Vatican 2.0

I watched Paul Volcker on Charlie Rose the other night. They discussed the role the Fed should have in over-seeing the “systemic risk” posed by firms that are too big, or too inter-connected, to fail.

Volcker was responding to Chris Dodd’s suggestion that the Treasury Secretary take on this responsibility. Volcker disagrees with Dodd. He thinks the Fed is the right candidate because it is the only “independent” entity. He also argued that the Fed was a superior choice because people who work in Treasury would not have the professional experience to assess these systemic problems appropriately.

I have a lot of respect for Paul Volcker and I tend to agree with his views on the economy. And I don’t, out of hand, dismiss the idea that the Federal Reserve would make a better regulator of systemic risk than the Treasury or any department or committee of the executive or legislative branches. But implementing these kind of changes, in particular, for these kind of reasons, is very, very dangerous.

To give the Federal Reserve increased regulatory authority because the Fed is staffed by experts who are independent of political pressure is to intentionally move away from democracy. What are we giving them? Law-making and enforcing authority. Who are we giving it to? Experts. Why do we want to give it to them? Because they are not accountable to the people.

Just to be clear, I am not saying I am against this move. I think a reasonable argument can be made that, because of the complexity of the global economic system, such moves away from democracy are required. But I think that we should acknowledge this fact and either find a way to compensate for it, restoring democracy, or conceive of ways to make non-democratic political institutions function in a way that approximates the intention of democratic institutions.

It may be that the move away from democracy is inevitable, much as the move toward democracy may have been inevitable a few hundred years ago. I believe that the structure of society is heavily influenced by the distribution of knowledge, and that this distribution grows naturally — it can be shaped but hardly re-structured. We may be entering a phase where democracy is simply untenable. But if that is the case, we’d better recognize it soon.

Health Care Reform — Why Change is Needed

I believe in the free market, and that is precisely why I am for major healthcare reform and the introduction of a public option.

I’ve detailed my argument in this previous post so I will only summarize here.  Free markets work because they permit supply to meet demand at a market clearing price.  Free markets insure that we spend the fewest resources we can to provide the things that people most desire. This does not work for health care because there is no proper, independent demand curve for health care services.  In simple terms, consumers do not know what health care services they want.   When demanding health care, consumers only know the outcomes they want.

In health care, as in many other industries, outcomes and services are de-coupled.  For the most expensive to treat, most pressing health care needs, doctors cannot know for sure what services will lead to the desired outcomes.  The variation across patients and the variability of complicating factors is too great.  This gap between services and outcomes is especially large for preventative and diagnostic medicine.  The sicker a person is, the greater the immediate risks to their life or particular bodily functions, the clearer the need for intervention.  But for long term care — managing risks of heart disease or diabetes, treating cancer — we just don’t know.  We don’t know enough about how well any particular treatment, test, or procedure will work to tie it to an outcome with an appropriate price.

The impact of this service-outcome disconnect is most evident in the proliferation of unhealthy behaviors in early and middle life.  What, for example, is the appropriate price for a service that sends you a sarcastic, disparaging text message (via your iPhone/Blackberry) every time you try to eat a cheeseburger?  Given today’s information, few young people would sign up for this service.  But given what they know in 20 years, when many people realize they have heart disease, many might. That is, when people find out later that their desired outcome (long life) is improved by a particular service, they’ll desire it.  But there is a good chance that, regardless of how many cheeseburgers one eats, there will be no heart disease.  There are too many complicating factors — we just don’t know.

Since we can’t expect the price of health services, particularly for long term outcomes, to be accurate, we can’t expect that a system that uses price to allocate resources and decide outcomes to be efficient.  In other words, for the resources people would desire to spend on healthy outcomes, the current system does not maximize health.

The current system performs exactly as we would expect it to perform.  It over-allocates resources to services that can be tied directly to outcomes, specifically, drugs and surgeries, particularly close to the end of life when consequences to inaction are imminent.  These are the services for which there is robust demand.  At the same time, suppliers spend resources trying to avoid these high demand customers — the sick and the elderly — in favor of low demand customers, i..e customers for whom no services are required to meet their desired outcome — the young and the healthy.

A crucial source of efficiency is lost in this shuffle.  We don’t spend enough on making young people healthy and this makes our old people sicker.   Or, in other words, we could have a lower cost, higher outcome system if we found a way to get young people to take better care of themselves.

Now here is the trick.  In whose interest is it to make this happen?  Insurance companies?  No.  As described above, this is fundamentally a demand side problem.  An insurance company cannot make more money off of healthier young people unless it can capture their health expenditures over their entire lifetime.  That is, if the demand curve was for a total lifetime expenditure, insurance companies could profit by making you healthy now so that you were healthier later.  What about employers?  No.  Same problem.  Only if the health plan is part of a vested pension would the company save money if people were healthy after they retired.  What about the individual?  This is the original point of the critique.  The individual lacks the information necessary to make an appropriate decision.

As I see it, there are only two entities that could conceivably gain from addressing this inefficiency:

The Government

The Family

These institutions can gain because they are the only institutions that stay the same for people throughout their entire life-span.  There are exceptions, of course, but for the most part people remain in the same country their whole lives, and people remain in close bonds with their parents and children their whole lives. Thus, these institutions stand to gain from better allocation of health care resources and are the biggest losers in the current, poorly allocating  system.

I will debate the pros and cons of these approaches in a subsequent post.

Letter in different form

Dear Dr. Krugman,

I write to encourage you to use the following argument in your arsenal. It is a simple argument that abides neo-classical principles but shows that sometimes the government is a better investor than individuals. If this argument is valid, then there is no justification for “tax cuts” as part of any stimulus package. The package should be purely spending (to keep us alive) and targeted government investment (to set the stage for future growth)

Tax cuts stimulate “better” investment only in certain circumstances. Tax cuts put decision-making power in the hands of those who hold more precise, but more local, information: individuals. When the basic parameters of decision making are already set — prices are stable, technologies and infrastructure are relatively fixed — individuals make better decisions than the government. This is because they have access to more precise information — they need to track fewer variables and receive more rapid feedback.

But in times of upheaval, when there are insufficient number of givens, calculations at the local level become too complex. Individuals have precise data but lack sufficient premises to interpret the data, rendering the precision useless. For example, since there are a dozen candidates for alternative energy technology, it is hard for a small business owner to know which kind of vehicle to buy. The individual can hold precise knowledge of the particular prices and features which are relevant to his/her business right now, but he/she assumes that the very basis of “relevant” could change dramatically at any point in time. When faced with this complexity, the rational thing for local investors to do is “wait and see” how things play out.  The deflationary trap is the manifestation of this collective “waiting and seeing” by rational individuals.

At these times, the most effective allocator of capital is any actor who can impose parameters rather than needing to wait for them to emerge from the decisions of others. This actor is the federal government. This pattern of toggling between local and central decision-making is well known in the studies of organizations (starting with March & Simon) and individual decision-making (see the work of Gigerenzer). More frighteningly, in biological communities that lack a central decision-maker, these situations generate calamitous collapses that solve the problem by forcibly removing interdependency. We don’t want that.

In 25 years, the current understanding of neo-classical economics will be changed. Either we will solve these problems by recognizing that government investment is a logical component of market systems with rational actors, or we will fail to solve them and have rejected the philosophy entirely. Please do what you can to encourage the former.

Thank you and sincerely,

Drew Margolin

Draft of Letter to Krugman

I’ve been working on this for a couple of days.   If anyone is reading… comments?

Dear Dr. Krugman,

I write to encourage you to add the following argument to your arsenal.

The neo-classicists argue that the market-clearing price is always the optimal price, but this is wrong.  As we know from game theory, locally rational decisions can produce collectively sub-optimal outcomes.  A depression is tragedy of the commons.

What is the externality that is lost in the depression?  Information.  Rational transactions are like scientific experiments.  They are informative both in their success and in their failure.  We aren’t normally aware of it, but when two parties transact there is an important benefit to third parties — it tells them something about the private beliefs of the transacting parties.  The transaction serves the market by calling attention to its basis and its outcomes.  This allows a third-party observer to form expectations about what the outcome “should be” based on his/her own information, which in turn gives the observer the ability to learn from the transaction’s outcomes.    Thus, the rational transactions of two parties creates the opportunity for third parties to gain information, improving their future decisions.

The market allocates capital efficiently given a level of information, but it does not allocate capital efficiently to produce information.  In a depression, there are fewer transactions and so there is less information gained.  Decisions by actors to hold their money are rational, but the market as a whole loses out.  The neo-classicists are correct in saying that for the government, or any other third party, to “force” investments is to spend capital on experiments that are likely to fail.  But the failure of investments provides information.  Neo-classicists would also be correct in saying that arbitrarily chosen, irrational transactions do not provide as much information as rational ones.  This is true, but slightly biased experimentation reveals more information than no experimentation.

Government investment is needed, and the emphasis should be on informativeness.

Sincerely,

Drew Margolin

Stimulate Disagreement and You Stimulate Trade

I think economists sometimes lose sight of the fact that their policies work within a context of real world events, ideas and discoveries.

I don’t see how any purely financial maneuvering — be they tax cuts or money supply adjustments — addresses the problem we have.  People don’t lack liquidity, they lack an incentive to take risks.  This isn’t because risk taking isn’t cheap enough, it’s because the advantages of being a first mover are almost the same as those of being a second mover or a tenth mover, but the disadvantages are much, much greater.    This is because there don’t appear to be any really good, concrete ideas on the horizon for new industries.  There doesn’t appear to be any “next big thing.”  So there is little to miss by sitting on the sidelines, but a lot to lose by running into the game where no one else joins you.

Imagine a herd of gazelles standing in a valley.  They all believe, based on the information that they have, that there might be a lion just over the hill in any direction.  There might be food, too, but none of them have any idea where.  Let’s assume the assign the danger (lion) and the value (food) the same probability.  Collectively, then, they have to try to leave the valley sooner or later.  But individually, the rational thing for each of them to do is to wait.  Maybe some other gazelle will get the urge and head over the mountain?  Sure they’ll have to go eventually, but they figure they can hold out at least as long as the average gazelle, so a decent set of lesser gazelles will have to check things out first.  So they just sit tight where they are.

Tax cuts and money supply adjustments can be represented by free steroids that make the gazelle stronger and faster.  If one goes over and meets the lion, its chances are marginally better.  They change the calculus slightly on the margin, but they don’t modify the driving calculation, which is that it’s still better to let somebody else go first.

What can the gazelle government do?  They can pick a spot where some (government bureaucrat) gazelles are just going to go over the hill, period.  They are taking tax revenue to make armor for these gazelles so they are safe.  They’re going to go over and see what’s there.

The free marketeer gazelles complain, with compelling arguments, that the government never chooses the best spot to go over the hill.  They are looking in the wrong place!  They’re taking our resources to make armor so they can go find a lion.  How stupid!

It’s true, it might be the wrong place, but this isn’t the point.  By forcing risk, the government is altering the distribution of outcomes.  Those gazelles that stand near the government expeditionary force could get a nice payoff or a terrible one.  Those that stand far away get neither.  Depending on a gazelle’s private information about that spot and their own risk preferences, there is now a reason to move.  It’s either time to move closer or farther from that spot.  In other words, there is now something to disagree about, something to debate, i.e. something to trade.

These trades (of position) start the herd jostling.  Other opportunities emerge to reflect their divergent preferences.   There is also more of an incentive to consider inventing new techniques identifying lion or food location, because now these ideas can be sold to gazelles who want to head to the front, rather than having to be tested by the individual who concocts them.  In other words, creative talent and risk-taking appetite don’t have to be located in the same gazelle.

Let’s assume the gazelle government picked a lousy spot to go over the hill.  The suboptimality of that probability is a cost.  But there is an enormous benefit to paying that cost — the reduction of uncertainty (entropy).  Our government should do the same.  Pick projects that make concrete claims about their outcomes: not just road improvements, new roads and bridges; not just school fix ups, specific promises about educational performance; not just money for alternative energy, concrete goals and timelines.  Yes, it would be better to be right — to achieve those goals, but there’s money to be had in betting against those things, too.  Let the disagreement begin!

Krugman and Bubble-Mania

Krugman had good column today on the weak long term prospects for our economy and our desperation for another bubble.  Here is the comment on I posted.

I agree, we appear to be bubble-addicted and bubble-reliant.  This is largely because our understanding of the economy insists that “growth” is the single criterion of economic health.  But as any investor knows, growth must be adjusted for risk to capture true return.

Almost all of the concepts we use to measure and describe the economy are measures of or references to transaction volume: gross domestic product, recession, stimulus, balance of payments etc.  When people say “the economy” is in trouble, they mean “transactions are down.”  When people say they are hopeful about an economic turn-around, they mean “I can see transactions increasing in the future.”

There are no strict measures of national economic volatility.  We carefully measure and debate whether we are in a “recession,” but not so whether we are in a “bubble.” Thus, even though there are times when volatility reducing recessions would be preferable to volatility increasing bubbles, we lack the tools to argue for this choice.  Recessions, we believe, must be avoided, and if the way to avoid them is by encouraging bubbles, so be it.  If you lose money at the track, try hitting the slots on the way out to “win it back.”

It is possible that, at one time, interest rates could have served the role of volatility monitors, but in the era of active management of the money supply (to serve growth) interest rates are tools of economic management rather than outcomes of economic performance.  For example, the low rates of the last five years clearly did not reflect the risk in the economy.

The recent attention to contributions by sector (e.g. how much of GDP comes from consumption, how much of profit growth comes from financial services) shows we are beginning to look in the right direction, but a more formal recognition and treatment of the topic is required.  Similarly, the long standing criticisms of economic policy by those concerned with environmental degradation and sustainability are informed by the same concern but tend to be stated in moral, rather than economic, terms.  Their arguments thus implicitly suggest that the growth-at-all-costs champions have the economic high ground.  They do not.

Put simply, some forms of growth are better than others.  Growth in the ability to efficiently satisfy deep human needs is likely to be stable, as those needs aren’t going to change, and is therefore productive.  But growth in the ability to tap the moods of the moment is not really useful at all.  It allocates scarce resources to industries and skills of short-lived application, sowing the seeds of future crashes.  This, more volatile growth, is economically inferior and should be treated by policy as such.

Krugman nailing it

I don’t always agree with Krugman, especially when it comes to politics.  But on economics he’s dead on, and this column nails it.  The point: people on Wall St. get paid far too much, not because no one deserves that kind of cash, but because the way they “earn” it is not really providing a valuable service.

First, the free market determines Wall St. compensation, so it must be adding value to the economy, right?  Wrong.

But surely those financial superstars must have been earning their millions, right? No, not necessarily. The pay system on Wall Street lavishly rewards the appearance of profit, even if that appearance later turns out to have been an illusion.

Consider the hypothetical example of a money manager who leverages up his clients’ money with lots of debt, then invests the bulked-up total in high-yielding but risky assets, such as dubious mortgage-backed securities. For a while — say, as long as a housing bubble continues to inflate — he (it’s almost always a he) will make big profits and receive big bonuses. Then, when the bubble bursts and his investments turn into toxic waste, his investors will lose big — but he’ll keep those bonuses.

Ok, so a few guys got rich and that is unfair.  What is the cost to us?  Well, the cost is in wasted resources.  Money invested that does not bring a return is lost.  It’s the equivalent of an agrarian society taking a storehouse of grain and lighting it on fire in the expectation that it would bring rain.  When the rain doesn’t come, the grain is still gone forever.  How much grain did we burn for rain that is never coming?

We’re talking about a lot of money here. In recent years the finance sector accounted for 8 percent of America’s G.D.P., up from less than 5 percent a generation earlier. If that extra 3 percent was money for nothing — and it probably was — we’re talking about $400 billion a year in waste, fraud and abuse.

I read somewhere that something like 60% of growth in profits in the U.S. over the last 3 years was in financial services.  An accurate figure on this is needed, but even if that’s close, it’s bad news.  It means that most of our “profits” were zero.

Then there is the demographic effect…

Meanwhile, how much has our nation’s future been damaged by the magnetic pull of quick personal wealth, which for years has drawn many of our best and brightest young people into investment banking, at the expense of science,public service and just about everything else?

If half of the minds that went into developing derivatives had gone into, say, alternative energy, where would we be?

And finally, the corruption of reason effect…

Most of all, the vast riches being earned — or maybe that should be “earned” — in our bloated financial industry undermined our sense of reality and degraded our judgment.

Think of the way almost everyone important missed the warning signs of an impending crisis. How was that possible? How, for example, could Alan Greenspan have declared, just a few years ago, that “the financial system as a whole has become more resilient” — thanks to derivatives, no less? The answer, I believe, is that there’s an innate tendency on the part of even the elite to idolize men who are making a lot of money, and assume that they know what they’re doing.

The laws of economics are very simple and straightforward.  Incentives and self-interest rule.  Markets favor two kind of innovation — innovations of production (new, useful ideas) and innovations of deception (new ways to make people think you have useful ideas).  If you see the market lavishing rewards on someone, it tells you they’re really good at at least one of these things, but it doesn’t tell you anything about which one.

No, wait, actually it does.  Truly brilliant, useful ideas are rare.  Brilliant ways to deceive are, depending on the environment, not so rare.  As we all know, there are times and places where it is easy to lie and get away with it.  So when lots of people start making atom-splitting money, it’s a good bet that their innovation is in the craft of bullshit.

Letter to Friedman

Tom Friedman had this column in Sunday’s NYT.  The basic point was that Obama should deal with the major problems of Detroit, Afghanistan, and banking with an eye toward fixing the underlying problems.  I sent this to him to further his point:

Great column today (Sunday). One thing to emphasize with both Detroit and the banks: bad decisions now will make things worse in the future.  And yes, they can be worse (see 1932).

The major reason the economy can, and will, get worse if we aren’t smart with the bailout money is that it is borrowed money.  Since the bailouts involving loaning money to companies, we citizens tend to think of ourselves as the big bankers assessing these companies with our charitable but scrutinizing hearts.  We forget, though, that just like most bankers, we’re not loaning our own money.  We’re loaning money we borrowed and had better pay back on time, or else…

These loans allow us to keep our economy alive in the short term, but like all loans, there is a time limit to their health-giving power.  Loans soothe short-term pain by re-packaging it as the risk of long term catastrophe.  This means that by borrowing money to give bailouts, we just made our short term situation less important and our medium term situation more important.  We don’t need to be marginally more healthy now, when our credit is good enough to borrow, we need to be considerably more healthy in the future when, if we aren’t healthy, we won’t have any credit to fall back on.  This means that any use of the money that doesn’t improve our fundamental economic health is not only “wasted” but is in fact endangering us at the time when we are most vulnerable — the future.

This is not to suggest that we should just let Detroit and many banks die on the spot.  Institutional stability plays an important role in the process of learning and innovating.  It is hard to grow anything in an environment of chaos.  But our goals cannot waiver: long term, sustainable growth.  And if that means short term pain, we need to accept that, because we still have a supply of pain relievers…. for now.

Community Squares

I agree with David Brooks column yesterday on how Obama should spend on infrastructure. We need to spend money to help people connect with one another. This will both improve the economy, because it will help with innovation and the distribution of risk, and quality of life.

Liesl and I were in Mexico this summer and in Belize in the fall (visiting the wonderful Cesiak and Blackrock resorts). In the towns there they always have a central square, the “plaza.” In the evenings, particularly on the weekends, everyone in town gathers there. Families with young kids, the elderly, and teenagers. They all do their own thing but they are there together and can’t deny they are part of a common experience. It’s great!

The untold story

Very few people are aware of this, but the so-called “free market” is dominated by the decisions made by a very small number of people at the very small number of rating agencies that set the credit ratings for debt. In fact, it is written into the rules of the contracts by which the vast majority of the world’s wealth is invested, such as the bylaws of institutional investors like pension funds, that these ratings are to override human judgment without exception. If debt is rated below a certain grade, these institutions may not hold it. For many companies, especially highly leveraged ones (ones that borrow a lot), this means that a drop in their rating equals instant bankruptcy, instant death. They are thus beholden to ratings agencies the way that a Soviet company was beholden to the central planners, with all of the attendant incentives for distortion of business practices and deception in reporting.  But as I said, very few people are aware of this.  Those outside the financial world don’t know about it at all, and those inside the financial world know about it but it is never discussed.  Ratings are treated like an objective fact of the world when they are, in fact, anything but.

Here is the NYT on the rating agencies involvement in creating the mortgage bubble.