cases, it is clear who has violated a property right. Maybe it was a thief. Maybe it was the state. But what do we say when, for example, an otherwise well-functioning democratic state fails to recognize a property right because almost all of its citizens do not recognize it? Almost everyone supports certain kinds of eminent domain without truly just compensation, say. And so a bit of my back 40 is confiscated to build a road.  Who has violated my property right by refusing to recognize and enforce it? You can say it’s “the state,” but that’s already a corporate body and not a natural person. Who is that really? And in this make-believe case “the state” really is just acting as an agent of “the people”–of most of them, at least. My guess is that Easterly is uncomfortable with the idea that a rights violation can be so diffuse, that responsibility can be so broadly distributed, and that there is no easily identifiable perpetrator. But I think that’s the way it is. That’s one of the dangers of democracy: it makes the diffusion of criminal responsibility easy.

Well then. Let’s back up though. What’s the problem with the “state” being the violator here? The state is not a natural person sure, but why does that matter? The state is an agent. Philosophically, agents violate rights. I don’t see how being natural, artificial or corporate really has anything to do with it.

However, if one wants to insist on rights violations being personal and human we don’t have to stop there. The proximate violator of Wilkinson’s rights is the bulldozer operator who comes to tear up his back 40. For suppose that Wilkinson’s land is “confiscated” but no one ever does anything about it. No one comes to take possession of it. No one restricts him in his use of it. No one prevents him from selling it at full value.

In that case the rights violation is moot. It is moot because no one has actually done anything to Wilkinson and therein lies the rub. For your rights to be violated, ultimately someone or some entity has to be doing something to you. Those violations have to be making you worse off than you would be if they left you alone. For me that is the acid test. If you could make this problem go away by never having any contact or relations with person X again then person X is violating your rights. Ultimately, your fundamental right is the right to be left alone.

In a series of posts Mike at Rortybomb, James Kwak at Baseline Scenario and the usual suspects around the finance blogosphere excoriate financial innovators for producing products like reverse convertibles: an opaque financial instrument that serves to trick unwitting life science folks into selling puts.

A reverse convertible is just a made-up security that creates a different return distribution than conventional securities. It doesn’t help Apple raise capital. And there is no investor who woke up one day thinking he needed the wacky return distribution it provides: basically, a stock with a 10% cap on gains and a small sweetener in case of losses, with some weird behavior in the middle (the $80-110 range). The complexity only serves two real purposes. First, it creates transaction fees for the bank that it can’t charge you for buying a stock; and second, it makes it harder for investors to understand what they are buying, which means that at least some of them will buy it, even if it’s bad for them. In other words, this is an innovation that creates no value, but just redistributes it between investors and banks, with the banks taking a transaction fee just like 0 and 00 on a roulette wheel.

To the extent these instruments are being pushed on retail investors there is almost certainly some shadiness going on. However, who exactly are these retail investors that are wary of the dangers of puts but fooled by reverse convertibles?

Indeed, I thought the market had taken care of this problem a long time ago via an innovation known as ringtones. Ringtones allow me to know instantly that my mother is calling and indeed calling from her cell rather than home phone. This is the signal of a quasi-emergency. You see just a few months ago market irrationality tried to rear its ugly head and was duly swatted down by the ringtone.

I had instructed my mother that she was never, under any condition, no not even then, to buy a financial product that didn’t end in the words “index fund” or “Treasury Bond.” This time, however, she called with a sure deal. GM as I might already know was trading near $2. “It’s GM honey”, she exclaimed “I know it’s going to come back.”

“Well mother” I explained, “some of these people on Wall Street are almost as smart as I am.” This is the highest praise that she can internalize for in my mother’s world, no one is as smart as her son.

“If they think it’s not worth more than $2, it’s unlikely that you know something that they do not”, I said.

“I just can’t believe it”, she said.

“Well, ma stranger things have happened”, I went on

“Well, if you say so. Now, about your sister . . .”

And, thus another attempt at market irrationality was thwarted.

I say all of this in jest but there is a serious point. Who exactly are these investors that didn’t get the message about diversification and broad asset classes beaten directly into their head? What financial channel do you watch, what publications do you read, heck what friends do you have such that diversification is not gospel.

I find it hard not to believe that a simple retail investors buying these complex products doesn’t think that he is getting one over on Morgan Stanley, if not the world in general. Arguments about the distribution of Math PhDs notwithstanding, this situation is substantially less bothersome than one in which an innocent old lady is taken in by the brain trust at a big Wall Street investment bank.

Maybe I am wrong here and the allure of shinny and new is just too much for well heeled but poorly read retail investors to withstand. However, I’d like to see some real cases before I am convinced that this is more than a rehashed version of the Fable of the Bees.

A post at Free Exchange reminds me of something that I have been meaning to look into for a while. Willem Buiter had a series of posts a while back explaining that housing could not cause a recession because housing wealth was not wealth. The accuracy of his predictions aside, the series always struck me as being off the mark. Now Free Exchange points to a piece at Real Time Economics which revives the case:

A more careful look at the data, guided by economic theory, however, suggests that much of this evidence [for a housing – consumption link] has been misinterpreted and that the reaction of consumption to housing wealth changes is probably very small. First, several recent studies have shown that the logic of the housing wealth effect is faulty. Houses, unlike stocks, are not just assets but are also consumption goods themselves. Theoretical papers by Willem Buiter, as well as by Todd Sinai and Nicholas Souleles, cast doubt on the notion of a large spending effect from housing

There are a lot of very nerdy economics issues to be waded through here – issues that I have an interest in pursuing. For the purposes of this blog, however, let me cut to what I think is the chase. Here is my interpretation of Buiter’s logic: When the price of houses goes up that doesn’t represent an increase in anything real. Houses still do what they have always done, keep people warm and dry. So why should we expect real economic effects from an unreal cause. That would imply some sort of systemic irrationality on the part of consumers.

The problem with this argument is two-fold. First, there is an illusionary effect. Increases in the price of housing can be symptoms of a real change. In the latest case they were symptomatic of a technological change in financing. That change, we believed at the time, reduced the real costs of risk. A lower risk society is a wealthier society and that wealth manifested itself in higher home prices. Greater wealth drives greater consumption. This effect is closely related to the “permanent income” effect that Calomiris, et al report at Real Time. However, it is important to note that housing prices signal real changes in the economy. In some sense this holds true for stocks as well. Much of the inflation adjusted gain from holding stocks stems from the dividend, but not all of it.

Where does the rest of the gain come from? After all, a non-dividend gain can only be realized by selling the stock and for every seller there is a buyer so isn’t society as a whole neither long nor short that gain? Indeed, the gain comes from future expectations. One could say that once you account for future expectations you will see that there is no real effect of stock price increases on consumption but this misses the point. Stock price increases are important because they are a signal of changing expectations about the future.

There is second, intellectually more interesting effect, however. That is, that home prices provide buyers will a real option that is socially valuable. Everyone, on net, really is better off in a world with higher home prices. Why?

Well, rising home prices allow an owner to sell for more than he or she owes. This in turn lowers the systemic probability of default. Systemic default serves as a tax on financial markets. There are wealth creating transactions that will not occur in a high default environment. There are willing buyers who could be matched with willing lenders if only there wasn’t the systemic problem of default. The important thing to note is that nothing has changed about the buyers or sellers individually but in an environment of rising home prices both can do more business.

This is more than the second-order effect of relieving constrained households. I am not simply arguing that there are some people who exogenously want to consume more but are constrained. I am arguing that society is poorer when housing prices are falling because society is facing an implicit tax. Thus the optimal level of consumption should rise when housing prices are rising.

Interestingly, this effect depends heavily on expectations and so could be spuriously ruled out by Calmiris et al’s technique. That is, when people expect housing prices to rise they feel better. They feel better because they have just received an implicit tax cut (sometimes made explicit by falling mortgage rate spreads.) If we rule out the expectation effect we are missing a real effect of rising housing prices. Said another way, rising housing prices and positive attitudes don’t happen to go together and it isn’t just that home prices are rising because expectations are rising. Rising housing prices are driving the positive attitudes.

Much more needs to be thought, researched and written about this, but at this point I am inclined to believe that housing price can and should have strong effects on consumption.

Jim Manzi and Ryan Avent continue their erudite food fight over Cap and Trade.

Manzi quoting Avent and then replying

Second, the cost overestimates have nothing to do with any underlying issue bias; as Brad Plumer notes, those favoring and opposing regulations both historically overestimate costs.

Presumably the same awareness of the track record of asserted prior under-estimation of environmental costs was available to both the EPA and CBO as they prepared their cost estimates. Unless we wish to assert that they are biased or simply irrational, why would we assume they failed to incorporate this information into their (very similar) forecasts of costs by 2020?

Avent back again

One thing that recurs in Manzi’s writing on climate change issues is an extreme devotion to the infallibility of models. There is a belief, seemingly, that the moment something becomes known, it is seamlessly and perfectly modeled. In practice, this almost never happens.

Here I have to side with Ryan. In my limited experience building and evaluating models for government there are two types of modelers. I won’t tell you which I am.

First, there are the purists. To the purist, nothing matters more than consistency. If we did it that way when the first model came out in 1946 then unless there is a darn good reason then we should be doing it that way now, the purist argues.

The reason is simple and compelling. No model is perfect, but people calibrate their expectations to the model. If the model says that proposal X will raise the baseline deficit by 1% of GDP then people have an idea what that means. That idea might or might not have anything to do with how much 1% of GDP actually is, but that’s not important. What’s important is that people can get a sense of the consequences from reading the results. This can only happen if consistency is paramount. Furthermore, the purist is afraid of the moralist.

The moralist has a different approach. Sometimes consciously, sometimes unconsciously the moralist shaves the model one way or another. Before everyone draws in a collected breath, ready to exclaim “I knew it was all bunk” allow me to explain.

Ninety-eight times out of a hundred the moralist’s goal is to constrain the excesses of policymakers. This means estimating higher deficits, larger costs, or smaller benefits. The moralist knows that policymakers will cherry pick the scenarios to find the most favorable and so he or she shaves the favorable ones. The moralist also knows that every model contains an “um, let’s just say four” factor or constant within it and he or she doesn’t want to be responsible for the institution or government taking on obligations it cannot meet. A cynic might also say that the moralist realizes that no one gets yelled at when the deficits turn out lower than expected.

Now, I have never worked with the CBO and I can’t in any possible way claim to know the culture there, but I can tell you that if anyone came to me and said, “Our models have been consistently conservative, maybe we should goose the costs downward” I would laugh out loud. Unless of course that person was a lobbyist in which case I would launch in to a long and to my colleagues well-known monologue that begins with “Well, you see . . .” and ends when the lobbyist has been worn down by technical jargon.

On the other hand I do think Manzi is right on the basic logic of the precautionary principle. But, more on that later.

Ryan Avent objects to Calculated Risk’s comparison of unemployment and housing prices in DC, noting that the level and variation in unemployment is concentrated in the lowers classes

Second point — unemployment in the District is probably extremely bimodal. Professional Washington probably has something like 1% unemployment in boom times and 3% unemployment right now. The lower-skilled workers in the city have near double-digit unemployment all the time, and I hate to think what the jobless rate looks like for them right now. And most of the home buying taking place in the District involves professional Washington.

But isn’t this true everywhere. Clipped from the BLS

This is an unfortunate and powerful truth behind unemployment, it comes primarily to those who can least afford it.


On home prices: The general thinking is that low unemployment allows the least worst off among the poor to buy starter homes, which allows the starter home owner to by a move up home, the move up owner to move up further and so forth on to the McMansion in McLean or the brownstone in the District.

Pat Buchanan hosted a conference this weekend to promote a linguistically pure America. HT: Think Progress

There is widespread grassroots concern about the future of English as the language of America. I have never been particularly worried and this scene from Iran is why:

Those are brandished by the officers of an avowedly anti-British, anti-American regime; and yes they are printed in English. These are streets signs in the same country.

Note that not only is English not a native or official language of Iran, but the alphabet is not even Latin. Yet, the street names are co-listed in English.

English is not the language of the US or even Great Britain. English is the language of the world. Barring worldwide economic disaster, by the year 2075 English will be spoken on the street in every city, in every country in the world. Economically speaking there are large network externalities to using a common language. These externalities suggest that in equilibrium there will be only one language. The road signs suggest that that language will be English.

Conor Clarke has the specifics on the tax burdens from the proposed Cap and Trade legislation

This does a fair bit to alleviate some of my worst concerns about cap and trade, that even after the rebate the excess burden would leave lower income households worse off. In answer to Conor’s query:

But families in the second highest quintile will end up with an additional burden of $340 a year — more than the wealthiest Americans. How to make sense of this?

My guess is that middle income American’s bear the highest burden because carbon usage levels off as income rises, while average income increases exponentially as one moves up the percentile. My “graph” such as it is:
See update below




Unfortunately, since Cap and Trade has emerged I have become concerned about its ability to pass a Cost Benefit test even sans-distributional concerns. At this point it seems to me that the onus is on Cap and Trade proponents to show that this is generally worthwhile. The back of the envelope calculations don’t look good.


UPDATE: After actually skimming the report I realized I was totally off. The burdens are not percentage of income but percentage of tax collected. (I could have also noted this by reading the axes on Conor’s graph)

So here is the real story. Upper income households get a big benefit in the form of business tax relief which offsets the increased costs they face from cap and trade. Upper middle income households don’t get nearly as much business relief and so their total burden is higher.

In the response to Shelia Blair’s call for an end to the doctrine of “Too Big to Fail”, I count only one voice, Paul Krugman’s, among the dissent. Even Krugman seems to think that ridding the world of systemically critical institutions is a pipe dream. Suppose, however, that we could get rid of Too Big to Fail, would we want to?

When questioned about the numerous bailouts late last year, Ben Bernanke replied,

If you have a neighbor who smokes in bed and he’s a risk to everybody. And suppose he sets fire to his house. You might say to yourself, ‘I’m not going to call the fire department. Let his house burn down, it’s fine with me.” But then, of course, what if your house is made of wood and it’s right next door to his house. What if the whole town is made of wood? I think we’d all agree that the right thing to do is put out that fire first and then say, ‘What punishment is appropriate? How should we change the fire code? What needs to be done to make sure this doesn’t happen in the future?

Now the Shelia Blair seems to be arguing that to prevent this from ever happening again, no house will be “too close to burn”. All homes will be built so far apart that we can allow one to burn to the ground without endangering the others. Is that a good idea? Aren’t their benefits to density that outweighs the costs?

In the financial world large multinational firms lower the cost of global trade. They allow a manufacturer in China to be connected to his supplier in Malaysia and his retailer in the US through a single financial counterparty. Last summer I met a gentleman from Africa, no older than his mid-20s who had a business harvesting and exporting hardwoods directly to Europe. When I asked him how he managed to set all of this up he said that HSBC did it all for him. They knew the shippers, the customs regulations and the retailers and they could supply letters of credit for the entire supply chain.

Larger firms also lower average costs and distribute research and development expenditures across a wider base. Before it got tangled in the mess from Countrywide and Merrill Lynch, Bank of America was busying itself developing the first fully integrated backend for handling mortgages. It would allow loan officers to pass mortgage applications on for approval utilizing the same system they used to collect the mortgage information. This process would cut down on error, improve the detection of fraud and perhaps most importantly allow Bank of America to handle more of its mortgages in house rather than via brokers. Throughout this crisis broker originated loans has significantly underperformed those originated at the bank itself.

Critics might argue that innovations and cost savings are nice but they hardly compensate for the costs of moral hazard. The problem is that moral hazard is a fundamental part borrowing short and lending long. Restrictions on size or interdependence cannot change the fact that when a financial institution goes down, it is the creditors of that institution who overwhelming bear the costs. For a bank it is the depositors that pay. For an insurance company the policyholders take the loss, and for a shadowy Special Purpose Vehicle, it is the buyers of Asset Backed Commercial Paper. One can’t design a financial firm where the executives or even the shareholders bear most of the costs of failure. Finance is the management of other people’s money and the implicit mitigation of other people’s risk.

This is why regulation is appropriate in finance that would be draconian anywhere else. It is why all institutions that borrow short and lend long must be subject to similar standards. It is also why we shouldn’t be afraid of too big to fail. Systemic has to be handled by a regulatory process that constrains it and an emergency management process that mitigates. It cannot be done, however, by destroying the interdependence that is at the heart of finance itself.

Megan McArdle addresses Laffer Curves and the marginal cost of public funds. I think this whole topic deserves much more attention but for now let me wax nerdy and just say that that Laffer Curves take average taxation on the X axis. This is really the only way to make sense of the typical shape. It is plausible to create utility functions such that maximum revenue occurs at 100% marginal taxation. More importantly there is really no reason to expect that revenues will go to zero at 100% marginal taxation. So to make the basic assumptions stick in general we have to be talking about average taxation.

Deadweight loss, however, is a purely marginal phenomenon. It is possible to have a 90% average tax rate and no deadweight loss if marginal taxes are zero along the relevant range.

Dean Baker seems to suggest that the real economic problem is the decline in housing prices not the credit crisis. However, as Free Exchange points out the housing bubble was the symptom of a credit bubble and the popping of the latter lead to the popping of the first.

You take away structured finance and the subprime market, and the fire runs out of fuel much more quickly. Think about this—the big leap in subprime mortgage originations took place between 2003 and 2004. At the end of 2003, the Case-Shiller 20-City Composite Index stood at 150—50% above its level in 2000. It would subsequently peak at around 206. That additional doubling was largely due to the expansion in the number of prospective homebuyers, and it turned a bad bubble into an historically awful one.

I would go even further and suggest that the reason bubble began was the proliferation of Alt-A mortgages that were at least as intimately connected with the rise in housing prices as subprime. Both changes gave borrowers significantly more purchasing power and with all due respect to Ed Leamer did in fact change the technology by which land was transformed into housing.

There is a big debate going on now about the role of shadow banking in the current crisis. Charles Davi says Brad Delong and Mark Thoma have got it all wrong. From what I can see Delong and Thoma are on the right track. Now, different commentators seem to mean slightly different things by the term shadow banking. So let me state explicitly my views on the roots of the financial crisis.

First, there was a lot banking activities by institutions that had no access to the discount window and no lender of last resort. What does that mean? It means that retail loans were produced and distributed to investors without ever passing through what we would think of as a traditional bank. Fundamentally, a bank is a middle-man. It borrows money from one set of people and lends it another. The trick of banking is to convince the people its borrowing from that their money is safe and liquid, while at the same time lending the money out to the type risky, illiquid projects that actually cause the economy to grow. This sleight of hand is added by the Federal Reserve, who in exchange for regulatory oversight promises that it will guarantee the bank is always liquid. Given that the Fed prints the money, that’s a promise that you can well, take to the bank.

In our new world, however, a potential home buyer could walk into the offices of New Century. New Century would provide them with a loan. New Century would then sell that loan to Bear Stearns. Bear Stearns would then take that loan and packaged alongside other loans in a Collateralized Debt Obligation. Those CDOs would then be sold directly to investors. The trick in all of this is that the CDO did the work the traditional bank used to do. CDO’s as you probably know are cut up into traunches. When the investors send in their mortgage checks the traunches are paid off in a particular order. That order means that even if some of homeowners didn’t make their payments, the highest rated traunches would still get paid.

So the CDO has produced safe debt from a risky project. So, safe in fact that it can get a AAA rating that makes the debt liquid. So we have safe liquid debt from an unsafe and illiquid project. That is a bank. This bank, however, has no access to the discount window. So what happens when so many people are late on their payments that the market gets spooked and won’t buy your bond despite its AAA rating? Liquidity collapses, trades don’t occur and the market grinds to halt. From the point of view of the outside world, the “bank” was run. Investors can’t get their money back and potential borrowers can’t get loans.

Second, there was the use of off-balance sheet entities. From the point of view of investors this bank without a bank thing was a great idea. See, with a traditional bank the Federal Reserve wants to get caught up with annoying details like capital adequacy ratios. Being the spoil-sports that they are the Fed makes you put a lot of your own money in the game, so that you are not hanging the taxpayer out to dry if they have to step in and provide their liquidity guarantee. The more of your own money you put in the less leverage you have. The less leverage you have the less money you make. So, the Fed is really cramping your style here.

To make matters worse, now that non-banks can do banking you have a competitor on your front end, stealing business from you. So what is a bank to do? Well, since non-banks can get into this why don’t we just create a non-bank entity that is funded by the bank and gives its profits to the bank? This entity can engage in the same CDO transactions without those pesky regulators harshing your mellow. Yes, there are those who say that ultimately if the non-bank entity goes bad then the bank will lose its investment and therefore reduce its capital just as if the non-bank entity were actually a part of the bank. Sure, that may be technically “true” and “completely reflect the actual aggregate risk.” But, they are forgetting something – it’s totally legal.

Third, there is another layer to this where we get into something called Synthetic CDOs. Here we don’t even have to get rid of the loans. We can keep the loans and buy insurance against them going bad. If we structure the insurance just right it will have the same net effect as having chopped up the loans into parts based on their riskiness and then selling the parts. The insurance we buy is called Credit Default Swaps or CDS. As long as the companies we buy the CDS from a solvent and able to meet their obligations, there should be no problems.

The entire system created here operated outside of the traditional commercial banking and outside of the regulatory power of the Fed. Yet, it funneled an enormous amount of money into the real estate, car loan and to some extent even credit card markets. This in turn allowed consumers to take on more debt than was sustainable. When it all came crashing down there were three huge consequences. One, once the easy credit was gone the economy was faced with a sudden readjustment. Homebuilders were building too many homes. Automakers were making too many cars. Retailers were stocking too much merchandise. This sudden adjustment weighed on the economy.

Two, the riskiness of a mortgage depends crucially on the amount of equity the borrower has. The end of easy credit meant a reduction in the number of home buyers and a reduction in the price of homes. Falling home prices mean falling equity and hence rising riskiness. This increase in riskiness lead to even wider losses on mortgages and an even sharper reduction in the supply of mortgages.

Third, the collapse of some non-banks, in particular Lehman Brothers and Bear Stearns created a panic which reduced the availability of credit for everyone and sent the world economy into a tailspin. Lehman and Bear had engaged in this CDO business but they also had other more benign business. They were storied firms and they could and did borrow freely in the credit markets. Then everything went bad and investors became afraid that the money the lent to Lehman and Bear would not be paid back. Those fears were realized on September 15th 2008, when Lehman went bankrupt. Now the fear was not only not getting your money back from Lehman but getting your money back from people who may have in turn loaned your money to Lehman. The best course actions was to hoard all the cash you possibly could and buy US Treasury bonds. So Treasuries soared and everything else tanked. Credit dried up and companies wary of not being able to make payroll or meet suppliers began to lay off workers en masse.

This is the outline of the crisis as I see it and it stems mainly from the proliferation of the non-bank banks.

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