Finance: History and Policy

Burgernomics Redux

2012-01-20T14:02:00.001Z

Recently, a very smart, and smart looking, description of The Big Mac Index was posted at:
www.onlinemba.com/blog/the-big-mac-index/

Note especially the "Issues and Limitations" stuff at the bottom.

For use of the index as an economic indicator, of course see the book Simon Constable and I put out last year, The Wall Street Journal Guide to the 50 Economic Indicators that Really Matter: From Big Macs to "Zombie Banks," the Indicators Smart Investors Watch to Beat the Market.

More Evidence Against Citizens United

2012-01-17T00:53:00.000Z

I've said it before, and I'll say it again, Citizens United, the decision in the recent SCOTUS case that allows corporations to donate money to political campaigns, is way off in its reasoning and its historical facts.

Just happened to run across the following in my research:

"Higgins Suggests Insurance Reforms: Election Reform," New York Times, (4 January 1906), p. 7:

"Political contributions by business corporations are illegal and ultra vires. ... The practice is morally as well as legally wrong. ... I recommend that the making of political payments by corporations be made a penal offense."

The author of such blasphemy? New York governor Frank W. Higgins.

The Occupy Movement and Ever-Rising College Costs

2012-01-05T20:26:00.000Z

The people occupying various open spaces in urban centers and university campuses around the nation and world are a diverse group of individuals who share at least one thing, discontent with the status quo. If their concerns remain unaddressed, there is no telling where their Occupy Movement may lead.

A large and conspicuous segment of the movement is composed of college students and recent grads fed up with rapidly rising college costs. Between 1930 and 2000, average college costs in inflation-adjusted dollars increased more than five-fold. In the last decade, average tuition has increased two to three times faster than inflation or family incomes. And quality has not palpably improved. College graduates today are no better prepared for life or the labor force than previous graduates were.

The tide of ever-rising costs may be turning in the college textbook market thanks to the Internet and new companies that offer lower cost—even free—alternatives. But textbooks still represents far too high a percentage of overall cost for students (26% of tuition at four-year state universities; 72% at two-year colleges). And textbook prices, like tuition, continue to rise faster than inflation and will continue to do so until structural reforms are implemented.

Despite that, most studies show that a college education is still a winning investment because over their lifetime college graduates earn more than non-graduates, on average. But some schools are better values than others, offering more future income per dollar of cost expended today. The schools that offer the best values are not easy to spot, however, because they are not always draped in ivy or adorned with winning football or basketball programs. What we see in the Occupy Movement is the margin, the growing number of students who consider their college experience, correctly or not, as a losing proposition.

If the labor market remains soft, as some fear it must for years or decades given the nature of the financial calamities and bailouts of 2007-9, student unrest will grow more widespread and virulent. Few twenty-somethings believe that they will ever collect a Social Security check and hence feel as though by protesting they have nothing to lose except their (seemingly) overwhelming chains of debt. If the government were to resolve the Social Security question once and for all, student protests would abate somewhat because the status quo would appear less unfair and young people’s futures less bleak.

Regardless of the fate of Social Security, however, fundamental educational reforms will have to be undertaken sooner or later. Tuition, like healthcare costs, cannot continue to increase faster than other prices indefinitely or there will be no money left in family budgets for food, clothes, shelter, transportation, and so forth. (Many families already feel the strain.) To be effective, reforms will have to change incentives within higher education.

Colleges and universities are inherently inefficient because most are owned by governments or trustees (Corporate universities raise a different set of problems that won’t be addressed here.) and competition is less intense than one might think due to the tremendous segmentation of the market by geographical area, student ability, class size, physical amenities, population density of the surrounding community, religious orientation, sports programs, and so forth. Much of the competition that does occur is over research grants or student athletes and not over effective pedagogical techniques.

Due to that fundamental dearth of competition, tenured professors, administrators, legislators, and trustees have preferred to pass the cost of their inefficiencies onto students (past and present), taxpayers, and untenured professors. I have therefore proposed that governments allow professors to form new colleges as professional partnerships. In addition to increasing competition and student choice, collegiate professional partnerships would have bona fide owners, their professors, and hence a real interest in providing high quality, low cost educational services to the broadest swathe of Americans possible.

A second reform, the payment of government subsidies to students rather than to universities, would also help to transform higher education by shifting schools’ focus toward undergraduate education and away from graduate research. (Adam Smith made a similar proposal over two centuries ago, one of his many bright ideas unfortunately lost during the twentieth century.) Subsidies that are at least partially earned rather than merely received usually have greater impact, so they should arise out of some form of student service, perhaps a G.I. bill-like program that would provide students with money for college in exchange for a wide range of services to the country. Implementation would cost taxpayers no more than higher ed subsidies currently do and would soon turn disenchanted protestors back into students and workers.

Another Leading Economic Indicator

2011-12-09T17:27:00.000Z

My book (with Simon Constable) The Wall Street Journal Guide to the 50 Economic Indicators That Really Matter continues to sell circa 500 copies per month. It is a great, inexpensive holiday or birthday gift for anyone you know who is interested in investing and/or economics. It has received some great reviews and is an EZ and interesting read.

At a meeting last night I got a lead on yet another important leading economic indicator, a "canary in the coal mine" if you will -- RV and mobile home sales. A local dealer explained to me that she realized that something bad was afoot a full year before the subprime sh ... feces hit the fan because banks greatly reduced the volume of lending. For investors, RV, camper, etc. sales would be good to track but also the industry's manufacturing output, employment, and bank loans (though I'm not sure the last named are readily available).

Focus on Prosperity, not Jobs Reprise

2011-11-20T18:23:00.001Z

For those of you looking for my blog entry featured on KCPO's The Facts program today (11/20/11) here is the direct link.

My Amazon page, for those interested in reading more, can be found here.

Also, those of you looking for my piece on the OWS and the possibility of violence on Bloomberg can click here.

SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota

2011-10-19T18:57:00.001Z

SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota

It really pains me to have to write these scam alerts but when I see economic injustice, I have to speak. I hereby warn off all potential customers (new cars or service) of Billion Toyota in Sioux Falls, SD (and its affiliated companies). The service department there is engaged in very shady activities and should be avoided in all events.

Yes, I have declared shenanigans.

SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota
SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota
SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota SCAM ALERT: Billion Toyota in Sioux Falls, South Dakota

The Mainstream Media Is Running Scared, Again

2011-10-04T15:24:00.002Z

Yesterday afternoon, a major TV news outlet solicited an op ed from me. I agreed, though it was brutally inconvenient, because it seemed pretty wide open. Here is what the editor wrote: "Would you be interested in writing a piece for ... on the changing image of Wall Street and the financial industry over the past several years? It could be pegged to the Occupy Wall Street protests and the books and films that have focused on the topic since the financial crisis began – and could put that into the context of history. Our readers would appreciate your perspective.

The editor REFUSED to publish the piece I came up with, which I copy below, because he said that he was afraid that it would incite violence. I of course think the claim utterly ridiculous unless the editor believes that we are actually sitting on a powder keg of civil unrest and violence. The last time an editor refused to publish a SOLICITED op ed by me was back in 2005 or 2006 when I suggested that bank stock prices would suffer when housing prices stopped rising, as they inevitably would. The editor didn't want to "go there" because she would get into a lot of trouble if my little piece turned out to be the straw that broke the camel's back/the pin that pricked the bubble. So while the piece below is merely the musings of an historian conversant with the violence of our collective past, I am now worried that I hit too close to home. Allow me to reiterate, therefore, that I am not condoning violence, just warning that it may be around the corner due to deficient government policies. That the mainstream media (this left vs. right media argument misses the point, imho) is running scared again has me running scared! Here is the piece in question. Judge for yourselves.

Will Wall Street Burn?

In 1792, a mob of defrauded creditors would have lynched failed financial speculator William Duer had he not taken refuge in New York’s debtor prison. Adroit policy maneuvers by Treasury Secretary Alexander Hamilton quelled the subsequent financial panic and quickly righted the economy, diffusing tensions. But in 1835 Baltimore suffered one of the worst riots in antebellum American history because the city government failed to create a sense of social justice in the aftermath of the bankruptcy of the fraudulent Bank of Maryland. The lesson is clear: When tensions run high, how leaders respond to financial crises can make the difference between a peaceful return to prosperity and carnage.

We may be at another such crossroads today. Why Don’t American Cities Burn? asks University of Pennsylvania history professor Michael B. Katz in a forthcoming book. Other scholars have also been wondering why violence has not yet returned to American politics. Finance, politics, and explosions, after all, share a long history in America.

Some think that most Americans are too affluent and doped up on video games to risk life and limb for a cause. Others believe, Dylan-like, that revolution is in the air. The Occupy Wall Street protests, the increasingly negative portrayal of financiers in documentaries and the media, and renewed interest in movies like Fight Club, the 1999 flick in which Ed Norton/Brad Pitt sabotages credit card companies, suggest the Dylanites may know which way the wind blows.

Historical precedent is also flashing warnings. When they feel financially wronged, Americans traditionally complain to the authorities first but some turn violent when their concerns are not adequately addressed. After the French and Indian War, for example, a burst housing bubble and restrictions on international trade and money creation initiated scores of formal petitions of remonstrance. When British authorities responded to colonists’ concerns with new taxes, some Americans violently resisted the Stamp Act, the bailout of the East India Company, and other imperial policies. During the riot in Baltimore in 1835, at least five people died as the mansions of bankers and other moneylenders were looted and destroyed. Not everyone joined in the violence but thousands of bystanders stood by, cheering the rioters as they seized control of the city. The complicity of some militia units and fire brigades, members of which had been injured by the bank’s failure or subsequent downturn in the city’s economy, added to the carnage.

By the late nineteenth century, frustrated labor activists and anarchists frequently sabotaged corporate property and tried to take out anti-union business leaders and pro-bank politicians. In July 1892, Alexander Berkman shot and stabbed industrialist Henry Clay Frick in a failed assassination attempt. In 1901, Leon Czolgosz assassinated President William McKinley because “I didn't believe one man should have so much service, and another man should have none.” By staunchly supporting the gold standard, McKinley had aligned himself with banks and other creditors against the interests of indebted farmers and industrial workers like his assassin.

Attacks on anti-labor newspapers, mines, and other corporations, assassinations, and other forms of physical violence continued over the next few decades, culminating in the Wall Street bombing of September 16, 1920, which killed 38 people and wounded hundreds. Thereafter, however, class violence abated. Ostensibly, Americans were too busy to spend much time plotting, too busy sidestepping Prohibition and consuming new gadgets in the 1920s, too busy looking for employment in the depressed 1930s, too busy fighting fascism in the 1940s, and too busy getting busy during the baby boom of the 1950s. Riots rooted in socioeconomic injustices struck many major cities in the 1960s and 1970s but were more race than class based. More recent acts of extreme violence, from Oklahoma City to 9/11, were perpetrated by foreigners or directed at the U.S. government or vague notions of “capitalism.”

That could change, however, especially if banks continue to seek deficiency judgments against borrowers who lost their homes and jobs due to the subprime mortgage debacle and subsequent financial panic and recession. Many Americans still find it difficult to swallow the bailouts of 2008-9 and if the economy continues to wilt as bankers’ paychecks gain new heights they may find violence, particularly Hogan’s Heroes-style sabotage, palatable. So far most protests against the perceived injustices of the last half decade have been nonviolent and the authorities have used much more force than the protestors. If history is any guide, however, policymakers should consider the sustained protests as a warning. Nonviolent confrontations can and often have escalated into violence. Social instability is the last thing the economy or the government’s budget needs right now. Attention must be paid.

Robert E. Wright is the Nef Family Chair of Political Economy at Augustana College in South Dakota and the author of 14 books on financial history and policy, including Fubarnomics (2010).

****UPDATE****
A different publisher, Bloomberg, ran my updated version of the above on its blog last week. To read, click here.

Community Monies

2011-09-20T22:13:00.000Z

The Wall Street Journal today ran an article about community monies in Brazil called "In Pockets of Booming Brazil, a Mint Idea Gains Currency." Curiously, the author does not mention that 1,000s of other communities worldwide have local monies in circulation. The author seems to think that they stimulate growth but they don't. Central banks tolerate them because they are no threat to them: community monies in Brazil and elsewhere are fixed to sovereign currencies (e.g., each Ithaca Hour = $10 USD) so they lose purchasing power along with central bank notes. I find community monies downright pernicious because they induce people to hold inferior assets: relatively illiquid, zero interest notes with default risk. The only people benefited by them are the issuers.

If we are ever going to supplant national currencies in a major way, the alternative notes will have to be superior to what governments produce, not inferior to them. That is the idea behind the bearer money market mutual fund shares detailed in my essay "Reducing the Poor's Investment Risk: Introducing Bearer Money Market Mutual Shares."

What to do about the United States Postal Service? It's almost bankrupt, you know.

2011-09-16T19:47:00.004Z

Several years ago, on this blog ("Adam Smith, Profitability, and Efficiency") and in a scholarly publication (“On the Economic Efficiency of Organizations: Toward a Solution of the Efficient Government Enterprise Paradox,” Essays in Economic and Business History 25 (April 2007), 143-54.), I argued that the public-private distinction had been empirically bashed enough times that a new paradigm was necessary. In other words, not all private organizations are efficient and not all government ones are inefficient. Rather, I suggested, what matters much more than its ownership structure per se is an organization's internal incentives and the type of market (competitive to monopolistic) that it operates in. So the problem with the United States Postal Service (USPS) is not that the government owns it but rather that it has a monopoly on certain types of package delivery and that the remuneration of its employees is based largely on their seniority rather than their productivity. Open any organization to competition and reward employees for achieving goals aligned with the organization's purpose and it will thrive, even if it remains a government entity. It might be easier to privatize the USPS than to change its current culture but the privatization must be done correctly, i.e., without monopoly privileges of any kind and to companies that know how to properly incentivize workers, supervisors, and executives.

While discussing this issue with my son, Alexander Hamilton Was Wright, it dawned on me that physical delivery of letters over long distances could easily be eliminated even if a recipient or sender does not have email. Imagine a system of local letter delivery companies that zap mail back and forth to each other electronically, scanning paper documents when the sender doesn't have email and printing them when the recipient doesn't. No need for expensive, complex, international hub and spoke systems with airplanes, 18 wheelers, etc., just printers, scanners, and local delivery persons. Such a service would be cheap (the distance wouldn't affect the price but the quality of the desired output would), especially if competition was encouraged, and of course it would be faster than "snail" mail. So I'm not much alarmed at the prospect, however dim given our bailout-happy government, of the USPS shutting down. Everybody who wants will still get physical mail, maybe twice or thrice a day (from competing delivery companies).

Focus on Prosperity, not Jobs

2011-09-14T16:04:00.000Z

From Washington DC to my little prairie hamlet (Sioux Falls, actually a thriving small city of 160k, give or take), politicians are talking about using the government to "create jobs." Obama has a plan, of sorts, and so does Sioux Falls's esteemed mayor, Mike Huether, who thinks that a new "event center" he has been pushing will create 1,100 construction jobs.

Can the government really create jobs? I'm often asked. Absolutely, I respond, but should it? Aren't we really interested in prosperity, not jobs?

The government can create jobs directly by employing people or contracting with businesses and it can do so indirectly through its policies. Huether has the former in mind, Obama some of both. But neither will deliver what Americans really want, which is prosperity. The JOBS mantra is a load of bunk: American economic history is about working fewer hours at easier work for more and better stuff, not about employment. (And claims by the New York Times to the contrary, we are working less for more compensation and more and better stuff. More technically, real hourly compensation has increased markedly in both business and manufacturing.)

The federal government, for example, could ensure that every American would have work to do 18 hours a day, 7 days a week, 365 days a year by simply outlawing farm machinery and food imports. We could all work picking and shucking corn, milking cows by hand, etc. We'd be impoverished, but we would all have jobs. No politician would dare implement such a policy, of course, but tens of thousands of rules and regs have the same cumulative effect: creating work that need not be done. Reversing such policies would eliminate jobs but actually be good for the economy, especially after the workers freed from the bondage of un- or counterproductive work find value-producing work. I'm not saying that ALL regulations should be eliminated, just pointing out that they come with costs that are rarely understood or directly measured.

What about when governments hire employees or contract with private construction companies or other businesses that then make hires? Most people seem to have the sense that expanding government employment probably isn't a very good thing, at least not the way such employment is currently constituted (high pay and benes based on seniority rather than productivity). Surely the latter type, though, is beneficial? Only, I respond, if one forgets about Bastiat's window, or "that which is seen, and that which is not seen." What is seen are the burly men fixing a bridge or building an events center. What is not seen are the costs, the income that is diverted (through taxation) from one purpose to another. It isn't clear how such reallocation can add to the total number of jobs (unless they are lower paying than the ones they replace), but it is clear that it creates very salient jobs that politicians up for re-election can point to proudly and that it makes it difficult for their opponents and critics to point to the jobs lost due to the taxes. But we know that they were lost: the $1,000 or $10,000 that you paid in taxes did not go to the corner coffee shop, to the auto or boat manufacturer, etc.

If a government can somehow increase wages more than it decreases it, its ability to create prosperity with those wages must be limited in scope because communist nations like the former USSR that had nothing but government employment stagnated economically. They created plenty of jobs, in other words, but little prosperity. Why do the Obamas and Huethers believe that they can do any better?

How, then, can government promote prosperity? The quick and easy answer is by protecting life, liberty, and property because that will enhance incentives for improving productivity, for making more with less. What is meant by life, liberty, and property, and how government can best protect them, afford no easy answers but we can't even begin to have that conversation if politicians fixate discussion on "jobs.

Is Rick Perry Right about Social Security?

2011-09-09T20:55:00.000Z

During the debate on Wednesday night, Republican presidential candidate Rick Perry has taken som flak for calling Social Security a Ponzi scheme. Who's right?

On page 163 of Fubarnomics, I call Social Security a quasi-Ponzi scheme. I hedged because Ponzi schemes, pyramids, and related scams and flim flams are by definition illegal. Social Security isn't illegal and can't be unless declared unconstitutional, something SCOTUS has not done and is unlikely to do at this or any future juncture. Also, as Stephen Colbert hinted at last night in his critique of Perry's claim (sorry Parry's claim for Colbert -- the A is for AmericA and IowA), Social Security is not designed to enrich just one or a few people at the top, it is designed to provide modest annuities to millions of superannuated individuals (and in some cases their spouses and dependent children).

Social Security is like a pyramid scheme because it worked by increasing the number of taxpayers at the bottom of the pyramid. Demographics (the Baby Boom) helped at first, as did enlargements to the program. But now there are no new groups of any size (with the possible exception of immigrants) to add to the program and the demographics have reversed. Instead of a pyramid with a few at the top garnering benefits and a lot at the bottom each paying a little for their support, Social Security is more like a rectangle with the number of taxpayers not far outnumbering the recipients. Soon, the remaining taxpayers may feel the burden of taking care of so many beneficiaries too much to bear. In that sense, the Ponzi scheme metaphor is apt.

Interestingly, the government does seem to be following some of the recommendations I made in Fubarnomics, especially shifting Social Security from a special, highly regressive tax to the general fund. Obama apparently wants to continue the transition. The next step would be to tell everyone older than some age (I've volunteered mine) that they will receive Social Security payments as promised and everyone younger (including myself) that they had better start saving now because they will not receive any Social Security retirement benefits (and that the life insurance and disability components will phase out over the next few years). The final step would be to improve the regulation of our private security system: retirement plans, disability insurance carriers, and life insurers.

Our Government's Confidence Deficit

2011-08-22T20:00:00.001Z

The following appeared in the local newspaper, the Argus Leader, on Saturday.

August 20, 2011

My Voice: Our government's confidence deficit

Robert E. Wright
People in Sioux Falls and nationwide have a low opinion of the federal government right now, and justifiably so. Recent declines in the stock market have more to do with that "confidence deficit" and the uncertainty it spawns than Standard & Poors' recent downgrading of U.S. bonds (which actually rallied on the news of the downgrade). Sioux Falls city government also is suffering from a confidence deficit that threatens to negatively affect the local economy.

Thankfully, Sioux Falls is better governed than the nation, but residents whom I have spoken to note that their city government is far from perfect. So I decided to put the city government to a small test and am chagrined to report that it failed miserably. I chose the simplest issue that I could find - the lawn watering restrictions - on the presumption that if the government can't fix a minor problem undefended by any obvious entrenched interests, it won't be able to fix a major one defended by big bucks. (Like, say, construction delays on a $100 million plus events center.) The City Council not only did not resolve the minor issue that I raised, it did not even show that it understood it and instead made a series of ad hominem attacks!

What I pointed out to the council was that limiting lawn watering to every other day was not likely to conserve water, the ostensible goal of the restriction, because lawns can be watered without limit every other day, and nobody monitors nighttime watering. The local water authority admitted that there is no evidence that the restrictions, in place since 2008, have conserved any water. The effects of the restrictions are difficult to parse because it has been fairly rainy since then (so lawn watering has been less necessary) and water prices have increased a little (so people are conserving to save money). But absent any logical reason for the restriction to limit consumption, it is safe to say that, like low-flow toilets that simply induce more flushes, the city's restrictions might make some people feel good but have no real effect on water consumption.

Instead of removing the restriction as an unnecessary intrusion on residents' civil liberties, as I suggested, the council retorted with claims so outrageous that I will not repeat them here for fear of not being believed. I will note, however, that the council thinks the restrictions are a serious matter: one council member went so far as to relate how Harrisburg almost ran out of water "on a hot Sunday night a few years ago." Unfortunately, it never responded to my assertion that the best way to ration water is by price, not by making arbitrary decisions about what types of consumption are more important than others. I personally believe that homeowners should keep their lawns just green enough not to spontaneously combust but, unlike the city, I am unwilling to force my values onto others. Rationing by price allows people to decide whether they want to use more of their income for water use or whether they want to conserve, and if so how, be it by reducing lawn watering, closing the family pool or showering only once a week.

If the city ever shows that it can fix the many little annoyances such as the watering restriction, more residents might find a city-sponsored events center a project that they can support. In the meantime, however, many wonder why the city should take the lead on the project. If private investors cannot raise full money for the events center in a low-interest environment, can the project really be expected to turn an actual profit?

Moreover, even if Sioux Falls truly needs an events center, and even if the city government is the only entity that can create it, why should that particular need take priority over the city's many other needs? Many of its residents, for example, really need low interest mortgages so that they can find a buyer for their home, afford to buy a new one, avoid defaulting on an existing mortgage, or extricate themselves from lawsuits vigorously pursued by the same rapacious banks that received TARP money in 2008-09. Shouldn't such a need be fulfilled before the city launches into the entertainment business? I can't answer that because, again, unlike the city, I am unwilling to force my values onto others. But I suspect if a poll were to ask whether Sioux Falls residents would rather have a better-functioning housing market or an events center, housing would win, probably pretty handily.

Also, I recently received the following email regarding my book Fubarnomics:

Prof. Wright,

I have just completed reading ‘Fubarnomics’. Sir, a brilliant book, I laughed, I cried, I wet myself, I learned.

I learned and surmise, that our government and the governments of other nations will NOT try your ideas for a lasting change to ‘’’’’’economics’’’’’’.

As the individual is afraid of change, governments will only change if pushed to rebellion.

Per your suggestion, I want to read the book called ‘’ Nudge””.

Thank you for taking the time to write this book.

Whither now?

2011-08-05T20:39:00.000Z

I've been run ragged the last two days doing 4 interviews for local TV news reporters interested in where the economy will head next given the recent drop in the Dow, the debt/spending non-decision, etc. Of course I point them to my Wall Street Journal Guide ... but here I want to suggest something a little deeper. As I argued in my Mt. Vernon speech a few weeks ago, I think what Congress needs to do is to pass an array of taxes that automatically kick in should government revenues prove inadequate to cover current expenditures. That will prevent the need for the government to borrow substantially more (under normal circumstances) and direct attention to where it belongs, on the expenditure side of the government's income statement. Such a policy would not require the passage of a balanced budget amendment and would be more flexible than any balance budget requirement because it could be limited in various ways. Most importantly of all, it would follow Alexander Hamilton's dictum that whenever the government incurs an obligation (be it a bond, a contract, or an entitlement) it also creates the means for paying it. Only then will public credit be secure and not subject to the political brinkmanship witnessed during the recent crisis.

What should the proposed tax panoply look like? The easiest thing would be to pass a national sales tax, the rate of which would automatically increase to cover any projected budget deficits. Once its effectiveness is proven in the real world, such a tax could replace our current income tax system, which wastes billions of dollars each year on forms, receipt management, etc. Sales taxes are inherently regressive -- they fall more heavily on the poor -- but that disadvantage could be obviated by an income policy or by charging higher RATES on higher priced goods of the same weight and class. For example, a $1 12 oz. bottle of soda might be taxed at 15% but a $2 12 oz. bottle might be taxed at 30%. Similarly, a $10,000 sedan might be taxed at 10% but a $100,000 one at 50%. In other words, progressivity can be built into sales taxes too.

Identifying Asset Bubbles Before They Get Dangerously Big

2011-08-04T14:25:00.000Z

Several years ago, I considered trying to obtain funding for a project aimed at providing policymakers with tools to identify bubbles before they grow to dangerous proportions. For a variety of reasons I did not pursue the project but I have mentioned the basic ideas several times and they have taken on a cyber life of their own. I therefore post below my notions on the subject as I wrote them back in 2008-9.

Ex Ante Identification of Asset Bubbles

By Robert E. Wright, Nef Family Chair of Political Economy, Augustana College SD

Perhaps some readers will turn their attention to developing empirical tests that can reliably distinguish between bubbles and other phenomena that affect asset prices, of which there is now a shortage (LeRoy 2004).

Crises, major and minor, litter financial history. Most crises, including the most recent one, occurred when rapidly declining asset values caused the failure of highly leveraged investors, leading to credit constraints that negatively impacted the financial system and aggregate output (Kindleberger 2000). The frequency and severity of financial crises would be diminished if asset bubbles could be identified ex ante, to wit before they become large enough to pose a major threat to macroeconomic stability. U.S. policymakers admit that bubbles (“rational” or otherwise) are possible and potentially destabilizing but believe that they cannot be identified ex ante (Raines et al 2007). Even if they were detectable, the proper policy response would remain far from clear (Barlevy 2007). Academic economists debate whether bubbles can be identified econometrically even ex post (Gurkaynak 2008; Bhattacharya and Yu 2008)!

Contrary to O’Hara’s (2008) claim that no clear “operational way to establish empirically the existence of a bubble” exists, this paper hypothesizes that the likelihood of bubble formation in specific markets can be estimated ex ante and that regulators can implement inexpensive policies to minimize them. Building on Allen et al (1993), bubbles are more likely to form in markets for assets that:

a) can be shorted or otherwise arbitraged only at great expense (Abreu and Brunnermeier 2003; Brunnermeier 2007);

b) can be purchased with cheap borrowed money;

c) are subject to high agency costs, including poor corporate governance (Benmelech et al 2008);

d) have recently attracted numerous (Tirole 1982)[1] inexperienced participants (Porter and Smith 2003; Greenwood and Nagel 2008);

e) are subject to higher levels of risk-taking due to the moral hazard created by repeated recent bailouts (Hetzel 2009).

The paper will formalize the model then test it empirically using evidence from a wide range of markets spanning the globe and several centuries. Shorting costs will be proxied by a new index, borrowing costs with appropriate interest rates (using Homer and Sylla 2005 for historical markets) compared to the Taylor Rule (McKinnon 2008), corporate governance with an index such as Nicolo 2008, new market participants by market entry costs, and moral hazard by the number and nature of government bailouts in the period prior to bubble formation (Reinhart and Rogoff 2008a, b). Bubbles are assumed to have caused all financial crises without obvious non-bubble causes, such as military defeats (e.g. the sack of Washington, D.C. in August 1814, which triggered the suspension of payments in banks south and west of the Hudson river) and natural disasters (e.g. the Kanto earthquake of 1923, which caused a Japanese banking crisis).

An initial literature survey suggests that the model will receive ample empirical support. From alpacas to sugar beets to thoroughbred racehorses, agricultural markets are particularly prone to asset bubble formation because shorting is impossible (except in the limited sense of selling the asset) and investor entry barriers low (Saitone and Sexton 2007). As an example of agency costs, hedge funds and mutual funds knowingly invested in overvalued stocks in the late 1990s when investors compensated them to achieve short-term returns similar to other funds in the same class. When rewarded for longer term or above average returns, by contrast, funds invested much less in overvalued stocks (Dass et al 2008). Historically, many bubbles have involved real estate, which suffers from short sale constraints and entry barriers low enough that a significant number of traders may suffer from basic fallacies such as money illusion (Brunnermeier and Julliard 2008).

If bubbles can be identified ex ante, the appropriate regulators should monitor markets at high risk for bubble formation, ensure that participants are aware of that fact, and credibly warn them that government bailouts will not be available (Hetzel 2009) or that access to the safety net will be appropriately priced (Acharya and Richardson 2009). Government intervention in this manner is Pareto improving because short-circuiting the price-to-price feedback loop at the heart of most bubbles is inexpensive relative to blunter monetary policy options (e.g., increasing the Fed funds rate), limits the moral hazard and redistribution associated with bailouts (Wright 2009), and provides an information and analysis service that market participants are unable to provide or reliably obtain themselves. Agency ratings have again proven themselves impotent due to the conflict of interest at the heart of their current business model (namely, receiving the bulk of their revenue from issuers) and other problems (Partnoy 1999). Moreover, market participants apparently have difficulty incorporating highly relevant historical precedents into their market forecasting. For example, apparently no major investment bank executive knew that six earlier U.S. mortgage securitization schemes had failed due to incentive misalignments between originators and ultimate investors, a misalignment identically replicated in the 21^st century (Snowden 1995). Similarly, many home buyers apparently did not realize that the long-term upward trend in house prices did not mean that prices were monotonic. In fact, the trend has been repeatedly punctuated with reversals (White 2008).

Regulators could also reduce the likelihood of bubbles by encouraging the development of inexpensive shorting mechanisms, enacting policies to improve corporate governance and investment fund contracts, and to limit access to markets by inexperienced participants more efficiently than is currently done. (For example, accredited investor status might best be subject to examination as well as asset and income limitations.) The paper will not address any of these complex areas in detail but will offer them as potential policy options requiring additional research.

REFERENCES

Abreu, Dilip and Markus Brunnermeier. (2003) “Bubbles and Crashes.” Econometrica 71:173-204.

Acharya, Viral and Matthew Richardson, ed. (2009) Restoring Financial Stability: How to Repair a Failed System. Hoboken: Wiley.

Allen, Franklin, Stephen Morris, and Andrew Postlewaite. (1993) “Finite Bubbles with Short Sale Constraints and Asymmetric Information.” Journal of Economic Theory 61:206-29.

Barlevy, Gadi. (2007) “Economic Theory and Asset Bubbles.” Economic Perspectives: Federal Reserve Bank of Chicago 3Q:44-59.

Benmelech, Efraim, Eugene Kandel, and Pietro Veronesi. (2008) “Stock-Based Compensation and CEO (Dis)incentives.” NBER Working Paper 13732.

Bhattacharya, Utpal and Xiaoyun Yu. (2008) “The Causes and Consequences of Recent Financial Market Bubbles: An Introduction.” Review of Financial Studies 21:3-10.

Brunnermeier, Markus. (2007) “Bubbles.” In The New Palgrave Dictionary of Economics. New York: Oxford University Press.

Brunnermeier, Markus and Christian Julliard. (2008) “Money Illusion and Housing Frenzies.” Review of Financial Studies 21:135-180.

Dass, Nishant, Massimo Massa, and Rajdeep Patgiri (2008). “Mutual Funds and Bubbles: The Surprising Role of Contractual Incentives.” Review of Financial Studies 21:51-99.

Greenwood, Robin and Stefan Nagel (2008) “Inexperience Investors and Bubbles.” NBER Working Paper #14111.

Gurkaynak, Refet. (2008) “Econometric Tests of Asset Price Bubbles: Taking Stock.” Journal of Economic Surveys 22:166-86.

Hetzel, Robert. (2009) “Government Intervention in Financial Markets: Stabilizing or Destabilizing?” Federal Reserve Bank of Richmond. Working Paper.

Homer, Sidney and Richard Sylla. (2005) A History of Interest Rates. 4^th ed. Hoboken: Wiley.

Kindleberger, Charles. (2000) Manias, Panics, and Crashes: A History of Financial Crises. 4^th ed. Hoboken: Wiley.

LeRoy, Stephen. (2004) “Rational Exuberance.” Journal of Economic Literature 42:783-804.

McKinnon, Ronald. (2008) “Bagehot’s Lessons for the Fed.” Wall Street Journal 25 April.

Nicolo, Gianni, Luc Laeven, and Kenichi Ueda. (2008) “Corporate Governance Quality: Trends and Real Effects.” Journal of Financial Intermediation 17:198-228.

O’Hara, Maureen (2008) “Bubbles: Some Perspectives (and Loose Talk) from History.” Review of Financial Studies 21:11-17.

Partnoy, Frank. (1999) “The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating Agencies.” Washington University Law Quarterly 77:619-714.

Porter, David and Vernon Smith (2003) “Stock Market Bubbles in the Laboratory.” Journal of Behavioral Finance 4:7-20.

Raines, J. Patrick, J. Ashley McLeod, and Charles Leathers. (2007) “Theories of Stock Prices and the Greenspan-Bernanke Doctrine on Stock Market Bubbles.” Journal of Post Keynesian Economics 29:393-408.

Reinhart, Carmen and Kenneth Rogoff. (2008a) “Banking Crises: An Equal Opportunity Menace.” NBER Working Paper 14587.

Reinhart, Carmen and Kenneth Rogoff. (2008b) “This Time Is Different: A Panoramic View of Eight Centuries of Financial Crises.” Working Paper, April.

Saitone, Tina and Richard Sexton. “Alpaca Lies? Speculative Bubbles in Agriculture: Whey They Happen and How to Recognize Them.” Review of Agricultural Economics 29:286-305.

Shiller, Robert J. (2003) New Financial Order: Risk in the 21^st Century. Princeton: Princeton University Press.

Tirole, Jean. (1982) “On the Possibility of Speculation Under Rational Expectations.” Econometrica 50:1,163-81

White, Eugene. (2008) “The Great American Real Estate Bubble of the 1920s: Causes and Consequences.” Rutgers University Working Paper. October.

Wright, Robert E., ed. (2009) Bailouts: Public Money, Private Risk. New York: Columbia University Press.

[1] The number of investors need not be infinite, as some have argued, because that assumption is empirically fragile (Abel et al 1989). Rather, I’ll argue that the expected stream of new investors needs to grow fast enough to support expectations of rising prices. Bubbles burst when that condition is violated.

Why Deliberately Defaulting on the National Debt or Any Other Sums Owed Would be Unconstitutional

2011-07-25T19:08:00.000Z

This speech was professionally taped by 3 cameras and will appear on TV TBD. Enjoy!
Washington, Hamilton, and Jefferson – Funding a Nation

By Robert E. Wright, Nef Family Chair of Political Economy, Augustana College SD for George Washington’s Mount Vernon Estate, Museum, and Gardens, 22 July 2011

Thanks for inviting me back to Mount Vernon to discuss the history of the U.S. national debt. The debt, and its consorts the deficit and the debt ceiling, are again in the news, and in very palpable ways. The present situation is very difficult to understand in a deep way without the historical context that I have tried to provide in two of my recent books, One Nation Under Debt and Fubarnomics. I’ll summarize the gist of those books in this talk, reserving time at the end for your questions.

The second clause of Article I, Section 8 of the U.S. Constitution states that quote Congress shall have Power … To borrow Money on the credit of the United States unquote. Initially this meant that Congress passed a law every time that the Treasury had to borrow, typically to fund wars or territorial acquisitions. By World War I, Treasury borrowed so frequently that the traditional system was overwhelmed. The solution that evolved was to pass a law authorizing Treasury to borrow up to some limit, now commonly referred to as the debt ceiling. Contrary to the claims of some journalists and ideologues, most other non-authoritarian governments also enact debt ceilings as a check against usurpation of the budget by the executive or treasury. Unlike the United States, however, almost all other nations link their debt ceilings to their projected budget deficits or in other words to the amount that they know that they will have to borrow for government to operate smoothly. In America, by contrast, budgets and the debt ceiling are not closely coupled. Hitherto, Congress has increased the debt ceiling whenever necessary but sometimes it has hesitated before doing so, leading to partial government shutdowns as in 1995 or to extraordinary exertions on the part of Treasury to avoid default, as occurred several times during the administration of George W. … Bush that is, not Washington.

In May of this year, I argued in an op ed published on the History News Network that the debt ceiling is constitutional but that purposely defaulting on the national debt is not. In other words, the debt ceiling needs to be closely tied to projected budget deficits as it is in most other responsible nations in order to prevent it from becoming a tool that could cause irreparable damage to the nation’s finances and hence to the government’s ability to defend itself and American citizens from foes foreign and domestic. A default could send bond prices down which would increase the government’s debt service, the percent of the budget paid as interest to bondholders, potentially enough to force the government to print money to meet its obligations, a response that would lead to levels of inflation not seen in decades if not centuries. The depreciation of the dollar vis-à-vis other nations’ currencies that would occur as a consequence of such an inflation could lead to the replacement of the dollar as the world’s primary reserve currency. That would greatly complicate the nation’s ability to borrow abroad and raise the truly horrifying specter of the national government issuing debt denominated in a currency other than US dollars. A default or bout of inflation would also raise interest rates for businesses and consumers and thus slow or even stall an already anemic economic recovery.

In another, even graver scenario, a government default causes enough policy uncertainty to directly throttle an economy still gasping for breath following the 2008 crisis. With no way to finance a bailout or stimulus package, the government can only watch as the economy sinks into a debt deflation similar to that experienced in the Great Depression and Americans soon pine for the days when unemployment was only 10 percent.

These are not predictions per se mind you, just worst case scenarios highlighting the gravity of the situation we now face. Our salvation may be that matters are even worse in Europe and Japan, Canada is too small to provide the world’s currency, and that nobody really trusts China, Russia, or other so-called emerging economies.
Some other observers agree that a purposeful default would be unconstitutional and make good textual arguments to support their positions. Amendment 14, Section 4, clearly states that quote “the validity of the public debt of the United States, authorized by law … shall not be questioned” unquote. My argument, by contrast, relies on original intent. The Constitution as ratified did not explicitly rule out the possibility of a purposeful default but James Madison’s notes on the convention debates show that the delegates to the Philadelphia convention initially agreed that the Constitution should explicitly mandate that Congress quote shall discharge the debts & fulfil the engagements of the U. States unquote. (All quotations in this part of the talk, by the way, can be verified in Adrienne Koch’s 1966 edition of Madison’s notes, pages 511-12, 519, and 528-30.) Madison and Elbridge Gerry quote thought it essential that some explicit provision should be made on this subject, so that no pretext might remain for getting rid of the public engagements unquote. Delegate Pierce Butler later questioned that precise language quote lest it should compel payment as well to the Blood-suckers who had speculated on the distresses of others, as to those who had fought & bled for their country unquote. Two days later, George Mason raised the same objection, warning that quote the use of the term shall will beget speculations and increase the pestilent practice of stock-jobbing unquote. A debate on the specifics of debt repayment ensued until Edmund Randolph suggested language that did not commit Congress to a specific debt repayment policy. Randolph’s wording passed ten states to one and ended up as the first clause of Article 6, which states quote All Debts contracted and Engagements entered into, before the Adoption of this Constitution, shall be as valid against the United States under this Constitution, as under the Confederation unquote.
In other words, the Constitution did not explicitly state that Congress shall pay the debts the nation incurred after ratification only because the delegates were divided over the so-called issue of discrimination, or the question of who the government should pay, original or current bondholders. The original bondholders were largely farmers and soldiers while the current ones were generally perceived to be wealthy, urban speculators, a group despised even more than lawyers were, believe it or not, though there was some overlap between the two groups. The Constitutional Convention was of course called in large part to give the national government the means to repay its debts. The will to do so was taken for granted. The Framers believed, as Gouverneur Morris put it, that quote the New Government would be bound of course unquote to pay the national debt. Of course! And I should point out that the Founders made no distinction between bondholders and other types of creditors. For the government to pay Peter but not Paul would not establish public credit but only enrage Paul and make people wonder why Peter should be so favored.

After Ratification, purposefully defaulting on the debts owed to all domestic creditors was mentioned by a few radicals but never seriously considered and almost everyone believed that foreign creditors had to be repaid in all events. The Founders understood that defaulting on sums owed to foreigners would make it difficult to borrow abroad in the future and also would strengthen foreign incentives to invade the fledgling republic. The best way to avoid invasion is to owe large sums to foreigners but to pay the interest on the debt punctually, a point that is often lost in the handwringing over the trillion-ish dollars the federal government owes to a still communist China.

In sum, the early debates over the U.S. national debt were not about whether to pay, but rather who to pay, when to pay them, how much to pay them, and how the government should raise the necessary sums. As we will see, sharp differences existed on those latter questions, with Washington and Hamilton on one side and Jefferson and Madison on the other, but not over whether the government should honor its debts or not.

The questions of who, when, how much, and how to pay were crucially important ones because by the end of the Revolutionary War the national and state governments were such fiscal wrecks that they actually impeded economic development in the 1780s. Only after passage of the Constitution and implementation of Hamilton’s reforms in the 1790s did real, which is to say inflation-adjusted, per capita incomes grow consistently at modern rates and only then did the American economy show signs of development or modernization. Before the Constitutional Convention, the financial system consisted of just three small banks, a handful of securities brokers, and a coterie of suboptimal individual insurance underwriters. By the end of 1795, 21 commercial banks, a massive central bank, 4 insurance corporations, and scores of brokers and even two stock exchanges were in operation.

Aided by the rapidly developing financial system, entrepreneurs teemed in both the cities and the growing agricultural hinterland and some engaged in increasingly large-scale enterprises. Very few for-profit business corporations formed in the colonial period because of British policies. After the war, a few such corporations formed but in the 1790s the formation of joint-stock corporations accelerated ten-fold, launching the rise of what has been described as a corporation nation. By the Civil War over 22,000 business corporations had been chartered by special legislation and thousands of others by general acts of incorporation, far more than any other country on earth. Today, it is difficult to imagine what a developed economy would look like without the widespread use of the corporate form or some other mechanism for providing investors with perpetual succession and limited liability.

To fully understand Hamilton’s accomplishment, we must first understand the precise nature of the very serious difficulties that the young republic faced. The rebel governments, by which I mean the Continental Congress and the new state governments, successfully funded the opening years of the Revolution by issuing bills of credit, badly printed pieces of paper that circulated as cash similar to those used to fund the many wars of the colonial period. At first, the bills stimulated an economy that had become severely under-monetized after the French and Indian War due to the effective enforcement of British trade laws and severe restrictions on the issuance of bills of credit placed on colonial governments by London bureaucrats. The absolute dearth of monetary instruments caused by those policies greatly impeded colonial economic activity and were, scholars are increasingly beginning to recognize, lingering sores that set off the Stamp Act controversy and that soured Anglo-American relations throughout the Imperial Crisis that led to the Declaration of Independence, which in the section delineating the quote History of repeated Injuries and Usurpations unquote blamed the British quote FOR cutting off our Trade with all Parts of the World unquote and for refusing to pass laws, including bills of credit emissions, quote the most wholesome and necessary for the public Good unquote.

In an economy short of cash, the new money issued by the rebel governments at first lowered interest rates and facilitated the extension of credit, thus stimulating economic activity above and beyond the stimulus provided by mobilization for war. As the Revolution dragged on, however, the rebel governments had to issue more bills of credit than Americans believed they would be able to redeem at face value via specie redemption or taxation after the war, a valid perception exacerbated by a large influx of British-made counterfeits said to be distinguishable from the original only by virtue of their being of superior physical quality. Because there were eventually more bills of credit in circulation than were needed at the prevailing price level, bills of credit began to depreciate, by which I mean that they lost purchasing power vis-à-vis other goods, including gold, silver, land, food, and sundry services. As the War wore on, the depreciation became more serious until by early 1781 both state bills of credit and the Continentals issued by the national government were almost valueless.

Long before then, the rebel governments incurred other sorts of debts as well. They managed to sell some bonds and lottery tickets early in the conflict but by the late 1770s anemic tax receipts forced them to take the provisions they needed directly from American farmers, iron makers, and so forth. Many soldiers continued fighting in exchange for IOUs promising future payment but they had to be fed, clothed, housed, and armed if they were to remain effective in the field. Rebel governments could not very well seize private property and retain the affections of the citizenry so they gave handwritten promissory notes or IOUs for goods taken from Patriots. Outright confiscation was also resorted to, but the rebels tried to seize the estates only of known Loyalists. Though seemingly simple, direct requisitioning was inefficient because farmers could not always supply enough of everything that was needed to support the military units active in their regions and remain viable. If the army took a farmer’s last mare and the area’s last stallion, for example, no spring foals would be born to replenish his stable.

The Yorktown operation in fall 1781 and the war’s final years were partially financed with the aid of the private fortunes of the new Superintendent of Finance, Robert Morris, and subscribers to the new Bank of North America, a quasi-central bank that issued notes and deposits convertible into gold and silver. Most market participants believed the bank money to be more reliable than discredited government bills of credit so the bank helped to increase the supply of money, which after the collapse of bills of credit had shrunk to the point of being too thin to support normal economy activity. The new bank also made loans to the government and to businesses large and small. When peace finally came, however, the national and state governments remained in rough shape financially because the economy in most places remained extremely soft due to the disruption of prewar trading patterns, the wartime destruction of human and physical capital, and tremendous uncertainty about the future of the fragile new confederation.

The biggest challenge facing the new national and state governments was how to begin repaying their wartime debts. Some governments aroused the ire of bondholders by refusing to increase taxes and defaulting on their obligations. Other states, most notoriously Massachusetts, sparked rebellions by increasing taxes too high, too quickly. Both tactics played into the hands of nationalists, men like Madison and Hamilton who wanted to create a more powerful central government capable of repaying the nation’s war debts and thus of better protecting Americans from foreign invasion and domestic unrest. Such men, self-styled small “f” federalists, succeeded in establishing such a government when the Constitution was ratified in 1788. Many tricky details, however, remained to be worked out before public credit, wrecked by the depreciation of bills of credit and the inability of most governments to pay interest on their wartime IOUs, was finally and firmly re-established.

It is of course widely known that Hamilton, America’s first Treasury Secretary and the trusted confidante of Washington, who wisely supported first the military career and then the public policies of the brash young West Indian bastard, played the most important role in the reformation of the government’s fiscal situation and the economy’s remarkable growth in the first half of the 1790s. Many of the details, however, remain misunderstood or completely unknown. First and foremost, Hamilton helped the nation to build an effective tax regime, based largely on an efficient tariff collection system engineered by Hamilton himself, that lasted until the Civil War. Land sales, bank dividends, and excise taxes added to government revenues to some extent but the mainstay of the system, especially in peacetime, were taxes on imports. Contrary to myth, Hamilton did not advocate protective tariffs designed to aid American manufacturing interests but instead created a nuanced system of revenue tariffs designed to maximize the national government’s net income. Hamilton understood that high tariffs would hurt tax receipts by encouraging smuggling and corruption. He also understood that what people considered a high tariff depended on the nature of the good being imported so he charged higher rates on luxury and status goods and allowed many non-native raw materials to enter the country free of charge.

I should point out here that the excise on whiskey that led to the infamous Whiskey Rebellion was merely a tax designed to offset the tariff on foreign rum. Rather than protect domestic whiskey producers with that tariff, Hamilton wanted them to compete on a level playing field. One day, I hope, NYU’s Richard Sylla will finally publish his book explicating, among other topics, the details of Hamilton’s ingenious tariff system. Tariff is a dirty word today, at least among most economists, but it was certainly the most efficient means of taxation available in the eighteenth and first half of the nineteenth centuries in a world still dominated by mercantilist policies. Hamilton’s views on tariffs have been misunderstood because his Report on Manufactures has been misconstrued as a series of policy proposals rather than as a primer on the microeconomics of the effects of different types of government policies, including tariffs and export bounties, on market prices and quantities.
In any event, Hamilton used tariff revenues to pay the debts incurred by the national government during and after the Revolution and also to assume, or take over and fund, the debts incurred by the several states. He did so by reducing the face values of the scores of IOUs issued by the national and state governments during the war – a potpourri of instruments with different maturities and interest rates with names like indents, Hillegas notes, and Long Bobs – to their approximate value in gold and silver at their issuance. He then accepted them as payment for three new types of bonds called Threes, Sixes, and Deferreds. Threes were redeemable at the pleasure of the government and paid 3/4ths of one percent interest at the end of each fiscal quarter: March, June, September, and December – or 3 percent annually. Sixes paid 1.5 percent interest quarterly, or six percent annually, and contained an annuity feature that gave the government the option to repay part of the principal each year much like an amortized mortgage today. Deferreds paid no interest but turned into Sixes at the end of 1800. By issuing Deferreds and Threes in addition to Sixes, Hamilton reduced the government’s total debt interest charge from 6 to around 4 percent, quite a feat for a nation essentially bankrupt just a few years before.
To ensure that the government would not default on its new bonds if revenues proved temporarily insufficient, Hamilton also established a central bank, the Bank of the United States, partially owned by the government but essentially owned and operated by private stockholders. Run by the nation’s most experienced banker, Philadelphian Thomas Willing, the Bank of the United States held most of the government’s deposits, paid interest on the government’s bonds when they fell due, transferred government funds from city to city as necessary, acted as a lender of last resort during financial panics, and, most importantly of all, lent money to Treasury when the government’s revenues temporarily fell short of expenditures.

Finally, Hamilton also established the U.S. Mint and, in the most important part of the legislation, defined the U.S. dollar in terms of gold and silver, thus anchoring the new currency’s real value over the long term. The definition wedded the nation to a bimetallic standard and thereby ensured that the early U.S. government could not deliberately inflate away its debts.

Jefferson, Madison, and others disliked many of Hamilton’s policies and therefore split from Washington and his large “F” Federalist followers to form the Democratic-Republican party. Scholars sympathetic to that latter party often cast Hamilton’s policies in a negative, Jeffersonian-like light but most of their criticisms are unfounded. For starters, Hamilton did not want the national debt to be large as his detractors claimed. He clearly stated that the national debt would be a national blessing only IF IT WAS NOT EXCESSIVE. His claim that public debts were public benefits, he clearly explained, was quote liable to dangerous abuse unquote and should not invite what he termed “prodigality.” He believed it a quote fundamental maxim [that] the creation of debt should always be accompanied with the means of extinguishment unquote. He argued that such a maxim, one now unfortunately forgotten in the debt ceiling debate, would render public credit, and I quote, “immortal.”
Hamilton has been criticized for not specifying when a large national debt became excessive but he did in fact offer several criteria. A debt was too large, he explained, if the government could not honor its debts and pay the principal or interest when promised. As mentioned previously, Hamilton wrote when the government did not have the power to create money out of thin air. Today he would say that a debt is too big if the government cannot honor its contracts without causing inflation, which is known in the biz as a “soft default” because bondholders and other creditors receive less in real money, in purchasing power in other words, than they were promised or expected. Today, many observers fear that a serious bout of inflation is inevitable and the only question remaining is when it will rear its ugly, economy-damaging head. Federal Reserve chairman Ben Bernanke’s recent comments about further stimulating the economy should it continue to show weakness were comforting in the short term but further fueled fears that a big inflation will occur in the next few years.

Hamilton also considered too big a debt that led to a political impasse and deliberate default. Sound familiar? He also argued that a debt is too big if it raises interest rates so high that investment in government bonds crowds out investment in wealth-producing business ventures like farms, factories, and foreign trade. By that criteria, our national debt also currently teeters on the brink of being excessive.

Finally, Hamilton considered excessive a national debt that necessitates a high level of taxation. Like Adam Smith before him and David Ricardo after him, Hamilton understood that taxes are necessary evils best minimized. Today, higher tax revenues are fiscally necessary – the only question is upon whom they should fall, a very tricky issue politically but also economically due to the complex nature of tax incidence or discerning who actually pays taxes of different types.

The most quizzical thing about debates over taxation today, IMHO, is that politicians dicker over questions like the effect of higher tax rates on government revenues. The silly thing about such dickering is that nobody can know what receipts will be – the U.S. economy is too large, complex, and variable to predict with precision. What politicians ought to do is decide how much they need to spend and then create taxes that automatically adjust until the needed amount is in the Treasury. That would obviate the need for significant additional borrowing and move the tax debate to where it belongs – what should the government do and what shouldn’t it do? Hamilton never created such a system because it would have been technologically impossible to do so in an era of quill pens and paper ledgers. That excuse, however, is no longer valid. Hamilton, by the way, was no advocate of big government. What he and Washington envisioned was a government larger than that desired by Jefferson but one far, far smaller than what we have today.
Hamilton fought for the assumption of state debts by the national government for four practical reasons: first, the Constitution stripped the states of the best tax then available to them, the tariff, so it was only right that the national government should reduce their fiscal burdens; second, having just three types of bonds meant that the markets for each would be liquid, fancy finance talk for efficient and convenient, rendering the bonds more attractive for investors and hence less expensive to the government; third, due to economies of scale the federal government was able to collect tariffs and make payments on the debt more cheaply than numerous small state governments could; fourth, the debt helped to cement the union together.

Hamilton was right on all four points, especially the fourth one. As I show in One Nation Under Debt, government bonds were widely held not only in the North but also here in the Old Dominion – including in the portfolios of large planters -- and in Charleston, South Carolina. Most of the state governments also owned substantial amounts of federal government bonds. I do not think it a coincidence that the Nullification and Secession crises occurred at times and places when the federal government owed nothing to state governments or to prominent citizens. The detailed data supporting those claims, by the way, are available free of charge on EH.NET.
Hamilton opposed discrimination, the Jeffersonian idea of compensating the original holders, the soldiers and farmers who took government IOUs in lieu of cash during the war, for practical reasons as well: first, it would have been extremely difficult to ascertain who the original holders were, where they currently resided, when they sold their IOUs, and how much they received in exchange; second, while agreeing that most of the original holders who sold their bonds did so for pennies on the dollar, Hamilton found no evidence that the original holders received anything less than the going market rate when they sold, the dark years following Yorktown when repayment was a distant prospect and interest rates were in double and triple digits. As Hamilton and other opponents of discrimination argued, the speculators who bought up government IOUs helped public credit because the only way that they could profit would be by supporting the reforms necessary to fix the government’s financial situation. From that perspective, speculators were just as patriotic as the original holders and perhaps more optimistic about the young republic’s eventual success. As I mentioned previously, it was the supporters of discrimination at the Philadelphia convention who unwittingly blocked language that would have prevented use of the national debt as a political football today.
The Jeffersonian claim that Hamilton sought to make the national debt perpetual was also seriously mistaken. By making Threes, Sixes, and Deferreds repayable at the government’s pleasure rather than on specific dates, Hamilton ensured that the government could not experience a debt crisis brought on by the maturation of bonds at an unpropitious moment. Hamilton wanted to see the national debt shrink in real terms, and in per capita and percent of GDP terms it did decline during the 1790s, from about $20 to $15 dollars per person and from about 30 to 15 percent of GDP. That progress was not enough for the Jeffersonians, however, who wanted the debt paid down quickly in nominal terms as well. As Hamilton noted, however, increasing taxes enough to generate the revenues necessary to pay the debt off quickly and completely would cause the economy to stall and perhaps foment rebellions even more serious than Whiskey and Fries’s. Growing out of the debt was the most prudent path and hopefully will be the one the U.S. follows in the immediate future. Only the Jeffersonians and their political heirs, the Jacksonians, paid off the national debt completely. From then until recently, the government has simply maintained balanced budgets in peacetime and allowed the burden of the debt to shrink as the population and economy grew. That tactic will work again and minimize the economic pain incurred as a result of the sundry economic and policy disasters of the first decade of the 21st century.

But inducing politicians to run balanced budgets has become difficult of late and was never easy. As Jefferson astutely noted, elected officials have little incentive to tax and spend, especially in a country filled with people who believe that that government which governs best governs least, at least when it comes to issues that don’t personally concern them. Rather, politicians have incentives to borrow and spend, which allows them to offer constituents vote-garnering services now and to put the taxes off until later. Only when voters are astute enough to understand British economist David Ricardo’s point that borrowing today is simply higher taxes tomorrow can they hope to hold politicians in check. The most comforting thing about the current debt ceiling impasse is that it shows that the American people are again awakening to the dangers inherent in an excessive level of government debt. It is a shame, however, that they were not alert enough before 2004 to thwart the ominous trend in government deficits that some observers then warned about.

At this point, you may wonder what budget reforms I would advocate. As I argued in my 2010 book Fubarnomics, I think that Social Security, healthcare, education, and construction are ripe for radical change. To that list I will add the military. The key is to make each of those areas more efficient without breaking promises or increasing taxes more than absolutely necessary.

The government wastes billions of dollars each year by paying construction and military contractors too much. The problems here are rooted in the nature of contracts and markets. Governments should hire the best bidders, not the lowest ones. That would require carefully tracking contractor performance over time, information that would also help private parties to make better decisions and greatly improve the efficiency of the construction industry, the productivity of which has been stagnant for half a century now. The government should also encourage more entry into markets where it is tempted to resort to no-bid contracts, as in military procurement. Even if we significantly scale back the military, the Pentagon will still have many billions of dollars at its disposal each year, ensuring vigorous market competition if only the government would allow it to take place. Inefficient defense contractors, even large ones, should be allowed to fail as newer, better ones will surely emerge soon after.

The same goes for transportation contractors. Funding transportation improvements with a tax on gasoline is a flawed approach because it gives the government a vested interest in gas guzzlers and because gas mileage and wear and tear on road surfaces are not strongly related. If the government cannot make the necessary reforms, it should lease the interstate highway system to the best bidders and essentially re-privatize the nation’s roads and passenger railways. Think of it as reverse eminent domain – if the government does not put an asset to best use, the courts should allow private parties to make a fair offer for it.

Social Security has been a tough nut to crack, just as FDR predicted. What needs to be made clear is that the system is not based on actuarial data and its payroll tax is regressive so Social Security is patently unfair to some groups, especially minority males. The payroll tax should be abolished and payments slowly phased out as annuity recipients pass away. Everyone over age 45 – I’m 42 by the way – should receive the benefits they have been promised out of general tax revenues and everyone 45 or younger should be told to start purchasing private security products unless they want to work until they perish, an option that is increasingly possible in our service-oriented economy. The financial system should also be reformed to ensure the continued development of disability and life insurance, annuities, mutual funds, and other forms of private security. Products with so-called nudges designed to counteract known, common human foibles built into them should be encouraged. The only reasons we adopted Social Security were the economic trauma caused by the Great Depression and the regulatory repression that ensued. Had the Depression not occurred, and it was by no means inevitable, one of the great albatross’s currently astride the economy’s neck would never have landed.

And neither would the elephant-sized albatross called Medicare. Prior to the Depression, health insurance was evolving toward personal prepaid doctor and hospital systems that incentivized doctors and other healthcare professionals to heal patients rather than to merely treat them. The Depression and some ill-conceived tax policies changed that, laying the seeds of the problems, like large numbers of uninsured individuals, that led to passage of controversial healthcare legislation last year. By repealing that legislation and allowing new types of health insurance policies to emerge, ones that better align the incentives of doctors and their patients, trillions of dollars can be saved in the coming decades.

By reforming higher education, hundreds of billions more can be saved. The current system favors specialized research, leaving many undergraduates ill prepared for the work force or citizenship and many thousands of dollars in debt. A much better system would subsidize students rather than schools, inducing the latter to focus more attention on teaching undergraduates and less on publishing hack scholarship in obscure journals. If coupled with a GI Bill-like service obligation – which could include service in Homeland Security, FEMA, schools, hospitals, parks, and so forth in addition to traditional military service – the subsidy could be rendered budget neutral while simultaneously building the character and maturity of our young adults, thus rendering them better students and better citizens.

In sum, America still has plenty of what some call “dry powder” in its arsenal. Instead of raising taxes or slashing expenditures, policymakers and entrepreneurs need to think about how to make the government and the economy more efficient. We can’t ever have our cake and eat it too, but we can bake a larger or a better tasting cake in less time and for less money than we currently do. That is something that Washington, Hamilton, and Jefferson would all agree upon.

Thanks for your time and attention and I will now entertain your questions.

Debt Ceiling Dilemma

2011-07-19T21:23:00.000Z

Peter Klein of the Independent Institute says that he is "a bit surprised no one has brought up William English’s 1996 AER paper, “Understanding the Costs of Sovereign Default: American State Debts in the 1840′s,” which provides very interesting evidence on US state defaults." My response is that I'm VERY SURPRISED no one has bothered to look at the data freely available on EH.NET (gathered by myself, Dick Sylla, and Jack Wilson) that shows that the prices of Pennsylvania bonds (and other defaulting state bonds too) plummeted from the low 90s (par = 100) to the low 70s in just 6 weeks in early 1841. That was an era, btw, when banks did not have to mark to market and when state bonds were not an important part of the portfolios of most financial institutions. In other words, Klein is right that the default of state governments in the 1840s was not catastrophic but it was pretty bad and any significant drop in Treasury bond prices today would be much more severe.

Keep Your Student Loan Debts Under Control -- Know How: A Guest Post by Stewart Smith

2011-07-15T18:56:00.001Z

Below is my first guest post. Written by Stewart Smith, the post is designed to help students to better understand and cope with their debt problems, an already large and growing problem. Readers of Fubarnomics (and Higher Education and the Common Weal in the India market) will understand why the topic appealed to me.

Keep Your Student Loan Debts under Control -- Know How

A study conducted by the National Center for Education recently stated that the student debts for the graduating class of 2011 are going to exceed the debts of the previous graduating classes. Statistics indicate students will be leaving college with at least $23,000 of debts. It will be an 8% increase from the last year record and a whopping 47% increase from the record over a decade ago. Graduates burdened with large student loan debts usually end up living with their parents longer and get married at a much later age. Why the rising costs? Some say it's the economic meltdown and post recession hangover, while others believe the cost of higher education is increasing because more people are keen to attend college and university now and there is a cutthroat competition for admission and scholarships. With no debt settlement around to help you out, student loan debts can put your finances in jeopardy in the long run. Read on to know how to deal with student loan debts and ensure a financially secure future ahead.

* Make sure you apply for federal student loans to pay tuition fees rather than seeking private loans with high interest. Federal loans have relatively lower interest rates than private ones and their repayment plans can save you big bucks, because you do not accrue interest while you are in school. Most private loan lenders have hidden rules that cause you to pay more fees in the long run if you don't read the fine print carefully.

*Attempt to understand the amount and type of student debt that you owe clearly. Determine exactly how much you have to repay on each loan and how much you will have to pay altogether each month. To gain a deeper comprehension of your financial obligations, visit http://www.projectonstudentdebt.org.

*Once you know the amount and type of debt you owe, request the lenders to prolong your repayment duration, if possible. This will enable you to make smaller payments right after school when you are hunting for jobs or as a fresher making less money. It's true that extended payment plans will cause more interest to accrue in the long run but the interest will be tax-deductible within certain limits.

*You can opt for an income-based repayment plan as well. Under this payment plan your monthly payment amount is limited to a specific percentage (depending on the lender) of your discretionary income each month. This certainly helps you to keep current on your payments more easily.

*During a period of unemployment if you are simply unable to make payments, request a forbearance or deferral on your loans. This will temporarily suspend your payments and give you enough time to discuss the repayment procedure with the lenders.

Last but not the least, check your budget, embrace frugal living, curtail entertainment cost, take a part time job and make sure you do not end up incurring a six-figure amount of student loan debts. If you have to spend three to four years focusing on reducing your balance, there will be a delay in achieving your primary goals of life like marriage or buying a home.

Mismanagement of the Buffalo Marriott Niagara on Millersport Highway

2011-07-06T20:33:00.000Z

The general manager of the Buffalo Marriott (the one on Millersport Highway near SUNY Buffalo's Amherst campus) needs to go to hotel school or something because he is running a wreck.

Here are the facts:

1) His front desk staff quoted my family and I $140 (per room, per night) but charged us $180 without verifying the charge. Worse, they did this on a LATE NIGHT check-in. I did not discover the over-bill until it was too late. I cannot prove that the hotel regularly takes advantage of weary travelers but it certainly did in this case.
2) The manager's staff did not advise us that the hotel was doing construction on our floor or that the hot tub was out of order. They also promised to send around a luggage cart but never did, forcing me to walk through the construction zone to retrieve it myself.
3) Two huge spiders and webs awaited us at the exit door upon our departure at 11 am the next morning. I have spent maybe 1,000 nights in hotels during my lifetime and do not recall seeing any spiders, even in cheap-o hunting lodges much less ones charging almost 2 bills a night in backwater Buffalo!
4) The room appearance and smell, TV, bathroom etc. were no better than $100/night hotels and my room was considerably noisier than most, perhaps due to the undisclosed construction activity.
5) When I called the GM to advise him of the dreadful experience we had, he:
a) got back to me some 24 hours later without researching my complaints;
b) acted very defensively and twisted everything I said;
c) refused to offer ANY compensation for our troubles.

Facts 1-3 could have been a string of bad luck, as the GM weakly claimed, but there is no excuse for 5 and I suspect 1-3 would not have occurred under better management. 4 is simply the state of the hotel and should be sufficient to prevent any but the most desperate souls from staying at the Buffalo Marriott Niagara on Millersport Highway in Amherst, NY (near SUNY Buffalo), even if management improves.

And one last thing: the website describes the hotel as "minutes away" from Niagara Falls but that is disingenuous as it suggests that most people would measure the time in minutes (say, 5 or 10) instead of fractions of an hour (half to three quarters depending on traffic unless you want to risk a speeding ticket on Grand Island).

Self-Regulation of Hedge Funds

2011-07-05T20:51:00.001Z

Hedge Fund Group is paying me a small stipend to blog about its Certified Hedge Fund Professional (CHP) designation. That's great because probably I would have done it for free! Here's why:

1) I believe that Americans have come to rely far too much on the government to solve (or more usually attempt to look like solving) problems that it is not designed to address, much less fix. Seriously, how can 100 Senators and a couple of hundred Reps, the vast majority of whom know little to nothing about finance, let alone an ever-changing beast as complex as the hedge fund industry, create effective regulatory legislation? The odds of success are vanishingly small.

2) The U.S. financial industry has a long history of successful self-regulation. I'm not kidding! The NYSE is probably the most famous of the many SROs (self-regulating organizations) that, though not without occasional lapses, have prevented the sort of investor expropriation that has short-circuited the development of numerous economies in Latin America, Africa, Central Asia, etc. Professional designations such as CPA, CFP, CFA, and so forth are part of the SRO apparatus because of the knowledge and technical expertise that holders must demonstrate, usually on rigorous blindly scored examinations, before becoming certified. During the healthcare/insurance debate of 2009-10, many Americans were outraged at the suggestion that government bureaucrats might replace the American Medical Association (AMA), the medical community's major SRO. They should also bristle at any attempt to weaken financial SROs and in fact should encourage pro-SRO legislation.

3) The CHP appears to be a worthy attempt to help hedge fund managers to self-regulate. Started in 2007 in Boston by experienced risk management expert Richard Wilson, HFG now has over 20,000 members because its CHP caters specifically to hedge fund professionals. To meet the needs of those professionals, HFG is growing quickly and also expanding its training programs and videos and will probably continue doing so in the future as its forebears in banking, insurance, and personal investing did. There is a demand for good people in every industry and HFG is doing a great job increasing the supply, both by increasing the knowledge of people in the industry and by allowing those with its designation to signal their knowledge more effectively to hedge fund managers.

4) Getting CHP designation empowers job applicants to land the positions they want, helps hedge funds to hire the best and the brightest, and, I believe, promotes financial sector stability. Many hedge fund strategies entail taking large amounts of risk. Although much of that risk is so-called "tail risk" (i.e., highly unlikely to occur), individual hedge funds and even entire hedge fund sectors could fail, roiling financial markets (e.g., your 401K). Government cannot really stop people from taking risks (look at the miserable job it has done eliminating pot, crack, murder, rape, and risky banks) but the hedge fund industry itself can minimize the risks and collateral damage by ensuring that the people working in the industry are as intelligent and well-trained as possible. One great signal of those attributes, and perhaps the best currently available, is CHP designation. So if you are in the hedge fund biz, know someone who is, or just want to help keep government waste in check, read this FAQ.

Bad Financial Advice

2011-06-27T13:33:00.000Z

AccountingDegree.Com recently posted "10 Financial Gurus Who've Given Terrible Advice," a short piece that nails almost all the biggies for providing the masses with advice ranging from silly (buy a commode instead of a toilet) to expensive (buy stocks! in 2001, 2007-8, etc.). Simon Constable (my co-author on The WSJ Guide to the 50 Economic Indicators That Really Matter, out since May and doing pretty darn well) and myself are not mentioned, perhaps because our book is too new but, more fundamentally, because we offer a different type of product. Instead of pretending we are gurus with special information or knowledge that we deign to share with the average American, we take the role of teachers, carefully explaining how investors can learn about the economy for themselves. Ultimately, our advice is not that investors should follow blindly the advice of purported gurus but rather that they look at and understand for themselves the cues that the economy constantly spews out. The book tries to demystify the economy in general and investing in particular, thus inoculating investors against the sometimes dumb advice of Donald Trump, Bernie Madoff, Jim Kramer, and so forth.

Obama History?

2011-06-27T13:15:00.000Z

The Misery Index (MI), inflation plus unemployment, suggests that the Republican candidate, whoever he or she will be, should defeat Barack Obama in next year’s election.

Politics and the economy became so thoroughly intertwined after World War II that changes in one realm began to help predict changes in the other. Most famously, changes in MI have predicted most presidential elections since Harry Truman’s victory in 1948. When MI increases during his first term, the incumbent usually loses his bid for a second term (George H. W. Bush; Jimmy Carter) unless he is a bona fide hero (Dwight Eisenhower, the architect of the defeat of Nazi Germany; George W. Bush after 9/11 but before Iraq and Afghanistan were clearly quagmires). When MI declines, the incumbent wins re-election (Richard Nixon; Ronald Reagan; Bill Clinton), unless he was essentially appointed instead of elected. (The MI fell 3.7 points under Gerald Ford, who lost to Jimmy Carter anyway.)

Since Obama became president, official MI has increased about 50 percent, from just under 8 to over 12 because inflation increased while unemployment peaked and remained stubbornly high. Some suspect that MI has risen even faster than that because government statistics may underestimate unemployment and inflation the higher those crucial macroeconomic variables become.

Fifty important economic indicators, the subject of my new book with Wall Street Journal reporter Simon Constable, suggest that the economy will remain weak and unemployment high into the foreseeable future. Inflationary pressures are also likely to increase due to the massive monetary stimulus implemented by the Federal Reserve, which moved overnight interbank lending rates to almost zero and completed two rounds of quantitative easing (money creation). The Fed could fight inflation by increasing interest rates but in the process probably would injure employment and growth. In short, it appears highly unlikely that MI will decrease below 8 before the election next fall and it may even rise further before then.

If that prognostication proves correct and postwar election patterns hold, Obama’s main hope for re-election will be to posture himself as a war hero, the mastermind of a successful counterattack against Islamic extremists. That might be a tough sell, however, for a Nobel Peace Prize recipient.

The Fatal Flaw in Citizens United v. Federal Election Commission; a Federal Council of Revision

2011-05-13T21:14:00.000Z

While working on my next book, Corporation Nation: The Rise and Demise of the American Economic Juggernaut (publisher still TBD), it occurred to me that the Founders would NOT have included business corporations (or other types of corporations for that matter) in the first amendment protection of speech because the concept of ultra vires was then so ingrained in corporate law. Ultra vires held that corporations could only engage in actions that they were explicitly chartered to conduct, strictly construed. Any other action was considered a fraud upon stockholders because it was an unauthorized use of their money, even if the action was approved by duly elected directors. Ergo, the originalist argument used by SCOTUS is flawed as the founding generation could not have had in mind a corporation that could *lawfully* use its resources to influence politics. As I have pointed out in a previous post, the founders were also very concerned about corporate influence on the political process in less direct ways, e.g. lobbying and coercing votes (in an age of open voting).

We really need to think about reforming how our Constitution is interpreted. As I have recently argued in this op ed, I think that it would be unconstitutional for the federal government to purposely default on the national debt. Apparently, however, it will have to actually default before the theory could be tested! Maybe what we need is something like the Council of Revision that was in place under New York's first constitution, a body of learned jurists who must pass on the constitutionality of bills before they become law and also empowered to treat serious constitutional issues BEFORE they inflict financial losses on taxpayers.

My Latest Doings

2011-05-09T15:49:00.001Z

Been very busy of late promoting my new book, with the Wall Street Journal's Simon Constable, on 50 "musty" economic indicators. The book briefly hit number 94 on Amazon's overall list and #1 on the economics, personal finance, and investments lists before slacking off somewhat.

Among other activities, I've done several radio interviews, most with Simon but one solo that you can listen to here.

I also penned (well, keyboarded) an op-ed that the major newspapers were too cowardly to run, "Original Intent and the Debt Ceiling," that argues that it is unconstitutional for the U.S. government to deliberately default on the national debt. Of course I sent it out the same week as the orgy over the OBL story took place so it may simply have been too wonky for the times. Maybe I should have gone "smexier" and called the piece "Why Killing OBL Isn't Going to Save Us." But I'm kind of old school and believe that if a person or organization isn't smart enough to see the crucial importance of a topic without putting makeup on it, I can safely "forget" them all.

Finally, I have posted a paper on the history of bank governance on the Social Science Research Network. It's free.

Organizational Incompetency and a New Bigness Dilemma

2011-04-23T15:31:00.000Z

Is it possible for a large number of highly intelligent, highly competent people to act together in a highly INCOMPETENT fashion? Of course, just look at Congress! But even for-profit, joint-stock corporations can behave incompetently if they are cloistered from competition due to legal entry barriers and/or their large size. I've been interacting with LCFIs (large, complex financial institutions) since the beasts blew up the economy back in aught 8. My working hypothesis is that they were, and remain, organizationally incompetent. Lots of smart people behaving like utter morons. LCFIs resist this hypothesis because it suggests a policy that they cannot countenance, their breakup by regulators or raiders. They are too big to manage efficiently (diseconomies of scale) but so large that they cannot help making large profits, at least accounting profits, due to their market and political power. What Henry Kaufman called the Bigness Dilemma c. 2005 has muted somewhat. The dilemma now is HOW to break up ... you know the ones ... not IF they should be dismantled. At present, regulators have the power but not the will to do so and takeover specialists have the will but not the power.

The Debt Ceiling Crisis

2011-04-21T01:16:00.000Z

Article I, Section 8 of the U.S. Constitution states that "the Congress shall have Power ... To borrow Money on the credit of the United States." Early in the nation's history, Congress passed a law each time the Treasury Department borrowed. By World War I that had become tedious, so Congress began to authorize Treasury to borrow up to a set limit. (See this source for details.) Ever since, Congress has periodically raised the debt ceiling as needed to finance federal budget deficits -- 69 times since March 1962.

Most of the time, bills increasing the debt ceiling have been politically mundane because the ceiling is usually, and rightly, seen as an EFFECT of federal budget deficits, not their cause. The CAUSE of deficits, of course, is Congressional authorization of expenditures that exceed revenues. Occasionally, however, some lawmakers convince themselves it is a good idea to render the debt ceiling a political football.

The debt ceiling has never caused the Treasury to default on its bonds but it has rendered Treasury operations precarious and uncertain on several occasions, including May-June 2002, February 2003, and October 2004. During those episodes, Treasury resorted to various legal accounting ruses to temporarily stave off default until Congress approved increases. (Essentially, it temporarily replaced bonds held in various intergovernmental accounts with "non-debt instruments," thus allowing it to borrow mo' money. After the ceiling increase, it swapped the non-debt instruments for its bonds once again, restoring the status quo pre factum, so to speak.)

Another debt ceiling crisis is currently brewing and it is shaping up to be a real rumble as Tea Party members and other fiscal conservatives hope to use the approaching ceiling to force large expenditure reductions. Using the debt limit as a political tool, however, is potentially dangerous. It backfired on Republicans in 1995 and could do so again because American swing voters (like yours truly) know full well that fundamental tax reform, even if it leads to higher taxes paid by some, should be on the table too. And most Americans understand that defaulting on the national debt, even if only "technically" and for a short time, is not a trifling matter, especially given the economy's continued weakness and China's positioning of its currency as an alternative reserve currency.

Fiscal conservatives have shot back that failing to decrease the debt limit does not mean that the government will have to default. The Full Faith and Credit Act (S. 163/ H.R. 421) would "require that the Government prioritize all obligations on the debt held by the public in the event the debt limit is reached." In other words, Treasury would be legally required to pay bondholders first. That, however, will look like another Wall Street bailout to many Americans when they learn that the government failed to pay its other creditors, like Social Security recipients and government employees and contractors.

There is, I believe, a compelling argument that it would be UNCONSTITUTIONAL for the government to purposely default on the national debt. I think the argument could be easily extended to its other creditors as well but, as usual, I will defer the point to experts in Con Law (which is not an oxymoron but an abbreviation).

What I will do instead is to submit that it would be highly INEXPEDIENT for the government to fail to raise the debt limit, whether its failure results in a default on its bonds or the non-, late-, or partial payment of its other creditors. Credit is like a tender flower in that it takes only one misstep to crush it forever. Governments interested in borrowing in the future (as all with any pretensions to anything like the preamble of the Constitution must be) should never incur financial obligations of any sort that they do not intend to pay as promised.

Alexander Hamilton, writing as Publius in Federalist No. 30, stated the same idea rhetorically: "Who would lend to a government, that prefaced its overtures for borrowing by an act which demonstrated that no reliance could be placed on the steadiness of its measures for paying? The loans it might be able to procure, would be as limited in their extent, as burthensome in their conditions. They would be made upon the same principles that usurers commonly lend to bankrupt and fraudulent debtors ... with a sparing hand, and at enormous premiums." And in a letter to Hamilton from William Bingham in November 1789: "A Government should therefore pledge every security it can offer, to engage the Confidence of the public Creditors, which, if once impaired, the pernicious Effects can be felt in all its future Dealings. ... The Credit of the Funds must essentially depend on the permanent Nature of the Security; & if that is not to be relied on, they will fall in Value, the disadvantage of which, Government will experience by the payment of an exorbitant Interest, whenever it is compelled to anticipate its revenues. .... Great Attention should be paid to the public Creditors, by making Such Proposals to them, as are consistent with the Principles of Justice & Equity. ... To take Advantage of their Necessities, would be to lose their Confidence." [And on and on and on in Hamilton's public writings and private correspondence.] In other words, failure to raise the debt ceiling could make it much more difficult and much more costly for Treasury to borrow in the future, when America may really need the money to fight a large war or rebuild a region ravaged by a natural catastrophe.

As I have said on this blog and in my books many times before, the federal government DOES need to get its fiscal house in order and the sooner the better. Playing roulette with the debt ceiling, however, is not the way to achieve it. At this crucial juncture America needs economic statesmanship, not financial brinkmanship. It needs policies that will energize entrepreneurs and increase productivity so that the government's debts -- all of them -- can be serviced according to contract more easily. But that would require a lot of thoughtful conversations, a good that again appears to be in short supply in Washington.

Government Shutdown: Why Should Senators, Reps, and the Prez Still Get Paid?

2011-04-08T18:32:00.000Z

According to the Washington Post, a growing number of members of Congress will return their pay to the Treasury in the event of a government shutdown. They have to make that pledge because a law mandates that they continue to receive their pay in the event of a shutdown. Why not repeal that law? In fact, why not make members of Congress and the top levels of the executive branch personally liable for any damages caused by the shutdown? America needs statesmanship, not brinkmanship. Think I'll tweet that last bit.

The National Debt and What We Can Do About It

2011-04-06T19:49:00.000Z

About 50 Kentuckiana CFA's were in attendance for the following:

CFA Society of Louisville Lunch Lecture Series
Tuesday, April 5, 2011 at the Pendennis Club
218 West Muhammad Ali Blvd. | Louisville, Kentucky 40202

The National Debt and What We Can Do About It
By Dr. Robert E. Wright
Author and Nef Family Chair of Political Economy at Augustana College

The U.S. federal government now owes its creditors $14.25 trillion dollars, give or take a few hundred billion dollars. That’s a lot of moolah in nominal terms, enough in $1 bills to stretch to Saturn I’m told. If that sounds far-fetched, keep in mind that a trillion is a thousand billion, a one with 12 zeroes after it. But is $14.25 trillion dollars a lot in what economists call real terms, in terms of its purchasing power? That is much less clear. The national debt amounts to about $45,800 per citizen. Maybe that isn’t so bad. But two out of three citizens do not pay taxes, at least not directly. So maybe we should judge the debt by how much each taxpayer owes, currently a little over $128,000 dollar. When we consider that the median household income was a little shy of $50,000 dollars last year that number looms much larger but of course people with seven figure incomes and bad tax accountants will bear the brunt of it.

We also need to consider the fact that the debt need not be repaid in a year. Theoretically, America can spread its burden out over years, decades, centuries even. But in actuality it can do so only by rolling over existing debt. The average maturity on U.S. treasury bonds is about 5 years. That means that we have to repay the $14.25 trillion within that time or borrow that amount at prevailing interest rates. Let’s hope Treasury bond rates stay low because taxpayers are already paying over $200 billion a year in interest on the national debt alone.

While some of that interest goes to domestic bondholders, much of it goes overseas. The governments of China and Japan combined own about $2 trillion dollars of U.S. treasury bonds and the rest of the world about $2 and a half trillion more. That makes a lot of Americans wary but generally for the wrong reasons. Many imagine that our debt makes it easy for China to manipulate U.S. policy. That’s backwards. China doesn’t invade Taiwan because it knows that such a move would cost it, at a minimum, the $1 trillion plus of Treasury debt that it owns. Rather than invade the U.S., China actually has an incentive to protect it from attack. One of Alexander Hamilton’s key insights was that debt ties the interests of the borrower and lender together, except in Sopranos scenarios. But it’s not like China can break our thumbs or kneecaps.

What IS scary about the large foreign holdings of our debt is what will happen if foreigners dump a big batch of Treasuries on the open market or, more likely, simply slow or stop their accumulation of them. If that happens, yields on Treasuries will jump and American taxpayers will have to pony up even more in interest in the years to come.

Thankfully, the U.S. national debt is all currently denominated in dollars, which makes it mighty convenient to service Treasury bonds by firing up the proverbial printing press. But if the government resorts to making lots of new money to pay its debts, the dollar will plummet as inflation soars. The former will help with our huge trade deficit, currently running at over $660 billion dollars, but not enough to offset the many economic distortions that domestic inflation causes. Things don’t have to get as bad as in Zimbabwe a couple years ago to have serious negative economic and social consequences. Anyone remember the Great Inflation of the 1970s? I do, barely, but isn’t pretty. Government price control-induced shortages, rapidly declining real wages, deep trouble for financial institutions like Savings and Loans, and my father fighting with the farmer up the road over the rising cost of bailing hay.

Too much inflation would eventually induce foreigners to stop buying dollar-denominated debt. We glimpsed this in the 1970s, when during the Carter administration the U.S. government actually sold some debt denominated in West German marks. If the U.S. government ever has to borrow large sums in euro or yuan, we will be subject to the same budget constraints as Mexico or Argentina and probably won’t handle it as well.

But that won’t happen, will it? The mighty U.S. dollar can handle any strains, can’t it? Maybe, maybe not. If that 9.0 had hit Cali instead of Honshu we might have learned its limits. The most astute economists argue that the debt to GDP ratio is one important metric to watch. Right now, it is almost 100 percent. That means that the national debt is almost as large as the value of the final goods and services Americans produce in a year. That might sound like an upper limit, but it is not. During World War II the ratio topped out at about 120 percent and has hit several hundred percent in other countries, sometimes with disastrous results, other times not.

If the federal government continues to run budget deficits that exceed the growth rate of the economy, which will average about 3 percent per year at best without reforms like those I’ll discuss later, the national debt will continue to grow vis-à-vis the economy until something gives. I liken the situation to that of a large man in a small boat. If the man grows faster than the boat, the latter is sure to sink at some point. But economics is more black art than physics so economists can’t know for sure when that tipping, or rather sinking point will be reached. Part of the problem is how to precisely measure the debt’s size. That $14.25 trillion dollars I mentioned earlier is just the par value of Treasury securities, the amount the Treasury has promised to repay bondholders. Unfortunately, the U.S. government owes a lot more than that, but how much more is difficult to say.

The government’s Social Security liabilities are estimated at about $15 trillion, the Bush prescription drug benefit at a pill popping $20 trillion, and Medicare at an eye popping $78 trillion. If people work longer than expected, however, the Social Security figure will go down a bit. And if they are healthier than projected the drug and Medicare figures will be lower. But the biggest savings would come from older Americans dropping dead younger than expected and dying more quickly and cheaply than anticipated because that would mean less paid in Social Security, which is after all a life annuity product, and would mean less paid for drugs and other types of healthcare. I’m convinced the people screaming about death panels during the healthcare debate last year intuited – correctly – that the federal government has a vested interest in their sudden death the day after they retire.
On top of all this, Americans have personal debts all their own. I’m less concerned about this as the average citizen owes $178,000 dollars but has assets of almost $250,000. Granted, those averages disguise the fact that a few Americans owe nothing and have assets worth millions while millions of others are underwater on their mortgages. But like Alfred E. Newman, I’m not worried about consumer debt. The claims of numerous historical ignoramuses in the media to the contrary notwithstanding, the average American has been in hock up to his eyeballs since at least the eighteenth century without causing any systemic problems. Let’s not blame the victims in other words. Credit cards and other forms of consumer finance are a big part of America’s social welfare net.

What does concern me is how our nation got into the fiscal, financial, and economic mess that it currently faces. The best escape route out of governmental and personal debt as well as high unemployment is sustained and robust economic growth. At present, achieving genuine economic growth, as opposed to tricking the economy into a temporary prosperity with another asset bubble like the dotcom and real estate bubbles, appears impossible because too many important economic sectors are FUBAR – that’s fouled up beyond all recognition in polite company – and because Thomas Jefferson was right when he predicted that politicians would find it difficult to resist the allure of borrowing and spending.

Jefferson’s view grew out of his public dispute with Alexander Hamilton over the proper way to handle America’s first national debt, the one it racked up fighting for independence from the British. The rebel governments – I mean the ones in Boston and Philadelphia, not Benghazi -- found it too difficult to tax so it resorted to lotteries, currency inflation, and borrowing, some of it voluntary but much of it forced on soldiers and provisions providers. After the war, most states continued to find taxing Americans challenging to say the least. Some threw up their hands and defaulted on their debts, the market price of which dropped to pennies on the dollar. Others, most infamously Massachusetts, pushed taxation until they sparked rebellions in their western hinterlands. The situation was dire but thanks to some invisible elixir the Constitution resulted, Federalist George Washington was elected president, and the Senate confirmed fellow Federalist Alexander Hamilton as his Treasury Secretary.

Hamilton certainly had his faults. Most infamously, he had an affair that would make Bill Clinton blush and did it with a woman who by all descriptions would make Megan Fox look like Monica Lewinsky. No joke, Maria Reynolds was smoking. Hamilton also lost a duel to a Vice President, a species of politician not known for its acumen at anything. But when it came to finance, Hamilton was a freaking genius. Freaking genius. He established a tax that Americans would pay -- a revenue tariff that he let manufacturers believe was a protective tariff -- and used it to service three new types of bonds issued in lieu of the scores of different types of junk certificates the rebels unleashed on their fellow Americans during the war. Because tariff revenues were volatile, Hamilton also established a national bank, the Bank of the United States, charged with lending the Treasury money to pay interest on its new bonds should its revenues fall short. Suddenly rendered safe and liquid, government debt soared from a few cents on the dollar to above par. Bond yields, in other words, dropped from high double digits to under six percent.

You would think that Jefferson and his followers, then called Democratic-Republicans, would have been happy that in a few short years Hamilton transformed the United States from a bankrupt backwater into a nation whose bonds -- which were briefly more valuable than British Consols – cemented the nation together just as Hamilton said they would because they incentivized holders, who were spread wide geographically and occupationally, to back the new regime.

But the Democratic-Republicans were not happy. Some of it was just party politics but some was genuine. They did not like the fact that speculators seemingly made large profits when yields plummeted during implementation of Hamilton’s reforms. As argued then and shown since, speculative profits were not out of line given prevailing interest rates and risk premia but Democratic-Republicans nevertheless argued that the original holders of the governments’ IOUs, the soldiers, farmers, and other patriots to whom they were first issued, should be compensated instead, even though that probably would have delayed the development of our capital market for decades.

Jefferson and his buddies also loathed the Bank of the United States as they harbored a deep distrust of all banks and corporations, except for the ones they owned shares in of course. They also did not believe that the Constitution allowed the federal government to charter any corporation, let alone one so big and extensive. When it was formed in 1791, the Bank of the United States dwarfed all the other banks then in existence – COMBINED. Although headquartered in Philadelphia, it soon began establishing branches – tentacles in the eyes of those who feared this alleged Leviathan – in the nation’s most important cities, a sure sign of its evil designs according to its foes.

Finally, Jefferson and his Democratic-Republican followers disliked the fact that the federal government assumed the state government’s debts even though Hamilton clearly explained that the measure was necessary because the federal government monopolized the best tax then available, the tariff. Hamilton, they believed, was trying to make the national debt as large and long-lasting as possible so it could drain taxpayers in favor of a large national government and a handful of its pampered cronies and rich capitalists.

Hamilton, however, wanted no such thing. He wanted the debt to be widely held so that it would cement the union together and also so the bonds would be liquid, valuable investments. Moreover, Hamilton argued in favor of a vigorous national government not a large one, at least not large by today’s standards. He wanted a tiny national government by today’s standards, Jefferson a teensy-weeny one. Hamilton also did not want the national debt to be perpetual, as his detractors claimed. The new bonds his Treasury issued did not have fixed redemption dates because he did not want to encounter a re-financing problem in the future. The government could still retire its debt and in two ways in fact: First, it could do so at any time by buying its bonds in the open market via an institution called the Sinking Fund. Second, it could retire its bonds slowly via an amortization feature built into some of the bonds that gave the government the option, but not the obligation, of repaying 2 percent of the principal each year.

Maybe that was all too technical for Jefferson, who for all his brilliance in other areas was a financial illiterate and an insolvent debtor most of his adult life. But his Treasury Secretary Albert Gallatin and subsequent Democratic-Republican and Democratic treasury secretaries all understood and used those mechanisms to pay off America’s original national debt, as well as subsequent debts contracted to fight the War of 1812 and several lesser conflicts, and to buy the Louisiana Territory from Napoleon. So score one for Little Hammy.

But Jefferson had the last laugh. As he predicted, politicians would not be able to resist the lure of borrowing and spending. Taxing and spending was of course a political death sentence most election cycles but borrowing and spending could be conducted to great electoral effect because taxpayers received more in benefits from government programs than they paid in taxes and that made them happy, at least in the short term.

Not surprisingly, after completely paying off the national debt in early 1835, the U.S. government had to sell bonds again just a few years later. Tariff receipts fell during a recession, you see, and because Andrew Jackson refused to recharter the second Bank of the United States it was not available to fill the hole in the budget. The federal government’s debt remained small compared to the overall economy but jumped a little during the Mexican war and of course took a huge leap during the Civil War, when it reached 30 percent of GDP for the first time since early in Hamilton’s era.

The government never completely repaid the national debt again but the early pattern established by Hamilton, Gallatin, and other early Treasury Secretaries repeated itself over and over: wars and occasional territorial acquisitions caused the debt to increase but thereafter a combination of expenditure restraint and robust economic growth reduced the debt’s real burden to manageable terms. Even the large run up in the national debt during the Reagan administration fit the pattern: the debt accumulation essentially won the Cold War and was reversed, in percentage of GDP terms anyway, during the 1990s, culminating in small surpluses late in Clinton’s second term.

The pattern, however, now appears to be history, if you can ever forgive that pun. I know I can’t. During the administrations of George W. Bush, the national debt rapidly increased in both nominal and percent of GDP terms, much more rapidly than the relatively minor wars in Iraq and Afghanistan could have caused. Under Obama the debt has continued to soar but due to an unprecedented cause, the bailout of the financial system and massive fiscal stimulus. Various myths to the contrary notwithstanding, the United States got out of the Depression by devaluing the dollar and increasing the money supply, not by large amounts of Keynesian deficit spending. The Depression was over well before World War II began though that fact was clouded by continued high levels of unemployment and the so-called Roosevelt recession of 1937 which was caused, in part, by Roosevelt’s strong desire to balance the federal budget.

The U.S. government certainly engaged in other bailout activity over the years – I’ve recently completed a paper about it that I’m happy to share with you if you wish – but not even the S&L bailout of the early 1990s comes close to the resources thrown at the economy following the Panic of 2008. We’ll never know for sure if the bailouts and fiscal stimulus saved the economy from a steeper or longer downturn than it suffered anyway because we can’t replay those events under a different policy. It’s pretty darn clear, however, that politicians chose to increase the national debt in order to appear to maybe have done some good over allowing the crisis to play out. They will be likely to do so again in the future until, that is, the crisis is about the national debt. Then, some fear, politicians will be flummoxed by hard choices that could potentially tear the nation asunder along its geographical, generational, class, or racial fault lines.

There is, however, an alternative that has not yet garnered the consideration it merits. We need to find ways to become more efficient, plain and simple. Our nation’s economic greatness was built on finding ways to do more with less. It used to take 90 of us to inadequately feed 100 of us. Now it takes only 2 to make 100 of us obese and to feed many abroad as well. We used to need half the workforce to toil 70 to 80 hours a week just to clothe us and provide some basic manufactured goods. Now 20 percent of workers lollygagging about a mere 40 hours a week provide us with more physical stuff than we have ever enjoyed in the past, and that’s not counting imported goods. That’s right, U.S. industry makes more today than it ever has in the past and does so with fewer workers.

Agriculture and manufacturing are our pride and joy but the very efficiency of those sectors threw most farmers and factory operatives out of those occupations and into the service sector, which now accounts for over 75 percent of U.S. GDP. That’s right, three quarters of our economy is service-based. Some service-based activity is low value-added. You know, proverbial burger-flipping. But most of it is higher end activities like construction, consulting, education, entertainment, finance, health-care, legal, and research.

Unfortunately, many of those areas suffer from stagnant productivity growth. We know that is the case in custom construction by directly comparing over time how many inflation-adjusted dollars it takes to complete a structure of fixed size and quality. It’s not an exact science, but the consensus appears to be that construction productivity in 2010 is not statistically significantly different from construction productivity in 1960. In other cases, we can infer productivity stagnation from price trends. When the costs of services like healthcare or education rise faster than inflation for decades on end, there is clearly a problem.
If we are going to jumpstart our economy, we are going to have to figure out how to make construction workers, financiers, healthcare providers, and professors more efficient. Good luck with that you might be thinking and if so, you are right. Reform, meaningful reform anyway, is not easy here as Dodd-Frank and the Mess in Madison attest. But we have to try, even if folks like Will Baumol think it silly.
Will is a friend of mine even though his first journal article appeared the same year my mother was born. We overlapped at New York University’s Stern School of Business a couple of years and worked on several projects together. He’s a brilliant man but that does not mean that he is perfect. He is currently working on entrepreneurship but earlier in his career he made a big impact on economists by describing what has come to be called Baumol’s disease. It’s basically a parable about a string quintet that purports to show how difficult it is to improve productivity among service workers: it still takes five musicians x number of minutes to play a tune composed by Mozart over 200 years ago.

That’s certainly true, but improved musical pedagogy could greatly reduce the amount of time it takes to prepare someone to be able to play a piece of music as sophisticated as that created by Mozart, improved practice techniques could greatly reduce the time spent learning the specific composition, and improved technology could enable a single playing session to be listened to an infinite number of times. When viewed in that light, Baumol’s disease looks more like Baumol’s case of the sniffles.

What actually ails the stagnant parts of the service sector is a bad case of mis-aligned incentives. Fix those mis-alignments and productivity will surge and with it the economy. The national debt probably won’t go away but it’ll look smaller compared with our ability to service it. For more details on this stuff, by the way, see my book Fubarnomics.

Let’s start with custom construction, the creation of quasi-unique houses, office buildings, and other built infrastructure for a specific owner. The root problem here is not ancient building codes, unions, the Davis-Bacon Act, a recalcitrant workforce, ineffective managers and supervisors, or even organized crime because those are all effects of what is effectively a non-competitive industry. Sure, there are millions of construction firms in the U.S. but they range from tiny to infinitesimal and many are highly specialized. In many markets, it is all that somebody can do to get three bids. Not that the bidding process does a dang blasted thing for owners because contractors game bids. In other words, the bid is not an estimate of the actual costs of the job but rather is a way of winning a job. The key is to set the bid low enough to win the contract even if it is unprofitably low. That is because a construction firm on the job is a near monopolist. Contractors use their market power to make so-called change orders stick.
Contractors call them change orders because bill padding is a little too obvious but that is what most change orders are, the means by which contractors who bid too low get their profits. The economic problem here is that contractors don’t so much compete on price, quality, and time as on how good they are at gaming bids and sticking owners with change orders. That is why so many construction firms are small and why so many construction projects come in late, over budget, or, most insidiously of all, under quality.

The fix here is to stop allowing contractors to issue change orders, perhaps through what has been called fixed-price contracts. In such contracts, construction firms face penalties if they do not finish within so many percent of the time and price they promised. The widespread adoption of fixed-price contracts would likely spur a huge consolidation in the industry which, in turn, would result in many fewer but far larger companies run by more professional managers and with far more ability to fight unions and to combat productivity-damaging government policies like antiquated building codes. Some segments of the construction industry are finally beginning to embrace this line of thinking but much work remains to be done.
Financiers can be made more efficient through incentive re-alignment as well. The Panic of 2008 occurred because some individuals profited from offering economically dumb-assed products like 125% LTV loans to NINJA borrowers – individuals with No Income, Job, or Assets – and the various derivatives based upon them. The individuals profited because they made big commissions or bonuses from the sale of the products but did not suffer personally when they all exploded a few years later. There was absolutely no excuse here as the subprime mortgage crisis was the seventh time in U.S. history that a mortgage securitization scheme blew up because of the same set of misaligned incentives. In other words, it was the seventh time that we forgot that brokers should not receive a full commission today for a product that has a 15 or 30 year life. In the nineteenth century, by contrast, life insurers learned and never forgot that they had to spread commissions out over 5 or 7 years or they would soon be inundated with terminally ill policyholders.
The fix for finance today is much the same as it was for the life insurance industry more than a century ago. Don’t pay people for engineering or selling products that haven’t proven their ultimate profitability. I realize that is easier said than done but deferred compensation and bonus-malus systems, where bonuses can be lost back if experience shows that they were too high when awarded, has worked wonders at mutual life insurers like Guardian and at some joint-stock companies as well.

Please do note that the recommendation here is about the structure of compensation and not its extent. As a possible future millionaire I don’t want to mess with market prices. I just want to destroy the ability of executives to pay themselves royally for royally bad behaviors. Not that it is their fault per se. Our corporate governance is really messed up compared to its heyday before the Civil War. We need to again incentivize shareholders to monitor the companies they invest in. But I don’t want to digress further about that complex subject.

Next up are healthcare providers of all stripes, or doctors for short. The solution here is so simple that even Jigsaw, the serial killer from the Saw movie franchise, was able to figure it out. We should pay doctors for curing us, not for merely seeing us. There are several ways of doing that. One developed in the U.S. in the 1920s was called prepaid medical. When you were well, you paid so much per month. When you were ill, you paid nothing until the doctor got you well again. Sure, some people tried to malinger and some doctors tried to stop treating really sick patients but disinterested third parties could generally sort them out and rule accordingly.

Another, not mutually incompatible proposal, is to mandate individual insurance for all, beginning in the womb before any genetic testing has been conducted. That would reduce adverse selection, or the predilection for sicker people to seek health insurance. Moreover, I think that health insurance should be tied to a life insurance policy and structured actuarially so that healthier people get a bigger life insurance payout per dollar of premium paid and sicker people get a smaller one. Combining the two policies into one has the virtue of bonding the insurer to pay for healthcare up to an economic breakeven point. Out of their own self interest, for example, an insurer would easily conclude to pay $500,000 to cure somebody with a $1 million life policy that would otherwise soon fall due. And if it clearly meant less money going to their children and grandchildren, more people would opt out of expensive end of life treatments. As in construction, such reforms would induce doctors to become more efficient, perhaps by tiering service more rationally, ordering fewer tests, embracing new therapies more readily, and so forth. Medical malpractice would still occur but the number and severity of suits would be reduced due to greatly increased emphasis on preventative care.

That brings us to professors and, what the heck, K through 12 teachers too. Unions and tenure are not the problem per se here but rather symptoms of the underlying disease, which is anything but Baumolian. The root problem in education is that professors and teachers are employees instead of professional partners. Like other employees, professors tend to do just enough to keep their jobs while bargaining hard for as much pay and as many perks as they can get, including lifetime tenure. If they have an idea about how to improve pedagogy they are generally mum about it because sharing it won’t get them any more money and might even cost them a teacher of the year award. If somebody suggests a change that personally inconveniences them, they fight it with all their might even if it would help students or cut expenses.

Imagine how differently professors and teachers would behave if their long-term compensation were tied to how well their school did, and how well their school did depended on how well they taught and, in a university setting, how well they completed research projects? That would be the actual case if governments subsidized students instead of schools and if profs and teachers were partners in an LLC instead of mere employees clinging desperately to unions and tenure. In an LLC, professors’ tenure would be priced instead of absolute. They would still have significant job security but could be bought out by the other partners, as in a law firm.

If these reforms are implemented, I think productivity would soar, just as it did when slaves were emancipated from bondage in Egypt and Central Europe. The world looks much different when one can reap the fruits of working harder and smarter. So there you have it. The solution to our macroeconomic woes rests in our willingness and ability to use the microeconomics of incentives to unleash the forces of human creativity.

I fear none of these ideas will ever be adequately tested in the cauldron of real life, at least not in time to do us much good, but stranger things have happened. I think we should try each one on a small scale and then encourage their proliferation should they prove salubrious.

But, you might be wondering, what about Jefferson’s insight? Won’t politicians still have an incentive to borrow and spend no matter how productive the service sector becomes? Perhaps. But recall that until recently American politicians actually did a pretty good job of restraining themselves, increasing the national debt only to fight necessary wars or to acquire vast territories on the cheap, and then working hard afterwards to make sure that the economy grew faster than the debt. Maybe we only need to re-educate voters to return to that relatively happy state of affairs because they will elect politicians committed to committing themselves to reducing the debt, through, say, a balanced budget rule. Some states, including South Dakota, have those and they work fairly well though some effectively circumvent the restrictions, which began in the 1840s when a number of states wrote them into their constitutions in order to avoid going bankrupt like Mississippi and several others did following the financial panics of 1837, 1838, and 1839, aka the good old days.

So voter education might work, but then again it might not. In case you haven’t noticed, candidates for high office have a way of saying one thing and doing another. I once suggested that we force them to post performance bonds that would essentially pauperize them if they ever went back on a formal, solemn promise but for some reason politicians never liked that idea.

If you are with Jefferson and despair of politicians ever again getting a handle on the federal budget, perhaps we should consider emulating Switzerland and have one house of Congress determine revenues, which then binds the other house’s expenditures. If you want to get more radical, how about allowing each taxpayer to determine the precise allocation of his or her taxes? That would reduce tax avoision by empowering the people to set the expenditure side of the budget.

Even more radically, why not adopt a one vote per dollar in taxes paid rule, similar to the one vote per share rule common in corporate elections? That would actually incentivize people to pay more in taxes in order to get more voting power. Most radically of all, why even have elections? No, I’m not advocating dictatorship but rather randomness. Politicians are NOT like the rest of us, that is why they became politicians and why most of them seem to have problems keeping it in their pants. I mean their hands, instead of stretching them out for bribes like that Senator from Alaska, may he rest in peace. If we want to be represented by our peers, we need to turn our legislatures into big juries, except instead of paying them $10 a day the government should pay anyone so drafted their accustomed salary at their regular job, plus 10 percent and reasonable expenses during the entirety of their one and only term. Sure, we will get some dolts in there but that would incentivize us to improve the educational system. Plus I’d rather be led by a group of honest dolts than a gaggle of shady ones.

Gosh, I hope there are no politicians in the audience. Or construction contractors, doctors, or professors! Or financial services professionals. Thank you for your time and attention. I’ll now entertain questions.

Recent One Nation Under Debt Review

2011-03-22T16:39:00.000Z

The book that launched this blog, One Nation Under Debt (McGraw Hill 2008) is still getting reviewed, usually favorably. This one, republished with permission, recently appeared from the keyboard of Scott Paradis:

One Nation Under Debt

Author:

Scott F. Paradis

In light of our burgeoning national debt and impending financial catastrophe, Robert E. Wright points out that without 'the debt', what we know as the United States would likely not exist. During and after the revolution the states united as much under a financial obligation as they did under a banner and a constitution. The debt the population of rebels, transplants, and immigrants assumed from the nation\'s founding served as seed corn for economic growth and prosperity.

Wright offers two golden nuggets in his book 'One Nation Under Debt' making the, at times tedious, historical exploration of the establishment of the national debt most telling and fruitful: the debt brought and held the nation together at its most crucial hour; and the 'development diamond' is a viable tool to gage past achievements and to leverage for future success.

One thing everyone agreed on during the struggle for independence was that victory would require resources: men, equipment, arms - money. From the beginning, promises were made, some kept, others dismissed, that ultimately carried the day. Two prominent figures offered prescient views over the means of securing the resources to birth a nation. Thomas Jefferson lamented long-term debt amounted to, 'swindling futurity on a large scale'; while Alexander Hamilton claimed a national debt, of manageable size, was a 'national blessing.' Both views proved correct, but it was Hamilton who secured the first four score years.

Motivated by the desire to be free the founding fathers debated the three major options for raising funds: tax, sell assets, issue debt. Understanding the multiplying effect of debt Hamilton invoked the maxim, 'The more you borrow, the more friends you make.' The rebellious colonies, the confederation, and ultimately the United States were able to secure credit abroad and raise capital through debt issued to citizens. The diversity and liquidity of the government debt bond markets, coupled with a strong political commitment to repay the debt bolstered government credit and bound the nation together.

'The public debt served as the bridge between the nation\'s nonpredatory government and its emerging financial system.' A land of dreamers, risk takers, and entrepreneurs fueled by additional funds made available through debt accelerated economic growth. The system was so prosperous that during Andrew Jackson\'s presidency the people retired the debt. Within months of paying off the debt however, for a host of reasons, not the least of which was government mismanagement, the United States went into hock and has never looked back.

In modern times, 'The people, not as enlightened as they once were...Their leaders, now mere politicians instead of statesmen, began to accumulate massive new debts to ensure their popularity rather than to fend off encroachments upon liberty. As foretold, the blessings of debt became a great curse...' Wright has no illusions about the predicament the United States is in now, as he calls on none other than Adam Smith to define the requisites for state prosperity: peace, easy taxes and a tolerable administration of justice.

While we tend to look for easy solutions and simple direct relationships we erringly believe national wealth is a function of cash aid, Western culture, greater democracy, more education, less imperialism, more natural resources and greater stability - our modern democratic, free-market ideal. But these are not the factors that foster economic prosperity. Wright demonstrates only two things create wealth: trade and increases in efficiency. He introduces the 'development diamond' as a model to measure a country\'s propensity for economic prosperity.

To succeed economically a nation must have: good (nonpredatory) governance; a sound financial system; a creative / industrious bent; and effective managerial acumen. Good governance is the basis for the other three components of the 'development diamond', and at a minimum protects the lives, liberty and property of its citizens. Progressive, prosperous countries do not seek to secure more of the pie - they enlarge the pie. Failings in government lead to circumstances that serve to enrich the few at the expense of the many. A reality increasingly evident in the United States today.

Debt was a necessity uniting disparate interests into one nation. The debt, as a tool of good governance served to foster economic prosperity the likes of which had never been seen before. But, like with most human failings, discipline and moderation gave way to excess. The United States abandoned a viable model of development and sought instead to invoke easy, convenient solutions to complex, persistent challenges. Well, times have changed, and we must now change, more than ever, to keep from being overwhelmed by a blessing turned to curse - debt.

Article Source: http://www.articlesbase.com/politics-articles/one-nation-under-debt-4443694.html

About the Author
Scott F. Paradis, author of 'Promise and Potential: A Life of Wisdom, Courage, Strength and Will' http://www.promiseandpotential.com publishes 'Insights' available for free at http://www.c-achieve.com

Price discrimination = yahoo!

2011-03-14T14:21:00.001Z

Whenever I talk about the concept of price discrimination, students and other audience members often get uncomfortable. It's probably because they are trained to think "discrimination = bad." What they don't realize is that price discrimination (PD) is ubiquitous and helps them when they most need it, when they are young, old, or down on their luck. PD is simply any mechanism by which sellers try to figure out how much to charge an individual consumer for a good. The most common example is probably the coupon. Sellers assume that anyone who takes the time to seek out a coupon and clip it must really want the price to be 15 cents (or 15%, etc.) lower to induce them to buy. Those who could care less about the five their blowing (that's from an old rap song btw) don't bother and pay full sticker.

Other forms of PD apply to enter groups, like people willing to eat dinner at 4 p.m. or, which often amounts to the same thing, senior citizens. Students can also leverage PD in their favor and to help them do that Onlinecollegesanduniversities.net has published "100 Niche Deal Sites Every College Student Should Know" that obviously goes beyond Groupon. Using such sites and inducing your professors to adopt open source textbooks like mine can help keep that student debt load down.

Net Outrageous!

2011-02-25T00:14:00.000Z

There was a fella whose name escapes me on the Colbert Report a few back complaining that many companies were paying later than usual. Like Net 60 or 90 instead of Net 30 or 15. In other words, corporations are getting forced loans from their suppliers and contractors. One way to fight this is to insist that the company pay interest on any balances still due after 15 or 30 days of invoicing. And the interest rate should be what YOU lose by not having the money, not the Fed Funds rate, the prime rate, etc. So more like 10% than 1%. Most corporations can of course get loans at a lower rate than a small business person can so they will likely pay up in a reasonable time. Of course they might not do any more business with you too in which case you might let them play their Net Outrageous game but increase your fee at the first opportunity. If they ask why your fee went up, dispassionately explain that your costs have increased because your clients pay so slowly these days but then offer them a discount (back to your usual fee) if they pay promptly, as you define it. Technology these days is such that Net 5 should be the norm, but that is another topic.

Federal Government Partial Shutdown? Huzzah! Huzzah!

2011-02-20T20:52:00.000Z

Due to the budget impasse, the federal government may experience a partial shutdown like that of 1995-96.

I think a partial shutdown is a good idea. No, a GREAT idea, but only if the parts that stop operating are shuttered permanently pending positive proof that they were providing goods (as opposed to bads) and that the government itself has to provide those goods. Such a shutdown would allow private enterprise and charity to step into the void and show that we don't need the federal government for much beyond homeland defense and federal courts. Leasing of national infrastructure and parks would allow the national government to run a surplus next year and soon after to implement a large, permanent tax decrease that will spark the greatest economic expansion since ratification of the Constitution.

On dentists and dentistry

2011-02-15T00:38:00.000Z

In Fubarnomics and Broken Buildings, Busted Budgets, I* show how we need to move toward fixed cost contracts if we ever want productivity in construction to improve. No more of this "I bid $3 [thousand, million, billion] but because of X, Y, Z [usually total b.s.] I need you to pay me $6 [thousand ...]" crap!

So when a local dentist advertised a price guarantee, I decided to check it out. That's when I confronted another problem, one of asymmetric information. The dentist said that I needed a filling in one of my molars. That's plausible -- I only brush, floss, and use mouthwash 4x a day, have missed only 1 cleaning in the last decade, and had only 3 small cavities as a child -- but the diagnosis rather took me by surprise. As advertised, the dentist gave me a firm quotation on the proposed work but while driving home from the appointment I heard another local commercial, this one by an auto mechanic who was making fun of mechanics who screw customers by coming up with screwy car ailments. Pretty funny: something about a muffler belt and a flux capacitor, the latter of which I am pretty sure is found only in certain time traveling cars. In any event, I thought what a nice racket this could be: appear to be a "good guy" by offering a firm quotation but do it on unnecessary work! Then an RDH friend of mine confirmed the validity (though of course not the veracity) of my fears.

So I've been musing about how to fix this problem and came to the following solution: instead of relying on "trust," as the dentist and the auto mechanic in question claimed I should, couldn't we devise a system where dentists, auto mechanics, and any other line of business where asymmetric information is heavy anonymously check each other's work? Say all dentists, or at least the ones that want to signal their quality, agree to review each others' diagnoses. (One for every patient of theirs reviewed by someone else in the group.) Upload the X-rays (c'mon, you should all be digital by now ... and if not, buy a scanner!) to a system that would randomly send them to another dentist in the region (or time zone) for review. Lacking any incentive to lie, the provider of the second opinion would be much more "trustworthy" than the first. The ADA or other association could spot check the diagnoses to keep everyone on the up and up and provide a third opinion in cases where the first two disagree.

The same could be done for automobile repair, I suspect, by creating short videos of the car experiencing problems when running, taking pics of the part(s) in doubt, etc. (And then give a firm price quotation, of course.)

Yes, these procedures would consume resources but they would probably pay for themselves with an increased volume of overall business as people learned that even though they can't trust their local service provider they can trust the second opinion system of which they are a part. For now, I'm leaving my tooth untreated and leaving the "check engine" light in my Saturn on for at least another month.

*And my co-authors on BBBB of course.

My Twitter "career"

2011-02-15T00:16:00.000Z

I haven't been blogging much of late because I've been too busy working on a massive project (that might be going bust soon). :-(

I have been doing a little tweeting though. Here they are to date. Feel free to "follow" if you like but I'm much less committed to it than to this blog, which finally generated some income for me last month! Tweeting is a little like a "quickie": it's better than nothing sometimes but not as satisfying as a good, long blogging. Ya know?

Wrighticism #19: If the measure of a man is earning more money than his wife can spend then I am surely a failure! Happy Valentine Day yall!

robertewright Robert E. Wright
Wrighticism #18: "skippy" = the way to pronounce Skype when the video isn't functioning well. "skyp" = skip; e = y (ee). Get it?

robertewright Robert E. Wright
Wrighticism #17: caveat erus = let the owner (investor) beware

robertewright Robert E. Wright
My textbook publisher is growing http://www.bloomberg.com/news/2011-01-20/bertelsmann-puts-cash-into-college-textbook-publisher-ft-says.html

robertewright Robert E. Wright
Wrighticism #16: homo ereptor = man the thief, in "honor" of the ways that we steal from each other, sometimes openly, sometimes in darkness

robertewright Robert E. Wright
Wrighticism #15: twittersated = to have written and/or read enough tweets for the day/month/year/decade. As in I am twittersated for today.

robertewright Robert E. Wright
Wrighticism #14: twittertwit = ppl hu rite in twitter in such s-hand tht it is freakin impossible to understd what the heck they mean.

robertewright Robert E. Wright
Wrighticism #13: triskaidekaphonia = fake fear of the number 13, not be confused with triskaidekaphiladephia = fear of 13 Phillies/Flyers.

robertewright Robert E. Wright
Wrighticism #12: trannycock = that's not a dead hen pheasant you just shot, that's a rooster that likes to dress up in hen feathers!!

robertewright Robert E. Wright
Wrighticism #11: fourclosure = when not one but four houses on your block are being sold at sheriff's sale in the same week.

robertewright Robert E. Wright
Wrighticism #10: antler (fur, feather, scale) "porn" = those hunting and fishing TV shows w/ only the biggest and best deer, ducks, fish etc

robertewright Robert E. Wright
Wrighticism #9: znorexia = when chubby people see themselves as skinny in the mirror and have another helping of chocolate-covered cumquats

robertewright Robert E. Wright
Wrighticism #8: crybaby capitalism = redistribution to private enterprises that complain loudest rather than create the most economic value

robertewright Robert E. Wright
Wrighticism #7: bailout nation = a country that instead of creating wealth redistributes it to special interests during supposed crises
29 Dec Favorite Reply Delete

robertewright Robert E. Wright
Wrighticism #6: bailoutnomics = the study of the economic effects of government bailouts of private enterprises and other governments

robertewright Robert E. Wright
Wrighticism #5: bailout incidence = the ultimate recipient of bailout funds; analogous to "tax incidence."

robertewright Robert E. Wright
Wrighticism #4: wheatful = fruitful, but in a non-gluten free format

robertewright Robert E. Wright
Wrighticism #3: cornful = fruitful, but in a corny way

robertewright Robert E. Wright
Wrighticism #2: megapocrisy = a grossly large or blatant hypocrisy; a mega-hypocrisy; the lifeblood of most DC politicians

robertewright Robert E. Wright
Wrighticism #1: Wrighticism = a neologism or witticism by Robert E. Wright

robertewright Robert E. Wright
Secession and America's Looming Fiscal Crisis, Daily Caller, http://dailycaller.com/2010/12/21/secession-and-americas-looming-fiscal-crisis/

Dying by Degrees: The Economics of FUBAR

2010-12-08T19:34:00.000Z

This is the text of a speech that I delivered at Augustana College's Center for Western Studies yesterday (12/01/10).

Dying by Degrees: The Economics of FUBAR
By Robert E. Wright, Nef Family Chair, Augustana College

FUBAR is an acronym that stands for Fouled (ahem!) Up Beyond All Recognition. Many military veterans know it as one of a family of acronyms, like SNAFU, TARFU, and SUSFU, that express anger for, and cynicism and distrust of, the status quo and the powers that be. Movie buffs learned the term FUBAR from films like Saving Private Ryan and Tango and Cash. I used it in the title of my book about the hyper-dysfunctional parts of the American economy because saying FUBAR isn’t cursing according to the word police but it definitely carries the connotation of the f-bomb. Like most folks, I’m a sinner … yep, yep, it’s true … and so I do curse when I’m angry or hurt. And the state of the U.S. economy has me feeling both of those powerful emotions.

But please don’t get me wrong – I’m not trying to cash in on the recent financial crisis … at least not in this book. The subprime debacle and subsequent financial system meltdown wasn’t the cause of America’s current economic plight but rather was a symptom of a much deeper illness, one that is slowly killing our economy. Hence the title of this talk, “Dying by Degrees.”

Given the events of the past couple of years, few people dispute that the financial system is totally FUBAR. Ditto with slavery, another melancholy subject covered in the book. Sometimes, however, people wonder if construction, higher education, healthcare, and Social Security are as economically dysfunctional as I claim. They certainly are if one accepts a simple objective criteria: quality and the price level constant, the costs of built infrastructure, college degrees, healthcare services, and retirement savings have been rising for decades and show no signs of abating. Dollar for dollar, our buildings, transportation infrastructure, and college graduates are no better now than a generation ago, Social Security continues to offer a substandard basket of disability and life insurance and retirement annuities, and our healthcare outcomes, as measured by mortality and morbidity rates and patient satisfaction, have improved relatively little, especially compared with those same outcomes in some other rich nations, like Switzerland. Yet all four services cost a lot more in inflation-adjusted terms than they once did – Social Security tax rates have risen over a dozen times, for example, and everyone knows about the soaring costs of tuition, health insurance, and construction services. As a consequence, those sectors swallow ever larger percentages of our GDP or total national income. Healthcare expenditures, for example, continue to soar towards 20 percent of GDP, or approximately the economy’s arm and leg.

The economy is littered with other trouble spots as well -- like military defense contracting, 401K administration, and automobile manufacturing and repair -- that I just don’t know enough about to discuss at present. But I heartily encourage others to do so using my theory of FUBAR-nomics, or the causes of economic hyper-dysfunction.

The core cause of the economy’s plight, I believe, is our society’s collective inability to first identify and then ameliorate what I call hybrid failures. No, not a Prius that won’t start but rather complex combinations of market failures and government failures that fester for decades until the infected sector or industry functions so poorly that vaguely obscene military acronyms become apropos. To understand my thesis, one must of course know a little bit about both market and government failures. After quickly reviewing some examples of each, I’ll then describe how they combine to suck the life out of some of the most important parts of our economy.

Market failure is the term that economists use to describe 5 situations in which markets do not function in the neat ways described by Adam Smith.

One: market power, or the ability of some sellers -- monopolies and cartels for example -- to make prices, generally by imposing their will on supply, rather than to take prices from the market as competitive firms must.

Two: public goods, or goods -- which is to say merchandize or services with a positive value -- that no seller could profit from by providing. National defense is the classic example but I like to expand the concept beyond the military to the Lockean trinity of protection of life, liberty, and property, the end all of all good governments.

Three: externalities, or situations where some of the costs or benefits of a good are not included in its price. Pollution is the classic example of a negative externality, one where some of the costs of production are not internalized by the polluter, who responds rationally by producing more goods and hence more pollution, than it would have if it had to bear the costs created by the pollution. Education is the classic example of a positive externality because some the benefits of education do not accrue to the student. More on that one later.

The fourth type of market failure is asymmetric information, or disparities in the quality or quantity of information possessed by the buyers and sellers of a good. There are three main varieties, adverse selection, moral hazard, and agency problems. The classic example of adverse selection is the lemons problem, the high probability that the purchaser of a used automobile in the person-to-person market who doesn’t know much about cars will pay too much. The most famous example of moral hazard is burning down the barn or shop for the insurance money. Agency problems are perhaps best exemplified by the shiftless fast food chain employee that we’ve all encountered or, in my case, was, albeit for a brief period.

The fifth and final type of market failure are asset bubbles, or periods when investors pay more for specific assets – sometimes land, sometimes equities, sometimes gold, sometimes Merino sheep, sugar beets, or other agricultural goods – than fundamental variables like interest rates suggest that they should. Some economists dispute the existence of bubbles, or at least definitions of them that assert the irrationality of bubble participants. That reminds me of a joke: “When an economist says the evidence is mixed, she means that theory says one thing and data says the opposite.” Whether they are rational or not, bubbles have certainly existed in the past and there is no indication that they are extinct.

Almost all economists agree that market failures exist but more libertarian slash Republican leaning ones tend to downplay their importance while more socialist slash Democratic ones seem to think that all markets are deeply infected with one or more failures. The opposite reaction occurs with government failures – libertarian-style Republicans see government failures everywhere and uphold them as the key problems to solve while liberal Democrats ignore or at least minimize them.
Government failures come in many different flavors but are most easily understood with reference to competition and incentives. No organization – government, non-profit, or for-profit – is likely to meet its goals in an effective way if it is cloistered from competition AND if the incentives of its employees are not clearly aligned with the organization’s goals. That is because a dearth of competition allows an organization to wax fat and inefficient and employees tend to do precisely what they are rewarded for doing.

Governments rarely face much competition, which is often legislated away. No bank, for example, can compete with the Federal Reserve’s monetary policy or regulatory powers; the Post Office has a legal monopoly on first class mail, which used to be important; in many municipalities it is illegal for anyone but local government employees to collect homeowners’ trash. And so on and so forth. Due to the government’s monopoly or quasi-monopoly power, customers need the government but the government doesn’t need the customers. Agencies like the DMV – those of every state are about equally notorious – are the result.

Compounding the lack of competition is the fact that most government employees are paid a salary based on the number of years that they have been employed. That incentivizes them to do the bare minimum, which they understandably negotiate to the lowest possible level, and also persuades them to NOT innovate because introducing new ideas might be seen as “rocking the boat” and lead to dismissal or undesirable assignments.

Thankfully, we live in the worst form of government except all the others, a democracy. So the public sometimes gets so irate at government inefficiencies that vote-hungry politicians take notice and implement some reforms. Were it not for that, and the occasional public-spirited do gooder, I suspect many government clerks would still be using quill pens. … I’m only half joking.

If you perceive from these comments that I lean toward libertarianism … kudos! … you’re paying attention and are an astute student of the subtleties of language and rhetoric. But I’m far from the anarchic end of libertarianism and in fact embrace so-called “pragmatic libertarianism,” a term applied to my thinking in a review of Fubarnomics that appeared in the Los Angeles Times early in the fall term. I’m not trying to score ideological points but rather am attempting to move public discussion out of the steep partisan ravine into which it has fallen. Instead of blaming market failures for our economic ills as Democrats tend to do, or government failures as Republicans tend to do, I argue that the FUBAR parts of our economy stem from combinations of the two. What that means in practical terms is that both sides hate me. …

Examples taken from the book are the easiest way to proceed next. The recent financial crisis -- you know the one that caused a worldwide recession and that injured the livelihood or savings of almost all Americans -- was caused by both market and government failures. The latter included all the artificial props to home ownership that various parts of the government implemented over the years as well as said government’s inability to see the Frankenstein it was unwittingly building in time to stop it from burning down the neighborhood if not the entire town. The mortgage interest deduction combined with the retirement savings tax structure rewarded people for staying mortgaged to the hilt and using their savings to speculate in the stock market, albeit via favored intermediaries rather than directly. Ironically, that led to LESS homeownership, as measured by the total equity invested in homes rather than the government’s preferred metric, the percentage of households who owned nominal amounts of equity in a house. That, in turn, led to an Alanis Morrissette-sized irony: homeownership was supposed to give people a stake in their communities and governments but the bass ackwards way that home ownership was encouraged actually decreased people’s commitment because they had so little of their own money invested. Instead of paying off their mortgages and owning their homes outright as in the pre-Depression period, most Americans today are essentially renting from the bank in exchange for an equity put option sweetener.

The most obvious market failure in the recent financial crisis was an asset bubble, or rather several of them. Homeowners paid too much for houses and lenders and appraisers were complicit. Please bear in mind that the conclusion that people were paying too much isn’t hindsight: every housing affordability metric, including the Price-Rent Ratio, was setting off more alarms than a high rise fire. Investors, goaded on by paid cheerleaders like the ratings agencies, also paid far too much for fancy securitized mortgage products like mortgage backed securities and collateralized mortgage obligations. Again here, some observers correctly perceived the bubble, arguing that no financial alchemy could turn a bundle of 125 percent LTV loans made to major credit risks into a golden opportunity.

Another major market failure contributing to the financial crisis was the principal-agent problem, though certainly asymmetric information and negative externalities were also present to some degree. In a nutshell, investment banks morphed from private partnerships into publicly traded joint stock corporations in the 1970s, 80s, and 90s but the new owners, mostly institutional stockholders, did not take effective control of the new companies, employees did. Exploiting our greatly weakened system of corporate governance, itself a hybrid failure, those employees compensated themselves both liberally and in a dangerous way. Basically, they created a game of “tails I win, heads you lose” that rewarded them for taking large, short-term bets. If a gamble paid off, they made literally millions of dollars in bonuses. If a gamble failed, they personally didn’t lose anything except maybe a job, one that after several years of large bonuses they no longer needed because they had already made enough to live out their days not just in the lap of luxury but in its very loins.

Sure there were some boneheads on Wall Street who didn’t understand what they were doing or who were fooled by the smoke and mirrors of fancy equations and theories. But most knew that it was not a good long-term business strategy to make adjustable rate loans to so-called NINJAs – borrowers with No Income, No Job or Assets. But Wall Street bigwigs didn’t care because they were not paid to care about next year, let alone next decade, they were paid to create short-term accounting quote unquote profits.

Custom construction contractors, by contrast, are paid to complete homes, office buildings, roads, and other types of built infrastructure. Its close connection to concrete reality, however, does not make custom construction immune to the hybrid failure disease. As you may know, most construction projects are over-budget, late, and/or under-quality. Unsurprisingly, productivity in the sector has been flat for decades, meaning that each inflation-adjusted dollar put into a construction project creates no more building, bridge, or tunnel than it did when I was born in 1969. So far over my lifetime, however, productivity in the manufacturing part of the economy has increased several fold.

The main market failures in custom construction are asymmetric information and market power. Owners and their minions cannot see everything that a general contractor does, or doesn’t do, and the general contractor cannot monitor all of his sub-contractors 24/7. The reasonableness of change orders, essentially increases in project costs, cannot therefore be accurately assessed and even if they could a construction company already on the job can be replaced only at considerable cost. Once a bid is won and a company is on the job, it is a near monopolist. Bids are therefore not an offer of a fair price but rather a strategic game, the sole goal of which is to win the job so that profitable change orders can be submitted. If an owner refuses to comply, profits can be extracted in other ways, by slowing down production or using inferior techniques or materials.
Yes, government officials inspect most buildings during construction but only to ascertain if they are up to code, the local minimum standard in other words. They do not verify that the materials or techniques specified in the contract have been actually utilized. Building inspections and codes are one of the government failures in the construction sector. They tend to be outdated and cause needless delays and their idiosyncrasies from municipality to municipality also help to keep construction firms smaller and less efficient than they would otherwise be. Governments also interfere with construction wages and labor conditions and help to perpetuate the flawed bidding system just described.

Before somebody in a hard hat takes a pot shot at me, I should describe the hybrid failure at the heart of ever rising college tuitions. As mentioned previously, the market failure in education is a positive externality. Specifically, if left to their own devices individuals would acquire less education than is socially optimal. Highly educated people, the standard argument goes, make better citizens and dinner party guests and are also more creative and innovative in ways that often enrich our culture and economy without necessarily enriching educated individuals. Ergo, the government needs to subsidize higher education. As a professor at a college that receives sundry government grants currently speaking at said college, I wholeheartedly endorse the standard argument.

Where I part ways with the status quo, however, is with the payment of educational subsidies to schools rather than to students. By supplying a large portion of higher education themselves, governments actually fail us. By and large government schools are not as efficient as private ones. Instead of investing in undergraduate education, most state schools invest in research, often of the most careerist, least socially remunerative types, and in lobbying legislators for more funds. Like other government entities, in other words, state university systems tend to bloat bigger than South Dakota roadkill … in July!! Private colleges often suffer the same fate, but generally to a lesser degree because they are less assured of receiving subsidies.

One major problem with colleges and universities of all types is that -- from the richly endowed private Harvard University to the public University of Virginia to the for-profit, stockholder-owned University of Phoenix – they all consider professors to be mere employees. That, I sincerely believe, is a major mistake because professors are professionals, the heart and soul of their institutions. Treating professionals as mere employees exacerbates agency problems, leading to bizarre institutions like the current system of lifelong tenure. Many tenured professors continue to work hard but enough don’t to serve collectively as a rather weighty millstone around the necks of their institutions and hence taxpayers and students and their families.

Slavery was – or rather I should say is because it persists in many places in the world – another hybrid failure. The government failure was allowing one person to own another, a clear violation of the enslaved’s natural right to liberty. Had the government failure ended there, slavery in the antebellum U.S. South probably would have petered out, as it did in the North, because slaves were not very efficient workers. Slaveholders didn’t have to pay them a wage but they had to pay a purchase price for them and feed and clothe them, even when they were sick or there was no work for them to do. Even more costly, slaves resisted bondage in a wide variety of ways, ranging from outright rebellion to working soft and dumb instead of hard and smart. As a result, slavery was generally unprofitable unless slaveowners could cajole the government into assuming some of the control costs of their peculiar chattels, which of course they did up until the Civil War. Slavery, then, was in a sense a negative externality, a form of pollution that planter-controlled governments not only countenanced but abetted far too long.

Rapidly rising healthcare costs are also caused by a hybrid failure, one almost completely unaddressed by so-called Obamacare. Health insurers suffer from adverse selection and moral hazard. More specifically, sick and sickly people are more eager to purchase insurance than healthy ones are and people who have insurance are more likely to seek medical attention, and more expensive varieties of medical attention, than uninsured people are.

The health insurance industry was well on its way to ameliorating those problems when the Great Depression struck and mucked things up. Then the government interceded in very damaging ways. First, the government literally regulated an entire genre of small mutual health insurers, fraternal benefit societies, out of business. That was damaging because small mutual insurers were very good at limiting adverse selection and moral hazard by carefully screening insurance applicants and monitoring claimants. Next, the government used the tax code to encourage employers to offer health insurance as a fringe benefit. That was damaging because employer-provided health insurance essentially de-coupled the cost of insurance premiums from the cost of healthcare by encouraging people to seek the best doctors rather than the most cost-effective ones. It also abetted pre-existing condition clauses and, given our extremely flexible labor markets, swelled the number of uninsured individuals. The government also became a little too friendly with the American Medical Association, which restricts the supply of doctors. Because of their artificially limited numbers, doctors have the market power to insist on being paid for seeing patients rather than returning them to health, another major flaw in our post-Depression system of which more a little later.
The government also responded in damaging ways to the retirement savings crisis created by the Great Depression. Social Security, in short, was a permanent solution to a temporary problem. The concept of retirement was more or less unknown until the late nineteenth century. Before then, numerous well-to-do Americans stopped working before they died but there was no widespread expectation that most people’s final years would be spent outside the labor force, except in cases of disability or dementia. As increasing numbers of people began to outlive their ability or willingness to work, families began to save for what came to be known as retirement by purchasing real estate outright and by investing in savings bank accounts, life insurance policies and annuities, and stocks and bonds. As a result, there was no epidemic of impoverished old folks leading up to the Depression. Some of the aged were indigent but most, in fact, were able to live off their savings, inherited wealth, and/or contributions from their children.

The Depression pinched those resources, however, by decreasing the value of real estate, stocks, and riskier corporate bonds, by throwing older people out of work sooner than expected, and by decreasing the ability of their children, many of whom were unemployed as well, to aid them. If the government had simply provided indigent seniors with direct monetary aid and not created Social Security, prudent Americans today would save for retirement at much higher levels than they currently do and would be much more astute about matters of personal finance. Instead, the government took a very different path that threatens to cause tremendous economic and possibly political instability. It strikes me as more than a little un-democratic that long-dead politicians, now accountable only to God or, more likely, Satan, should be allowed to burden posterity with such unnecessary legislation.

In case any of you are wondering, the Great Depression itself was a prime example of a hybrid failure. It began due to a real estate bubble and was exacerbated by the stock market crash of 1929, two clear market failures. But the numerous bank failures that followed were actually government failures caused by regulations that prohibited branch banking in most states. That left most banks small and hence vulnerable to local and national shocks that a wing of the government, the Federal Reserve, did not adequately address even though macroeconomic stability was its stated mission. A single policy, Roosevelt’s devaluation of the dollar, was sufficient to bring the economy out of the Depression. The rest of the New Deal was a mixed bag comprised mostly of government failures like the Agricultural Adjustment Act and the National Industrial Recovery Act. Even the Federal Deposit Insurance Corporation, which stabilized the deeply flawed Depression-era banking system by guaranteeing retail bank deposits, helped to cause subsequent financial crises, most notably the Savings and Loan crisis, by rewarding bankers for taking on excessive risks. The bastard offspring of the S&L crisis, the infamous Too Big To Fail Policy, played a major role in the most recent crisis.

Additional details on the financial crisis and all of the other topics touched on here today can of course be found in Fubarnomics but now I would like to sketch out the book’s recommendations. It is important to note that I do not think that any of these solutions are possible in today’s political climate, although the results of the recent election may have brought us closer to some of them. I offer them in the hopes that they will be discussed, critiqued, and revised so that they may be implemented when politicians get serious about fixing the economy and make the policy changes that will unleash the entrepreneurial energies under girding each recommendation. I should make clear at the outset that all of my recommendations essentially entail reversing or untangling the hybrid failures that cause the economic dysfunctions just discussed.

If we don’t want another gut wrenching financial panic and economic downturn, the government should:

1) abolish GSEs, or government-sponsored enterprises, including Fannie Mae and Freddie Mac. Andy Jackson called the GSE of his era, the Second Bank of the United States, a hydra-headed monster and he was right. Figuratively speaking of course. If an enterprise is profitable, the government doesn’t need to subsidize it. If it isn’t, and we’re sure it involves a public good as previously defined, then the government itself should provide the good.
2) reform credit rating agencies so that they actually assess credit risks again instead of merely pandering to issuers as they have the last few decades. That will entail returning to a subscription-based revenue model and eschewing payments from issuers, a business model that turned into a form of ratings-for-payment bribe.
3) expunge Too Big to Fail Policy from businesses’ expectation set by making it clear that if any company runs into difficulty it will be allowed to fail. Streamline bankruptcy reorganization procedures, especially for financial institutions, so that the threat is credible.
4) learn to learn from past mistakes. The subprime debacle of 2007 was not the first time that a mortgage securitization scheme in America blew up. It was the seventh. No kidding. Fool me once, shame on you. Fool me twice, shame on me. Fool me seven times and … that is, as they say in Boston, “wicked retawded.”
5) reward regulators for regulating intelligently, for discouraging bubbles, and for acting before matters get out of hand. The status quo is to reward regulators for preparing to fight the last crisis rather than the next one, a flaw that also pervades the TSA’s so-called thinking. But that is another conversation.
6) improve corporate governance by mandating deferred compensation or bonus-malus systems where ever and whenever appropriate, which would include at least some positions in most financial services firms.
All of those proposals have been made by others, but no one else, to my knowledge, has recommended all six.

The construction industry can be fixed by moving away from the current system, where numerous small firms compete based on their strategic bidding and change order skills rather than on their efficiency. Governments and private firms should choose the best bidder, not the lowest one. The best bidder could be ascertained more easily if someone had the incentive to track construction company and individual performance over time. Eliminating the bidding system altogether could work as well, as in new construction systems where architects, designers, and contractors are compensated to develop change order proof plans, or in other words are paid by owners to dramatically reduce both asymmetric information and post-contractual monopoly power. A recent book, the Commercial Real Estate Revolution by Rex Miller and others, essentially calls for the same reform, though for a less compelling reason.

Higher education would be vastly improved if professors were allowed to own their own colleges in professional partnership. Instead of being mere employees, they would be professionals akin to attorneys or business consultants and would have long-term incentives to provide students with the most inexpensive, highest quality undergraduate and graduate educations possible. Under such a system tenure would dissolve of its own weight but academic freedom, the right of tenured professors to say pretty much anything they want to without fear of being fired, would be priced in the market. A professor who is a partner in a college organized as a professional services firm could not be dismissed, he or she would have to be bought out by the other partners, essentially pricing tenure and academic freedom.
Other salubrious reforms would include the government allowing more competition in higher education, the creation of a system of standardized exit exams, the payment of subsidies only to students and not to schools, and passage of a GI-like bill expanded to include a wide variety of public service, not just military duties. Again, almost all of these ideas have been proffered by others, but never as a complete package designed to eliminate the hybrid failures at the heart of rising tuition costs.

The cure for slavery is economic development. Ironically, economists have a very poor track record at creating economic growth in poor countries. That is why vast swathes of Latin America, Africa, and Central Asia continue to suffer with per capita incomes not far above the subsistence level. A growing consensus among an interdisciplinary group of scholars who study the wealth question, however, suggests that national wealth is largely a function of institutional quality, particularly whether the government adequately protects life, liberty, and property or not. Where it does not, poverty is certain, even if oil or diamonds are present. Where it does, wealth is certain, even in barren, windswept places like Iceland … and South Dakota.

Of course dictators control most poor nations and most do not behave as enlightened despots and protect life, liberty, and property of their own accord. I suggest in Fubarnomics that dictators can be rewarded for providing such protections through the judicious use of aid and carefully designed long-term compensation schemes. It’s a long-term fix that won’t alleviate the suffering of all people enslaved today but will help to prevent the enslavement of future generations because slavery is highly unprofitable where governments are against it and where wage laborers are abundant and efficient, as they are in developed economies.
Speaking of enslaving future generations, it is now time for the big two, Social Security and healthcare. Seriously, the former might survive intact if the economy grows really robustly. If growth is anemic, as some fear, Social Security could be extended indefinitely by some combination of tax increases and benefit cuts, including raising the retirement age. My recommendation, however, is to simply eliminate it for myself and every younger than me and to pay the promised benefits to everyone older than me out of general revenues. My rationale here is that younger people still have time to save for retirement but older Americans don’t. Moreover, Social Security payroll taxes are highly regressive and the payout structure is distorted towards preferred groups. As a whole, the system redistributes wealth from poor minority men to middle class white women, a rather cruel and ironic outcome especially after, say, 1970. The structure of the system and demographics virtually ensure that poorer Americans, especially those from disadvantaged minority groups, almost never receive even modest inheritances, a leading spoke in the wheel that perpetuates the cycle of poverty. Due to the payroll tax, the poor can’t afford much whole life insurance or other asset building financial products.

I wouldn’t replace Social Security with anything other than the government’s solemn promise that when people my age and younger get old we will be on our own so we had better start saving now. And don’t worry about silly claims emanating from mass media outlets about the negative effects of higher savings rates on consumption. Via the financial system, one person’s savings becomes another’s consumption. We also need a much better, longer, and more comprehensive system of personal finance education, ideally supplied by teachers and professors in professional partnerships of course. I don’t want to hear any of this bull puckey about “privatizing Social Security” or “investing in the stock market.” Proper investing starts with rainy day savings, preferably in low-cost depository institutions like credit unions, then moves on to insurance, and only then moves on to well diversified portfolios of financial securities, derivatives, and commodities, portfolios that become less risky as the investor’s target retirement age approaches.

Finally, we also need much less but much better financial system regulation. The topic is too detailed to delve into during this talk but suffice it to say that pre-Depression historical precedents suggest that intelligently regulated financial markets and intermediaries can provide Americans with solid private security in a much fairer way and at a much lower overall cost than Social Security has done. Recent and current problems with pensions, 401Ks, life and disability insurance, and other private security products are due to relatively minor hybrid failures that could be fixed in fairly short order if desired.

That leaves us with health insurance. As hinted at previously, healthcare costs would stabilize and perhaps even decline if doctors were rewarded for healing people rather than merely treating them. That may sound like a radical idea but the U.S. healthcare system was moving in that direction when the Depression struck and the government sent us down a very different path. They were called prepaid plans. People paid monthly fees when they were healthy and stopped paying when they were sick. Healthcare providers therefore had strong incentives to keep people from getting sick in the first place and to fix them up quickly if they did fall ill. Today, doctors in most parts of the United States have incentives to keep patients sick. And don’t even get me started on pharmaceutical company incentives.
Another salubrious change would entail the creation of large mutual health insurers, under a general agent sales system, that offer joint life and health insurance policies that I call “health for life.” Mutuals are for-profit corporations owned by their customers, in this case their policyholders. Their profits accrue to the policyholders and to their general agents, which like large blockholders in joint-stock corporations serve to keep the companies’ executives on task. The joint policies would commit insurers to providing large sums for healthcare by promising a life insurance payment as well as health insurance. A rational company would pay healthcare costs up to the discounted present value of the life insurance due multiplied by the probability of treatment success. It’s called incentive alignment and it works much better than government mandates likely to spur premium increases or, if that avenue is blocked, exit from that line of business.

In addition, for a given premium level the life insurance benefit would decline as more healthcare was used and increase if relatively little was utilized. That would help to reduce the adverse selection problem by inducing healthy people to buy more health insurance. “Health for life” policies would also force insured persons, especially those near the end of their lives, to decide between living a few extra months and leaving an estate for their heirs, a vast improvement over the current system which more or less rewards people for receiving as many final treatments as they can get insurers or the government to pay for, no matter how expensive or futile. By leaving the final choice to the individual, “health for life” policies would be far preferable to any sort of non-price rationing system, fictional or factual.

Again, most of these ideas are not entirely original but no one else has offered them all and no one else to my knowledge has a set forth such a clear theory of the causes of such a wide range of economic hyper-dysfunction. I therefore encourage you to buy Fubarnomics, read it, and post 5-star reviews of it on Amazon. … But I also encourage you to critique any aspect of it that you think does violence to reality because, again, my goal is to have policies ready if and when politicians are prepared to save our economy from dying by degrees.

Thank you! I’ll now entertain a few questions.

Why won't Jon Stewart of the Daily Show read Fubarnomics???

2010-11-17T18:13:00.000Z

Don't get me wrong. I love The Daily Show with Jon Stewart and watch it at first airing most nights. And I realize that part of Jon's schtick is to pretend he is less intelligent and more ignorant than he actually is. But why won't he read Fubarnomics, or at least the chapter on the recent financial crisis? I sent him a copy over the summer and understand that he can't have every author on his show, which airs only 4 nights a week and only like 40 weeks a year. But if he would read it for his own edification, he wouldn't have to submit his audience to long rambling interviews like the one last night (11/16/10) and embarrass himself by positing inane hypotheses.

Credit cards for students (and spouses)

2010-11-09T15:51:00.000Z

Students often ask me for advice about their personal finances, especially credit cards. Henceforth I will point them to this site:
10 Things College Students Should Know About Credit Cards and eagerly await the day they have a site "100,000 things spouses should know about credit cards." ;-)

Kudos for this blog.

2010-11-09T15:32:00.000Z

The last week was ... wow ... very hectic. I received notice that this blog has been rated one of America's Top 50 American History blogs by History Masters! Check it out, #36.

South Dakota: Not North Dakota but Waaaaay Better than California and Just About Everywhere Else!

2010-10-22T14:27:00.000Z

I gave this speech yesterday morning at the Westward Ho! Country Club in Sioux Falls, SD at the first annual commercial brokers meeting.

South Dakota: Not North Dakota but Waaaaay Better than California and Just About Everywhere Else!

By Robert E. Wright, Nef Family Chair of Political Economy, Augustana College
As you are probably aware, North Dakota is doing pretty darn well economically. In a sense, it is a much closer, slightly warmer version of Alaska. It isn’t as visually stunning as Alaska and it has many fewer bears, especially of the larger and scarier varieties, but like the Last Frontier state, North Dakota is blessed with ample energy resources. The massive Bakken Oil field, which may hold more oil than in Saudi Arabia, extends into North Dakota as well as Montana and Saskatchewan. Unfortunately, a lot of that black gold is trapped in shale but for now the bigger pockets, some two miles down, are being profitably tapped and technology improvements may help our northern neighbor surge past Alaska in terms of oil production by the end of this decade.

Thanks in part to its western oil fields, and oh yeah its 800 year supply of coal, North Dakota has the lowest unemployment rate in the country, just 3.7 percent in August of this year, the most recent month available as of Monday of this week. South Dakota’s unemployment rate was about 21 percent higher than that but was still second lowest in the country, just a hair ahead of Nebraska. At 4.5 and 4.6 percent respectively, those two states look like employment heaven compared to almost everywhere else. New Hampshire, number 4 on the list, is at 5.7 percent, followed by neighboring Vermont at 6 flat. But it is pretty much all downhill from there, with California, Michigan, and Nevada in the ditch at the bottom of the hill, at 12.4, 13.1, and 14.4 percent respectively. And remember those rates are for people still looking for work. They don’t count people who have given up trying to find work, a number that probably grows exponentially with the official unemployment rate. In other words, those places are much worse off than the government statistics suggest.

The unemployment rate is a good proxy for economic growth, or per capita increases in the output of final goods and services. North Dakota’s economy grew by a scorching 7.3 percent in 2007 and 2008, the most recent years available. Wyoming was second at 4.4 percent and South Dakota third at a respectable, if relatively plodding 3.5 percent. Those were years when the economies of numerous states, including those of Michigan, Indiana, Ohio, Georgia, Florida, Nevada, and Arizona shrank and a slew of others grew anemically at less than 1 percent.
Finally, population growth in both Dakotas from 2008 to 2009, while hardly breakneck, was a respectable 1 percent flat here and .8 percent up there, ranking South Dakota 20th in population growth rate and North Dakota 23rd. Wyoming, by the way, grew fastest of all at 2.1 percent but still remained our least populous state with only slightly over half a million souls. Yes, I do believe that most Wyomingites have souls, probably a higher percentage than many other parts of the country in fact, but the Census Bureau doesn’t track that, just bodies.
But I digress. What I am trying to say is that instead of lamenting North Dakota’s advantages, the denizens of South Dakota ought to first take pride in what they have accomplished already and then seek to make further improvements, partly by intelligently emulating successful policies in North Dakota and elsewhere but also partly by striking off on its own, unique projects.

For example, North Dakota has a government-owned bank that is attracting considerable interest. Even the Minnesota Fed has looked at it. It acts as a correspondent bank that strengthens North Dakota’s network of community banks and it actually contributes to the government’s coffers. Colonial Massachusetts, New York, Pennsylvania, and some others had a similar institution. South Dakota should look into it, than if for no other reason we’ll have a bank capable of issuing fiat paper money when the dollar collapses. I think we should call that money SOTAs and the symbol will be a bison -- with two lines running through it because all the best currency symbols have two lines running through them. [When will I learn to never, ever make monetary policy jokes? -OR- I’m happy to see some of you share my bitterly cynical and sarcastic sense of humor.]

What does South Dakota have going for it? As the title of this talk suggests, its economy is really quite vibrant compared to that of every other state except those of some its immediate neighbors, especially the one to the north. The explanation for South Dakota’s relative success is relatively straightforward. Rob Oliver, Augustana College’s president, likens South Dakota to the tortoise in the famous tortoise and hare Aesop fable. That’s the one where the tortoise wins the race because the rabbit is busy showing off and napping while the tortoise plods steadily along. In slightly more sophisticated parlance, some places take big risks and take seemingly insurmountable economic leads until they inevitably collapse from some malady or misfortune or another brought on by their hubris. Other places, like the Ota states, play it safe and steady and hence don’t suffer when economic calamities strike.

There’s a lot of common sense in taking the slow road. South Dakota was not a hotbed of subprime mortgages or mortgage defaults and most of our banks and other financial institutions held firm. But it might make even more sense to try to develop what I’ll call – extending Rob Oliver’s animal analogy -- a raccoon economy. Yes, I know that dead raccoons litter South Dakota’s highways and byways but that carnage, believe it or not, is an integral part of a successful raccoon economy. Follow me here: the companies that are slow afoot and/or slow upstairs [point to head] need to get run over so as to free up resources for the more nimble and quicker raccoons. Due to that selection process, raccoons as a species are amazingly successful, managing to thrive in a wide range of environments, from forests to prairies to cities. The mischievous critters get into closed garbage cans and chow down, then sneak undetected into heated attics or crawl spaces in winter. In other words, I’m talking about developing an economy that is adaptable and clever, though not nearly as crafty as a Wall Street fox, about emulating a critter that isn’t as fast as a rabbit but works hard and smart and is much faster than a damn turtle and a lot nicer than a Wisconsin badger. We just have to be careful not to turn the economy into a skunk in the process. We have more than enough of those back East, out West, and down South. And in Michigan, the stinkiest of them all.

Fiscal policy is a good place to start. South Dakotans have to keep the state government not “lean and mean” but “nice and lean.” Not having a state income tax is a great feature but only if taxpayers don’t instead get pecked to death by a thousand little duck taxes. It’s not that bad here – yet – but eternal vigilance is the price of liberty as somebody famous – not Thomas Jefferson – once wrote. I have some other suggestions about taxation too but I am not going to make them as I don’t feel like getting shot at today. [Pause] Seriously, tax policy is very important but it’s a political minefield and a very complex area because of what’s called tax incidence. Just because somebody doesn’t get handed a tax bill doesn’t mean that they aren’t ultimately paying the tax. The so-called employer contribution to Social Security, for example, is pretty much pure bunk as most economists agree that workers almost always foot the full bill, half from their explicit contribution and half from a lower wage. Similarly, taxes on large businesses often fall largely on employees and consumers rather than on the owners. So you sometimes find people supporting taxes that will gore their own ox or fighting taxes that will actually be paid mostly by others.

Oliver Wendell Holmes was right when he said that taxes are the price we pay for civilization but most Americans, and almost every South Dakotan I’ve met to date, thinks we’re quite civilized enough already, thank you very much. If so, what we might all be able to agree on is the desirability of government making a credible commitment to limit the size of the state or, better yet, the state and municipal governments, to some percentage of state GDP. That would essentially force South Dakota governments to 1) not pass stupid, growth negative laws and 2) to concentrate their efforts on core areas, like law and order, and outsource the rest to the market.

South Dakota is ahead of the country here but could move even further ahead. I was pleasantly surprised to learn, for example, that private companies can pick up garbage in Sioux Falls. Believe it or not, in some parts of this great nation of ours municipal governments monopolize household garbage collection. It’s totally absurd but so well-entrenched that when I suggested privatizing the system at a public meeting when resident in one of those places many of my neighbors retorted with claims like “that couldn’t possibly work,” or “it would be chaos,” or “Duh, look at me, I’m a dumb ass Socialist.” Okay, I made the last one up but the rest of the story is true.

I broach it because there is a movement afoot to privatize roads in the U.S.A. For more on that, check out Clifford Winston’s new book, Last Exit, published by the Brookings Institution, a Washington-based think tank. Yes, occasionally a good idea comes out of that place, mostly from think tanks. In any event, when people first encounter the notion of road privatization, what most hear is “they want to charge me tolls to drive anywhere” and while that is true what folks tend not to grasp is that the tolls would be lower and fairer than the taxes they currently pay at the pump and elsewhere. Private companies would have incentives to make much better, longer-lasting and less congested roads than the government does so in-kind taxes like construction delays and traffic jams would be much lower too. The first state to privatize its road system – or I should say re-privatize its road system in the case of the eastern seaboard states, which were first crisscrossed by private toll roads -- would of course spawn the creation of start ups that would be eager to expand operations into other states once they too jump onto the privatization band wagon.

Schools are also ripe for privatization. The process here is on-going and taking baby steps with charter schools and vouchers. If South Dakota were to go whole hog and privatize its entire system, K through graduate school, it would foster start ups and also entry by existing for-profits. But again, such proposals must be pitched so that they can be heard by voters as “increased efficiency” rather than “those som’ beeches wanna take away our free schools.” Let’s face it, public schools are not free, they are very costly, especially for what some of them produce, which are people who know little and can’t do much. Others of course do a superb job but they could do an even better job with the same personnel provided with a more robust set of incentives. Among other things, I discuss the rationale and possibilities of privatizing higher education in more detail in my recent book, Fubarnomics.

Speaking of education, I attended a conference called the Innovation Expo last week at the Ramkota Hotel where there was much discussion of leveraging the state’s higher education assets for economic development. North Dakota has a great student-run venture capital outfit called Dakota Venture Group that has already helped to launch at least six new businesses: three software companies, a medical technology company, a furniture manufacturer, and a night club on wheels. And that last one is no joke!

Augustana College is starting something similar. I mean a student-run venture capital fund not a mobile Sodom and Gomorrah. The fund will help in the short term by funding start ups and in the longer term by increasing South Dakota’s human capital venture network. We hope our graduates will stick around and start their own funds in other words.

Many of us are also trying to fire up students about entrepreneurship. I taught a class in the history of entrepreneurship at Augie last spring, for example, and at the Innovation Expo last week many students from USD and SDSU were in attendance and the Enterprise Institute announced the winners of a student idea competition. Encouraging young entrepreneurs is really promising because entrepreneurship suffuses the air and water out here. What it tends to lack is direction. Some explanation may be necessary here. Entrepreneurship is generally great for economic growth but it’s not a monolithic thing. There are bad varieties of entrepreneurship where firms, or “families” or gangs, engage in rent-seeking or illegal activities. You know, the sort of stuff that thrives in Tony Soprano’s part of New Jersey. And Washington DC. Except for the drug trafficking, which apparently mostly takes the form of drug traffic, we don’t have too much of that out here and of course don’t want any more.

Another variety of entrepreneurship, called common or replicative entrepreneurship by some, is the type that thrives in South Dakota and other tortoise-esque economies. You know, micro to small businesses and franchises of regional or national chains. It’s good and it’s important but a raccoon-quality economy requires more, it requires some innovative entrepreneurship that leads to new goods and services, things that South Dakotans can export to other states, regions, countries, or continents.

As I learned at the Expo, we have some of those. There is an outfit selling wine made from South Dakota grapes – that’s not an oxymoron it turns out – South Dakota grapes into a nice business by stressing the marketing rather than the quality of the wine per se, which most people find less than extraordinary until third or fourth glass. Anyway, each bottle sold by this homegrown winery comes with a removable charm around its neck and sports some interesting looking labels, some of which were designed by Augie students I should add. There’s another startup out in Mitchell making fishing rod holders that can be installed without wrecking your nice fiberglass boat. Another dude figured out how to test beef cattle for certain genes that affect the marbling and texture of their muscles within a few minutes, right in the field, so that the ungulates can be sorted and fed accordingly.
That’s all great, even freaking great, but South Dakota could use more. We don’t want a rabbit economy so we don’t need entire warrens of innovators, especially schemers contemplating projects of dubious social merit. Rather, we need a nice steady stream, a Big Sioux rather than a Missouri River of innovators, or at least a Skunk Creek the way it looked after the rains last month. [What, nobody here from the West Siiiide? -OR- I’m happy to see there are others from the West Siiiide here.]

Increasing innovative entrepreneurship is no easy task and I think it a major mistake to try to plan it in any specific way. The economy is just too complex, the connections between industries and individuals too multifarious, for any one person or group to fully grasp it enough to implement a plan likely to succeed for reasons other than pure luck. For example, who in 1820 could have predicted that my hometown, Rochester, the one in New York, would have developed into an optics center, the home of companies like Kodak, which used to make cameras, Xerox, which used to make copy machines, and Bausch & Lomb, which used to make contact lenses? But it did, because it had water driven mills designed for grinding grains and millers and engineers smart enough to figure out how to change up and begin to grind glass. You’re probably all familiar with how Silicon Valley became Internet Valley and how Wall Street stole the nation’s financial center away from Philadelphia’s Chestnut Street back in the 1830s. Oh no? Well I have a book about it you can read sometime called The First Wall Street.

My point here is that even as one industry loses strength it can spawn others in a process that economist Joseph Schumpeter famously called “creative destruction.” When and where creative destruction exists, where slow and dull-witted raccoon companies are allowed to get run over by the Mack truck that is a competitive market, economies experience ups and downs but communities live on because the people within them find new things to do. Pittsburgh is a good example. It used to be all about steel, then stealing, but now it has a nicely diversified post-industrial economy similar to ours: healthcare, education, tourism, finance, and even some ag and some military, at least before their King of Pork, John Murtha, perished. Where creativity is lacking, we’re left with just the destruction and ghost towns -- like Youngstown or Detroit. Unlike those dismal places, South Dakota isn’t reliant on just one industry, just like the raccoon isn’t reliant on just one food source.

But the South Dakotan economy could use yet more diversification. As Nevada learned to its great pain, tourism depends a lot on conditions elsewhere, the credit card business increasingly relies on regulations set in Washington, and agriculture and construction are very fickle pickles. Healthcare and higher education costs have grown year after year but that does not always translate into higher levels of growth. According to Sid Goss, a demographer at the School of Mines out West River, South Dakota’s higher education sector is going to face a serious demographic shock in a few years that could spell trouble not only for local schools and their employees but also for all businesses that cater largely to students.
On the bright side, Obama’s healthcare reform isn’t going to stop healthcare costs from rising. For more on that, see Fubarnomics or Google up some of my op eds on the matter. The gist of the story is that health care costs will continue to rise as long as health care providers are incentivized to treat patients rather than to restore them to health and as long as health care costs are hidden behind employer-provided group insurance.

The really happy news is that potential sources of innovation and growth abound here. Now one of the speakers at the Expo, a college professor and an adherent of extremist urban-philes like Richard Florida and Jane Jacobs, argued that South Dakotans are too few to have a raccoon economy. To that I have only two words: bull puckey. Or is that one word? In other words, I think the notion that you need to be in a big city to be innovative is an idea that passed through the digestive system of male cattle, if you catch my drift. In case I am not being clear here, I’m skeptical of the notion that we can’t lead in at least some areas. The professor’s argument is based on what are called spillovers. People live in cities or technology areas, like the one in North Carolina, because there are dense networks of like-minded people in those places and they cross-fertilize each other with ideas, connections, and money. That is certainly an important point but isn’t the whole story because it’s not necessarily the case that you have contact with others close by or that you can’t communicate with others who are far away. Plus the culture in cities is less open than here. People are not as nice or open – and I know because I lived in such places much of my life. For example, I barely spoke to anyone outside of a narrow circle in my decade and a half in Philadelphia but out here a guy I had never met previously took me out pheasant hunting on opening day, made sure I got my three, and then fed me afterwards. And that was made possible by the fact that my new neighbor -- a man I had just met 5 minutes before -- fixed my shotgun for me, and for free! That sort of interaction just doesn’t happen much east of the Appalachians anymore.

And let’s not forget – I know I never will – that in more densely populated areas even a few miles can be a nearly insurmountable barrier to easy face-to-face contact. I’d rather drive from Sioux Falls to Vermillion or Brookings than from one side of Philadelphia to the other. No joking there. And don’t even get me started on New York.

The egg-headed critic also failed to see that we have comparative advantages over people in more populous places that we can leverage. Besides the fishing boat guy at the Expo there was a fellow selling pickup truck bins with solar panels on them to run coolers, drills, and so forth. Now is a Bostonian going to come up with that? Or some software engineer in San Fran? No siree, says Bob.
And who else but a pheasant hunter who can’t seem to shoot straight would come up with a shotgun that uses optical recognition software to differentiate hens from roosters and that uses radar to direct number 4 steel shot only to the head and neck of the latter? Okay, that one I made up but it would be wicked kewl. In short, we can come up with stuff that we can sell to other rural folk worldwide, not to a bunch of latte-sipping, turtle-neck sweater wearing urban elitists.

Not that we should entirely give up on urban markets. Although South Dakota has little coming in the way of oil windfalls, there is a lot of wind and sunlight here just waiting to be turned into electricity. The big breakthroughs in energy storage and transmission may not come out of South Dakota universities or companies. But then again they might. A South Dakota scientist recently invented a type of paint suffused with an anti-microbial agent that will make the lives of people with compromised immune systems a lot better. But of course we don’t have to invent everything ourselves and we surely will be able to capitalize once somebody, somewhere figures out a cost effective way of transmitting the electricity created with our ample renewable sources. It would be nice if our little prairie breezes and generally sunny disposition could not only light and heat the Twin Cities, KCMO, and “““STL””” but also run the cars of the people in those places. Ours too of course. Then North Dakota can lick our boots. Just kidding, they got a lot of wind up there too.

But that’s somewhere off in the future and conceivably may never take place. In the meantime, we need more tangible routes to further diversification. Even if credit cards go the way of the dodo bird, or rather the way of layaway, the physical infrastructure and human capital employed in the industry here could be turned to other, similar uses, like call centers for other types of financial products, maybe even ones that essentially replace credit cards with less heavily regulated alternatives. That’s one of the big lessons of financial history – regulations can and will be subverted, out maneuvered, and outflanked. With a credible promise from Pierre not to interfere too much, South Dakota could become a hotbed of financial innovation, a testing ground for new ideas. I mention several in Fubarnomics and Yale’s Bob Shiller published some great ideas about 5 years ago in a book called the New Financial Order. And of course it would be natural for any company that developed a new product in South Dakota to keep its headquarters here to take advantage of the local expertise in back office operations and such.
Now I know what you are thinking – how can Pierre promise not to interfere too much? Maybe by decreasing the frequency of its meetings? I’m thinking once every four years would about do it. And oh yeah, to meet no more than one week at a time, once each quarter or season, with a very loud bell that goes off precisely at 5 p.m. each Friday to close the session. No more putting coats over clocks. That’ll give legislators some time to think about bills before they pass them and give their constituents some time to think and chime in too.

Here’s another idea. Let’s pass a constitutional amendment that requires all regulations to be thoroughly tested before being implemented or, where that is infeasible, to have sunset clauses that will automatically repeal any new regulations unless the legislature thoroughly reviews and formally reinstates them? In most states east of the Mississippi, audience members would be laughing hysterically at this point but out here those or similar ideas could stick and become a real competitive advantage for the state.

To attract and retain the innovative entrepreneurs that we don’t grow at home in our colleges and universities, South Dakota needs to be an attractive place to live. Not much can be done about the weather, at least at present, but entrepreneurs could strive to make the place more palatable and make some scratch on the side. For example, many of us ride our bicycles on Sioux Falls’s wonderful trails all summer. But what are we supposed to do with our bikes the other 11 and a half months of the year? … Yes, that’s a joke. Besides cluttering up the garage, say half the year, what about an indoor cycling range that could be used as, I don’t know, an indoor shooting range in the summer when hunters want to zero their scopes without a 30 mile an hour crosswind? An indoor water park might be a big draw too. The sun rides low here in the winter but it’s out a lot and could be magnified to allow those interested in having that “I went to the Bahamas look” to get natural tans. Maybe a retractable glass roof over the Wild Water West? It would be a way to avoid that new tax on artificial tanning booths in the Obama healthcare bill.

Speaking of healthcare, the rise of medical tourism means that Sanford and Avera McKennan could grow to enormous proportions by providing fairly routine procedures on the cheap to people from all over the continent. Yes, even some Canadians might prefer to pay out of pocket rather than wait in a line up there, especially when the looney is strong against the greenback. Of course it would be helpful if it was cheaper to fly from New York to Sioux Falls than to fly from New York to India, which also has a thriving medical tourism industry. I’m not disrespecting the local airport, which has to play the hand it was dealt by distant policymakers. I’m just pointing out a constraint that could be overcome, albeit probably only with much lobbying effort. Or a high speed train line to Minneapolis. Or Omaha. Or maybe Southwest. I mean the airline, not the cardinal direction.

Speaking of Minneapolis, I had to drive there in early September to be on the Dylan Ratigan show for 5 minutes, 5 stinking minutes. No, I was happy to do it as it boosted sales of Fubarnomics for a week or so but c’mon, it is 2010. How will the rest of the world know that there are smart people here in South Dakota if it remains so isolated? When I say South Dakota to my friends back east their responses belie the fact that they believe the entire state remains like Deadwood as depicted in the HBO series. Or at least like Humboldt, that “small town with a big heart.”

The various chambers of commerce do a good job of asserting that all of South Dakota, and not just Ellsworth, is “da bomb” but they need all the help they can get proving that such assertions have a basis in reality. Outside of the Upper Midwest, misperceptions about South Dakota abound and are as difficult to dislodge as an impacted wisdom tooth. On a polecat.

To sum up, North Dakota is up at the ceiling. South Dakota is only here [reach up as high as possible] but California and a lot of other places are down here [point to the floor] with the ant excrement. Although relatively strong at this point, South Dakota’s economy may be under performing its long-term growth potential. It could ramp up from tortoise to raccoon status if one, the government credibly committed to staying as small and inconspicuous as possible and if two, more innovative entrepreneurs can be homegrown or imported and then induced to stay by leveraging the state’s many strengths -- its great faces and open places and its fairly consistently amenable business climate.

For folks in your business, turning our tortoise economy into a raccoon one could mean retiring comfortably at age 50 or 55 instead of at 65 or 70, which I’d hope would be enough inducement to get you interested in these important big picture issues and maybe get a little more involved in state economic policymaking in a positive and proactive fashion.

I thank you for your time and attention and will now entertain questions.

The Fight Against Hospital Infections

2010-10-14T00:25:00.001Z

I've made no bones about it, America's healthcare system is very FUBAR. I concentrate on rising costs in Fubarnomics but in this post want to stress the quality issue, or rather the lack of it. Under our current system, many people die or suffer serious complications from infections they contract while in the hospital. It's a tragic (and extremely expensive) problem.

There is some hope, however. Today at the Innovation Expo in Sioux Falls an entrepreneurial start-up outfit from suburban Minneapolis, Minn. called Pursuit Vascular won not one but two prizes for a new medical device that promises to significantly reduce catheter-related infections for dialysis patients. Basically, it is an expandable tube coated with an anti-microbial that effectively seals the catheter and kills most of the nasty bugs inside it.

It was also mentioned at the expo that an anti-microbial paint is being developed here in South Dakota. Applied to hospital walls and such, the paint could also work to reduce the infection rate.

My only concern is that private insurers don't seem to have much of an incentive to force HCPs to adopt these technologies and in fact the in-hospital infection rate could be reduced pretty substantially simply by adopting and following better sanitary procedures.

Readers interested in learning more about the fight against hospital infections are encouraged to visit Kimberly-Clark's "Not on My Watch" website.

The Irony of Constitution Day

2010-09-16T19:08:00.005Z

Every 17th day of September (or adjacent week day), schools across the nation that receive federal monies (to wit, almost all of them) must celebrate Constitution Day or face loss of their federal funding.
See
http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=108_cong_public_laws&docid=f:publ447.108
then search for "Each educational institution"
and http://www.law.cornell.edu/uscode/36/usc_sec_36_00000106----000-.html.

Don't get me wrong, I love the U.S. Constitution. So much so, in fact, that I find Constitution day, well, as ironic as that little ditty by Alanis Morissette. I'm not a Con lawyer (that's slang for Constitutional attorney, btw, not a redundancy) so I won't go so far as to say that the Constitution Day law is unconstitutional but I will assert that the Founding generation would not have approved. I know that because they didn't pass the legislation though they could have. In fact, they were almost all completely opposed to the federal government providing funds to educational institutions. J. Q. Adams tried and failed to establish a national university in the 10 mile square (Washington, DC). Thomas Jefferson established the University of Virginia because government funding of education was supposed to be left to the several states.

Do I want to see the federal government stop funding education? Of course not, dummy, I'm a college professor. But I would like to see the following:
1) the federal government to stop using its money, which is after all OUR money, as a weapon, even if it is for a "good" cause like promoting Constitutional awareness, because it sets a precedent that could be used for darker purposes;
2) more controversially, to stop funding colleges and universities directly. Subsidies should be paid to students just like Adam Smith argued, in 1776 ironically enough.

See my Fubarnomics for details.

Los Angeles Loves Me!

2010-08-28T21:58:00.002Z

In addition to my recent appearance on an L.A. radio show, Fubarnomics was recently reviewed, fairly favorably at that, in the L.A. Times.

I have no current plans to visit the place again, though I might be singing a different tune come January-February!

Wright v. Krugman!

2010-08-17T14:33:00.002Z

In my never ending quest to spread the word about Fubarnomics, I've taken on Paul Krugman. That's a lot easier than it sounds these days:
http://dailycaller.com/2010/08/17/paul-krugman-and-the-real-problems-with-social-security/

I also had an op ed in the Sioux Falls Argus Leader and soon will be on a radio talk show in Los Angeles.

Fubarnomics

2010-07-19T17:17:00.005Z

Fubarnomics is out and keeping me very, very busy!

For my views on the

state of the economy, click here:
http://dailycaller.com/2010/07/19/economic-pause-or-paws/

recent financial reform, click here:
http://allfinancialmatters.com/2010/07/19/deformed-reforms-the-new-financial-regulations/

sexy state of historiography, click here:
http://hnn.us/articles/129001.html

I was also on the John Batchelor Show on Saturday night ... the podcast isn't up yet but when it is:
http://johnbatchelorshow.com/podcasts/

I have several more pieces coming out in the Sioux Falls Argus Leader, the Readex Report, and the McKinsey Quarterly that I'll keep y'all updated on when I can.

REW

Kaiser Permanente

2010-06-01T20:27:00.002Z

The Economist had (May 1, 2010 pp. 67-68) a very nice article called "Another American Way," on Kaiser Permanente, an integrated American health care company similar to those in the Sioux Falls area that I blogged about in "Practicing What You Preach" (posted 2/4/10). Its success is not about "culture," as health economist Alain Enthoven supposedly told The Economist. Cultural "explanations" are the biggest cop out going because culture follows incentives. Integrating HCPs, health insurance, and life insurance (as described in Fubarnomics, which should be out in August) is the way to go because it aligns (almost) everyone's incentives towards longer, healthier lives and lower costs.

$13 trillion and counting

2010-05-26T22:10:00.001Z

Yes, I know the ND > $13T now. What I want to know is when will the rate of growth vs. the size of the economy slow and will it ever reverse? These are difficult questions because they are essentially political in nature and hence about as predictable as the Powerball. Hey, there's an idea. How about a big global lottery for GOVERNMENTS?

Yeah, I'm joking.

Our Cursed Blessing: The Power and Folly of America’s National Debt

2010-05-19T22:12:00.000Z

America joined the first rank of nations in early March 1797, when for the first time in history U.S. government bonds traded at higher prices than comparable British government bonds did in London. The inversion occurred because British investors feared invasion; the French had botched an incursion into Wales in late February but remained a potent threat to the Home Islands. Frightened investors from London to Liverpool swapped their own government’s bonds for those issued by the U.S. government, which since the early 1790s had proven itself highly creditworthy. Prices soon again reversed but the differential between British and American bonds remained close through the next century and more of peace and war, exhilaration and depression, prosperity and recession, a tribute to both the Mother Country and her upstart offspring. A nation’s greatness, after all, is usually directly proportional to its credit. Those with superior credit, like Holland, Great Britain, and the United States, long reigned as world super powers. Tiny Holland defeated the Hapsburg Empire because it could borrow large sums for long periods at low interest. The sunny British Empire was likewise built on the backs of bonds issued by a government that investors knew would pay its obligations punctually. And the U.S.A. won the Civil War, both World Wars, and the Cold War by borrowing sums so vast that its enemies could not hope to compete.

The close historical connection between credit and geopolitical might is why some observers were alarmed by the mid-March 2010 announcement that Moody’s, one of the largest, hoariest, and most respected credit ratings agencies, might downgrade its rating of U.S. Treasuries. With its bonds long accorded the highest rating, Aaa, the U.S. government has been able to borrow as much as it wanted from investors worldwide at the lowest rates available. If its rating was downgraded, the federal government would find itself in a position analogous to that of an individual with a credit score of 800+ who ran up credit card debt at low rates only to be hit suddenly with a much lower score and consequently much higher interest rate payments. A downgrade would negatively impact every American, from newborns to centenarians, unskilled workers to professionals, homemakers to home builders, prisoners to pensioners, students to teachers, and voters to politicians. Collectively, American taxpayers owe bondholders almost $13 trillion and much of that needs to be repaid or refinanced within the next 5 years. Interest rates are currently low, so “only” about 10 percent of the federal budget goes to pay interest on that debt. If budget deficits (which of course entail additional borrowing) stay high and interest rates rise, however, a larger percentage of the federal budget will have to be paid out in interest. That means that American tax dollars increasingly will go to China, Japan, and other bondholders instead of into education, transportation infrastructure, research, Homeland Security and the armed forces, and conceivably even Social Security and healthcare. Or, taxes will have to increase, perhaps considerably.

Barring a politically-motivated budget impasse like that of 1995, the U.S. Treasury will not outright default on its obligations. The government’s bonds are denominated in dollars, after all, and the government via the Federal Reserve can create dollars at will. More likely therefore is a “soft” default whereby the government meets its obligations by creating so much money that inflation results, as it did during the 1970s. (Oil embargoes didn’t help, but most of the rise in prices that decade was due to loose monetary policy.) Interest rates rise during inflationary periods because investors buy bonds in order to reap real returns, or in other words to increase their purchasing power, not to see it eroded by ever higher prices. Inflation also tends to weaken the dollar in international markets, causing foreign bondholders to seek higher interest rates as well. If the dollar weakens too much, the U.S. government may have to begin borrowing in foreign currencies like the euro, yen, or yuan, which could ultimately lead to a “hard” default, much like those in Argentina in 2001 and Russia in 1998.

America’s fiscal situation at present looks more dire than a wolf but the nation might be able to learn something from the experience of its founding generation, which faced a much more pressing fiscal problem but eventually found a politically palatable solution that worked wonders for the economy. The United States was born bankrupt. Even after the end of the Revolutionary War, its national and state governments could not find the means to repay the enormous debts they had racked up fighting for independence. (In fact, had the British not gone so far into debt fighting the French over the course of the eighteenth century, the rebels would not have prevailed and may never have rebelled in the first place. But that’s a different story.) Fearful that the young republic could disintegrate into warring factions or perhaps again be colonized by a European power, a small group of reformers pushed for the creation of a benign but relatively powerful national government. The story of how they wrote and ratified a new frame of government has been oft and well told. That the reformers followed up by establishing the new government’s credit is less well understood and often recounted, when discussed at all, through the lens of partisan politics. In fact, partisan differences were relatively unimportant compared to the broad consensus that the United States had to repay its debts and grow its economy. Squabbles there were, but mostly over details.

To establish its credit, Federalists (the party of George Washington and Alexander Hamilton) and Democratic-Republicans (the party of Thomas Jefferson and James Madison) agreed, the national government’s revenues had to exceed its expenditures. Federalists wanted a somewhat bigger government than the Democratic-Republicans sought but both sides believed that the government’s proper scope was extremely limited. Both thought that tariffs (taxes on imported goods) and tonnage duties (taxes on international trading ships) should be the national government’s major sources of revenue but they bickered a bit over technical issues like tariff levels on specific goods and subsidiary sources of revenue, including excise taxes on whiskey, which the Federalists thought necessary lest the tariff on foreign spirits do nothing more than encourage domestic whiskey production and consumption.
Because the national government laid exclusive claim to the tariff, traditionally a major source of revenue for the states, the Federalists thought it necessary to assume responsibility for the state’s wartime debts as well. To ensure that the national government could borrow large sums quickly if it ever faced a revenue shortfall, the Federalists also wanted to establish the Bank of the United States. The Democratic-Republicans pushed back on both assumption and the bank using the rhetoric of states’ rights and strict limitation of the national government’s powers under the Constitution but conceded both issues in exchange for locating the permanent capital on the Potomac.

The Democratic-Republicans also made a loud ruckus about who should receive the new government bonds created by Hamilton’s funding system, the original holders of IOUs issued during the war -- typically represented as soldiers, farmers, and patriots -- or the current holders -- usually described as grasping speculators. It’s an old canard that Hamilton and his Federalist minions wanted a large, perpetual national debt while Jefferson and his virtuous Democratic-Republican followers sought the opposite. Yet the plan espoused by Madison to discriminate against current holders of the debt would have actually increased the national debt in no small measure. Moreover, Hamilton believed that the national debt would be a blessing only if it wasn’t “excessive,” or too large a proportion of the total economy (gross domestic product or GDP in modern parlance). Hamilton therefore wanted to pay the debt off slowly so as not to jeopardize economic growth by burdening innovators with high taxes.

Jefferson and many of his followers accused Hamilton of merely copying British institutions, a bad omen in their Anglophobe eyes. In fact, Hamilton created the perception of European fiscal orthodoxy while simultaneously innovating around the edges, adapting Dutch and British precedents to American circumstances. The Bank of the United States, for example, was more sophisticated than the Bank of England because it had numerous district banks (called “branches”) and engaged in lender of last resort activities (a type of “bailout”) in March 1792, at least a year before its British predecessor did. Hamilton also innovated by building into some U.S. government bonds an option that allowed the government to repay up to 2 percent of the principal annually, much like a modern amortized mortgage. Finally, Hamilton realized before most that ownership of government bonds wedded prominent citizens to the new government. Only a small percentage of the population owned government bonds at any given moment, but holders were spread pretty widely geographically and tended to be local civic and business leaders.

Hamilton’s financial program established the new government’s credit as its bonds rose in price from a few pence on the pound to over 100 cents on the dollar and soon rivaled British bonds in Amsterdam and, as noted above, even in London. The Bank of the United States also proved a rousing success. Parts of Hamilton’s tax program caused political difficulties but his tariffs provided ample revenue in most years and were as popular as taxes can be. (Numerous uninformed claims to the contrary, he did not implement a protective tariff. That he wanted to is based on a misreading of his Report on Manufactures.)

Despite playing politics at times, Jefferson also helped to establish the nation’s creditworthiness. His administration tweaked the tax code but left Hamilton’s bank and funding system in place, allowing it to purchase the Louisiana Territory by selling bonds, something unthinkable just 15 years before. Until recently, subsequent administrations were also careful to maintain the national government’s creditworthiness. Time again, as the accompanying graphic shows, the debt to GDP ratio increased only during wars and recessions but quickly receded in the face of budget surpluses and economic growth.

One of Jefferson’s worst fears, a runaway national debt, may now be upon us, however. Politicians face an unquenchable urge to borrow and spend and of late have been unable to slake that thirst. During the administrations of George W. Bush and Barack Obama, the national debt has rapidly outgrown the economy, forcing the debt to GDP ratio towards 100 percent, a level achieved only once before, while fighting a two-front world war on the heels of the worst economic debacle in the world’s history. Two minor wars and sharp but short recessions in 2001 and 2008 have been used to cloud the trend, but voters appear to be catching on. Unfortunately, politicians have turned to accounting legerdemain designed to put off the pain until after the next election. Such tactics may work for a time but in the end bondholders and credit rating agencies will not be denied. What America needs now is the same as it needed in 1790, economic statesmanship, budget controls, and a vibrant economy.

Robert E. Wright has authored Fubarnomics, One Nation Under Debt, and 10 other books on U.S. business, economic, and financial history and holds the Nef Family Chair of Political Economy at Augustana College, SD.

Bailouts, the Supreme Court, and a Tax on Lobbying

2010-05-10T16:50:00.001Z

In Citizens United v. Federal Election Commission (http://www.supremecourtus.gov/opinions/09pdf/08-205.pdf), the U.S. Supreme Court overturned existing law and precedent and ruled in a 5-4 decision that for-profit corporations can spend as much money as they like on political advertisements at election time. Some see the decision as a great victory for free speech while others claim it will spell the end of the republic itself. Both extreme views are extremely wrong, rooted, like the Court’s decision, in hackneyed readings of tired secondary sources. What the decision should do is encourage Americans to reconsider the role that political influence plays in their material well being.

Instead of Homo sapiens, it might be wiser to think of humans as Homo ereptor, or man the thief. Given the chance, most humans like to get something for nothing, or to engage in “rent seeking” as economists term the activity. When directed at the government, rent seeking by individuals is generally ineffective and hence innocuous. When individuals with similar economic interests combine efforts, however, they often manage to obtain substantial favors from the government, including tariffs, subsidies, and favorable regulations.

For that reason, the Founders feared that “moneyed corporations” threatened the existence of the Republic. It was not that corporations would sway public opinion through advertising or publicity but rather that they could directly buy or coerce votes, a viable threat in a land where viva voce and other forms of open voting held sway and where landlords, employers, and creditors traditionally leveraged their economic power on election days.

By essentially eliminating direct corporate influence on voters, the “Australian” or secret ballot reforms of the late nineteenth century destroyed the threat that businesses would elect their own slate of candidates. The Court’s decision, however, makes it easier for corporations to co-opt whichever politicians the electorate happens to vote into office by allowing them to promise substantial resources when they are needed most, just before the next election. Money can’t buy happiness or elections, but it sure helps!

In other words, lobbyists just got a lot more powerful and that is not likely to be a good thing. Lobbying is nothing new and is generally considered a form of free speech that should be protected under the First Amendment. But does that mean it should be strengthened? I think not. In fact, lobbying should be taxed. The “free” in free speech does not mean gratis: the government has long taxed newspapers, TV stations, book publishers and authors, protest permits, and other forms of speech.
Tax is a dirty word but there is a very good economic rationale for imposing a tax on lobbying and other activities that create what economists call “negative externalities” and everyone else calls “pollution.” By definition, negative externalities impose costs on third parties not reflected in the market price, leading to a more than socially optimal level of output. Unsurprisingly, almost all Americans not directly benefited from lobbying activities believe that too much lobbying is produced, a good sign that such activity does in fact create negative externalities as palpable as belching smokestacks. The most efficient way to reduce such pollution is to tax it, thereby imposing appropriate costs on its producers.
The recent financial crisis and subsequent rash of bailouts is a good example of the pollution created by untaxed lobbyists. As shown in Bailouts: Public Money, Private Profit, the most recent addition to the SSRC/Columbia University Press Privatization of Risk series, statistical evidence that government bailouts since 1970 have sped economic recovery after financial panics is lacking. Historical case studies suggest that government interventions were sometimes successful, as in 1792, but at other times, like in the mid-1760s, they clearly made matters worse and the New Deal was a mixed bag at best. The book also demonstrates that most financial crises were not caused by market failures, like asset bubbles, alone but rather stemmed from hybrid failures, or complex combinations of market and government failures. Throughout history perverse incentives, most created at the behest of lobbyists on behalf of special interests, constituted a leading form of government failure and the most recent financial cataclysm was no exception to that rule.

Venal investment bankers (actually, bankers rewarded for maximizing personal short term returns due to a change in bank ownership structure from partnerships to joint-stock corporations), incompetent rating agencies (like Moody’s), distortionary tax incentives (mortgage interest deduction plus pre-tax 401K contributions), weak financial and economic education (don’t get me started), homeownership initiatives (like the Community Reinvestment Act), degeneration of creditors’ rights (non-recourse loans and silent second mortgages), low interest rates (due to the Federal Reserve and GSEs), and most of the other major causes of the housing bubble and subsequent subprime securitization crisis were the direct results of special interest lobbying, not widespread public opinion or the labored conclusions of a benign technocratic bureaucracy. The form (and size) of the bailouts was also largely a product of special interest pressures. Those bailouts may not cost taxpayers as much as once feared but clearly resources were redistributed from the many and innocent to the few and culpable. The bailouts also increased moral hazard, or risk-taking at another’s expense, and hence the probability of future troubles.
Giving lobbyists yet more power therefore seems an unpromising way to improve the quality of already dubious public policies. So why not tax the pollution created by lobbying activities? Give every U.S. citizen and organization the right to lobby anyone in the federal government tax free up to, say, $100 per year (indexed to inflation), more than enough to cover the cost of phone calls, letters, and emails made by typical individuals and small businesses. Beyond that, impose on lobbying activities a tax approximating the size of the rents sought after. Reduce the expected benefit of rent seeking and we’ll see less of it. Homo ereptor will not go extinct but we can then at least make a case to keep our species name as is.

A Prayer for the Government

2010-04-07T13:10:00.001Z

Missouri-born Protestant theologian Reinhold Niebuhr (1892-1971) is usually credited with writing one of my favorite prayers, The Serenity Prayer. Various versions exist, but the one I grew up with goes:

God
Grant me the serenity
To accept the things I cannot change
The courage to change those things that I can
And the wisdom to know the difference

Where I come from, though, it is in bad taste to pray for oneself. So I submit to you today a new, more public-spirited version of the Serenity Prayer, one that I hope you will say every chance that you get:

Dear Lord,
Puhleeeeze, please, please, please
Grant THE GOVERNMENT the serenity
To accept the things that it cannot possibly change, like prices and quantities
The courage to change those things that it can, like the arcane rules of the Senate and scientifically gerrymandered Congressional districts
And the wisdom to implement Pareto improving policies that keep the devil way down in the hole

Ahhhhhhhhhhhhmeeeeeeeeeeeeeennnnnnnn

Let the Lawsuits Begin!

2010-03-23T23:13:00.004Z

Some states have already filed suit against the newly enacted Obama health care law. Private citizens will certainly do so as well, though it will take some time before they can because they will have to suffer a tort first.

Proponents of the reforms are of course pooh-poohing the suit and I must say the new law's demise does not appear imminent. I would like to see, however, more constitutional law questions revolve around the Preamble. You know the song!

"We the People [of the United States,] in Order to form a more perfect Union, establish Justice, insure domestic Tranquility, provide for the common defence, promote the general Welfare, and secure the Blessings of Liberty to ourselves and our Posterity, do ordain and establish this Constitution for the United States of America."

In the 18th century (when our current constitution was ratified -- look it up!), the preamble of a law or constitution was of crucial importance because it established policymakers' intent by describing their overall goal. Every federal law, ergo, should achieve at least one of the goals listed in the Preamble or be declared unconstitutional.

The Obama health care legislation does not make the Union more perfect, establish justice, insure domestic tranquility, or provide for the common defense. It also does not secure the blessings of liberty to this or subsequent generations. Its only justification, like so many laws, is promotion of the general welfare. Unfortunately, the law only asserts to promote the general welfare, it does not prove that it will do so. Worse, nothing ensures the legislation will be changed if it does NOT promote the general welfare, or even that an attempt will be made to measure its impact on the general welfare. Due to its long phase in, which a cynic might think was created in order to shield its proponents from the wrath of voters in 2010 and 2012, the law's effect on the general welfare may not be discernible until 2015 or later. If at that time the law appears to be hurting the general welfare, I hope that somebody with the wherewithal to win files suit on the basis of the Preamble. Heck, I wish somebody would do that re: Social Security and a 1,000 other clearly pernicious pieces of legislation right now!

In the 18th century most laws expired after so many years (1, 5, 20). Laws that were salutary were renewed without any trouble. Those that were dead letters died as did truly pernicious legislation protected by powerful interest groups. We should really think about returning to the system of expiring laws. After all, what good is "democracy" and "representative government" if legislators can burden future generations, to wit people who did not vote for them, with policies that, while deeply and obviously flawed, become virtually impossible to reverse, no matter how dysfunctional they become? Call it the tyranny of the deceased.

Thank God They Weren't Students!

2010-02-13T15:31:00.003Z

But that isn't all I have to say about the shooting at the University of Alabama, which apparently was a dispute over tenure. I know nothing of the merits of the case -- I am not a biologist and have never taught at that university -- but I do know:

1) it doesn't vitiate the analysis I posted yesterday re: the 2A and gun free zones;
2) tenure fights can be quite emotional -- lifetime employment is at stake after all.

Such fights usually take place behind the scenes or in a small percentage of cases in courtrooms -- we're talking about professors after all, not the Sopranos, though they have the tenure-like institution of becoming a "made guy." If it seems a bit odd that U.S. colleges and universities share a major institution with the mob, you need to check out two of my forthcoming books, Fubarnomics and Higher Education and the Common Weal. There's a lot in higher ed that simply doesn't make sense. That doesn't absolve the shooter of responsibility but rather suggests that we need to re-think our public policies. Seriously.

The Supreme Court's Lousy Decision

2010-02-13T01:02:00.003Z

I have an op ed coming out on the Supreme Court's lousy decision to allow corporations free reign in political elections under the First Amendment (Citizens United v. Federal Election Commission). (Why can't it read the Second Amendment so liberally? See my previous post). The court's claim that the founding generation did not fear the political power of corporations (particularly banks) is of course ludicrous, as the following excerpt, with original emphases, shows:

Littleton Teackle, An Address to the Members of the Legislature of Maryland, Concerning the Establishment of a Loan Office for the Benefit of the Landowners of the State (Annapolis, 1817), 15-16.

"But the most dangerous and worst thing to be apprehended from the system of commercial banks is, that it has a tendency to destroy the government of the United States, and to establish a government of secret influence, in the place of the free and open government of the people by their representatives the congress and the president, and very much resembling the plan contrived by the French for getting the government of this country into their hands during the presidency of General Washington, and mentioned in Fauchet's intercepted letters. By that plan, a club was to be established in Philadelphia, which was to hold correspondence with a great number of subordinate clubs in every part of the country, the members of which, were to be under the direction of the club in Philadelphia, and were to use their influence to get such members elected into the Senates and Houses of Representatives of the United States, and the several states, as would act according to the directions of the club; and the French were to get their partizens [sic] admitted into these clubs, especially into the mother club in Philadelphia. This scheme of the French minister failed, as he himself says, because he had not the money necessary to carry it into execution. By the present system of commercial banks, the president and directors of the bank of the United States at Philadelphia, having a number of branch banks in every part of the United States, and having the appointment of all the directors in these branch banks, has the entire control and complete influence over all the directors of these branch banks and all the persons who borrow money of them, and these branch banks will have great power and influence over the commercial banks which will be indepted [sic] to them, and the directors of these commercial banks will have great influence over all the persons who borrow money of them; so that the merchants in towns, will be under their influence. The merchants or storekeepers in the country, being indebted to the merchants in town, will be under their influence, and the greater part of the freeholders and people in the country, being kept poor and indebted to the country merchants and store keepers, will be under their influence. By this means no persons will be chosen into the state legislatures or into congress, but such, as will be directed by, and comply with the desires of the directors of the mother bank at Philadelphia, and their associates the directors of the other banks; and the government of the United States, preserving all the forms of a free elective representative government, will by the operation of this secret influence, fall into the power of bank directors, Stockholders, stockjobbers, jew brokers*, and money changers ..."

*Yep, that's what it says.

Let Us Carry!

2010-02-12T23:18:00.002Z

Looks like there has been another college shooting, this time at the University of Alabama.

When will we learn that gun free zones are shooting galleries for bad guys (and apparently in this case gals)? How many students, soldiers, patients, etc. must die before we grow up, follow our own Constitution, and allow* people to carry everywhere and anywhere?

*I'm actually starting to wonder if the Constitution MANDATES that people of militia age carry firearms. Several months ago I sent the following to a (liberal) second amendment scholar who shall remain nameless. He hasn't responded yet so I don't think he ever plans on doing so:

If a well regulated militia is necessary to the security of a free state, why do we no longer have militias? I don't mean that in a quaint way. I'm thinking that we've returned to a state of affairs analogous to that faced by the founding generation, to wit one of "terrorists" (whether they are called Islamo-fascists, Indians, domestic extremists, or whatever) that can strike virtually anywhere, anytime. In this view, the return of a similar Zeitgeist allows for the clarification of the muddled discussions of the last 180-ish years.

So shouldn't someone sue to enforce the Constitution and the original intent of the Founders? Shouldn't the federal government force state governments to pass legislation mandating that all able-bodied adults (perhaps exempting conscientious observers, violent felons, etc.) fulfill their civic duty and carry a firearm with them (perhaps at all times) in order to protect the community from attack? Isn't it clear that nobody, not even military personnel on their own bases, can be protected by police forces for the simple reason that the police can't be everywhere at once and attackers have very clear incentives to attack where police protection is lowest? Do you see where I am going with this? The line between self- and community- defense is not clear cut but rather bleeds (forgive the pun) seamlessly from protection from a mugging through full scale invasion, with the biggest threat at present small scale attacks by one or a few people on groups ranging from a dozen or so to a hundred or so. Whatever the rationale (individual, community, civic duty) for the 2A, "the right of the people to keep and bear arms, shall not be infringed" yet it has been, in particularly egregious fashion from the standpoint of the communal and civic duty interpretations! What have I missed here? Please enlighten me when you have the time.

You have my permission to mock ...

2010-02-11T15:03:00.004Z

... anyone silly enough to claim that the recent snowstorms are "good for the economy" because they create jobs (or at least OT). Lost hours in factories, etc. will indeed be made up and most consumption nearly postponed (people will buy that new flat screen next week instead) but spending valuable resources (time, equipment, fuel) to move annoying white stuff entails a dead weight loss. The easiest way to see this is to look at government snow removal expenditures. The money spent on snow removal is no longer available for other services. I'm not saying that governments should refrain from plowing their own roads, of course, merely that it ain't helping the economy, just those who are in the snow removal biz. The situation is directly analogous to Bastiat's window, a tale of hidden opportunity costs.

Finding a way to remove snow more efficiently (more tons per $), on the other hand, WOULD be an economic boon.

If you do find yourself mocking the proponents of the "sbailout" (snow bailout) just don't call them "retarded." ;-)

Check out my op ed on History News Network!

2010-02-08T19:29:00.002Z

"The Great Recession of 2008 and the Sordid Historiography of the Great Depression"

There are already four comments (okay, one is mine) and Columbia University Press has already picked up on it. CUP has also posted an excerpt of Bailouts here.

Haiti's Future

2010-02-05T22:40:00.002Z

I'm not going to comment on the increase in the national debt ceiling to $14+ TRILLION bucks. It's inevitable. What is not inevitable, however, is abject national poverty. In my forthcoming book, Fubarnomics: A Lighthearted, Serious Look at America's Economic Ills, I argue that nationwide poverty, like that experienced in Haiti as well as large swathes of Latin America, Africa, and Asia, is always and everywhere the fault of predatory government, of governments, sometimes imperial but often indigenous, that prey upon their citizens rather than protecting their lives, liberty, and property. Natural experiments in North America, Germany, Korea, and elsewhere bolster confidence in this hypothesis, which exposes the fallacies of the flawed "democracy is necessary for growth" theory. Protection of life, liberty, and property are necessary for growth, be the protector a democratic government or an enlightened despot.

With the possible exception of the U.S. military occupation of Japan after World War II, no outside power has yet created a prosperous nation by replacing a predatory government with a less predatory one. The international community should give the idea a try in Haiti, the people of which have very little to lose at this point. The process won't be democratic, especially at first, but get over it. The Haitians will once they see what they are capable of when properly rewarded for working hard and smart.

Practicing What You Preach

2010-02-04T15:29:00.002Z

Perhaps the best way of ascertaining whether somebody is sincere about their predictions and policy suggestions or just blowing smoke is to ensure that they have some skin in the game, something to lose in the event that they are wrong. That can be done in a variety of ways, including bets (like my wager against Panarin about the alleged imminent break up of the U.S.A.) and making certain that the advice giver is engaging in the activity themselves. (A word of warning: stocks and other financial securities are very liquid assets -- they can be bought or sold very quickly -- so simply because some guru holds a position today does not mean he will hold it tomorrow and in fact he may "puff" or "pump" the security simply to acquire a buyer for the junk.) As in: oh, so you think that alcohol enemas are a healthier way of getting drunk than the old fashioned way of down the hatch. You do that for awhile (and live) and I'll consider it.

Last month, I suggested in an op ed in The Daily Caller that it would be a good idea if HCPs had incentives to CURE people rather than to TREAT them. There is a variant of that idea here in South Dakota, and it works extremely well as I can now attest firsthand having been treated yesterday. The health insurer and the HCP are one in the same, so they don't, I mean it doesn't, mess around with excessive or expensive treatments but rather follows best practices. The system could be better by strengthening incentives to CURE by foregoing premiums when the insured is sick, divorcing insurance from employment, and linking it to life insurance but it is a far cry better than elsewhere.*

*When I moved here last Fall, people told me that the HC system was better here but the reason was attributed to "intense competition" between two insurer/provider systems (Sanford and Avera-McKenna for those who care to know). That is a bit strange for a duopoly, I recall thinking (btw, Sioux Falls is 4-ish hours from anything else, except Sioux City, IA which even at 90-ish miles renders it a different market for quotidian care). I'm sure the competition is helpful but I think the internal incentive structures much more so.

This Week: IOUSA and health care op ed

2010-01-15T15:00:00.003Z

At my urging, the Concord Coalition showed IOUSA at Augustana College SD earlier this week. It made the Argus (the local paper) and KELO (a major local TV station).

Also this week, my op ed on the health care bill made it into The Daily Caller, a new political blog started by Tucker Carlson.

Congress: Reform Yourself First!

2009-11-12T14:41:00.002Z

This is the text of a talk that I gave at North chapter of the Rotary Club in Sioux Falls yesterday. I only had 20 minutes so I did the ad lib thang for most of it. It summarizes the stuff I discussed at the South Dakota Chamber meeting a few weeks ago (see below) but with a new twist and some new stories. The best part is the ending, where I suggest that before Congress tries to fix health care and the financial system it ought to fix itself first. Cheers!

Is the Financial Crisis Over or Just Beginning?

Even though various economic indicators are looking better, I’m considerably more pessimistic about the answer to that question than I was when I gave a similar talk before the South Dakota Chamber of Commerce a few weeks ago. The reason is that the Obama administration and Congress are suddenly starting to make headway on some reform measures. Unfortunately, the bills now in motion appear to aim at the wrong targets.

One possible economic path before us is a so-called double dip or W-shaped recession where the economy begins to grow robustly for a short time before again plunging into recession. Such a path could be caused by any number of shocks, including but not limited to:
1. excessive uncertainty caused by government policy debates, including healthcare and insurance reform like that which passed the House last weekend and punitive financial reforms like those put forth today by Senator Dodd, the white-haired Demicrit from Connecticut;
2. the overhang of toxic assets on bank’s balance sheets, specifically those related to commercial mortgage lending and credit cards, which have taken a beating during the recession;
3. new asset bubbles in gold, rare earth metals, oil, and equities. Once the current rallies end, lenders may discover once again that they have lent too much to borrowers banking on irrationally high future valuations.

The return of weakness in the dollar means that, should the financial sector take another tumble, the government will be even more ill-prepared to combat the inevitable economic downturn than it was during the last go round. I fear, too, that the political fallout of another big bailout could get quite ugly indeed.
Don’t get me wrong, I am bullish on America. For all its faults, it’s still demonstrably better than most other nations. Our many John Galts are still hard at work. But we are in a dangerous period because if the government goes much further the Galts may strike. That’s a double entendre by the way. I myself have wondered why I put in 70+ hours a week only to see it frittered away by the half-wits that inhabit Washington.

Yes, I said half-wits. When the serial killer in the horror flick Saw VI more accurately and succinctly outlines the problems with the current healthcare system than federal politicians, bureaucrats, and pundits do, there is a real problem. It all comes down to incentives, Jigsaw noted between torture scenes. In short, health insurance should not be linked to employment any more than automobile insurance should be and doctors ought to get paid when their patients are well, not when they are sick. On those points, I tend to agree with that sadistic lunatic. The so-called public option can’t help, and neither can anything else, until we get the incentives straight.

The financial system will be a bit more difficult to fix because the causes of its pathos are less obvious and more numerous. To date, none of the reforms before Congress come close to fixing the system’s root problems and if anything the government’s bailouts have made matters worse. In the interest of time, I’ll limit myself to the 11 most important causes of the crisis:

1) Bubble, bubble, toil and trouble. It’s pretty clear that people can and do invest irrationally at times, paying much too much for assets. Nevertheless, many economists still believe that asset bubbles are impossible, that prices always reflect so-called fundamentals like interest rates and expectations of future prices. Following their lead, the Federal Reserve does not try to identify bubbles ex ante, which is to say before they burst and cause trouble. No other part of the government does much of anything to prevent or deflate bubbles either.

2) Financial dumb-dumbs. Very few Americans understand the basics of investing. American consumers know that it is better to buy low than to buy high, and to sell high rather than to sell low, except, it seems, when it comes to financial assets. Many confess to dumb mistakes like putting all of their savings into a single investment such as Fannie Mae, staying invested in stocks as their retirement looms, and extrapolating trends far too far. Because it controls most education K through 12 and even much of the college market, the government could work wonders here, but it hasn’t. Most people never take a course in finance or investing and it shows.

3) Skewed tax incentives. Americans do, however, follow their self-interests when the rational path is unambiguous. When the government basically told them via the IRS code to borrow to the hilt on their houses in order to invest in the stock market, they did so. I refer to the combination of the mortgage interest deduction and the ability to make pre-tax contributions into retirement accounts like 401Ks. No longer rewarded for striving to own their homes outright as they once were, Americans in the final quarter of the last century increasingly rented – for lack of a better term -- their homes from mortgage lenders and bought equity shares in corporations over which they had no control. The ability to put little or nothing down and to easily tap accrued equity through lines of credit of course fueled the real estate bubble. Those tax distortions have not been addressed and are unlikely to be anytime soon.

4) EZ money. Low interest rates basically reward borrowing and were a major factor in the dotcom and housing bubbles, as well as most of the scores of other bubbles that have troubled the U.S. economy since before the nation’s inception. Overnight interest rates are now near zero and the Fed shows no signs of increasing them anytime soon. So once again the government is encouraging investors to borrow to the hilt in the apparent hope of ending the ill effects of one bubble with yet another.

5) Abominations of Nature, a.k.a. Government Sponsored Enterprises or GSEs. Colloquially known as Fannie Mae and Freddie Mac, the GSEs were privately owned but publicly backed. They provided an important service called securitization, or the bundling of individual mortgages into bonds for resale to institutional investors worldwide. It is not at all clear, however, why the market for such securities needed to be subsidized with the full faith of the U.S. government, or in other words with taxpayers’ wallets. The original Fannie Mae was a government agency and should have remained as such. The government spun it off in 1968 to get it off its books, which were under pressure due to LBJ’s Great Society programs and the Vietnam War. With the government’s financial position again rather tenuous there will be tremendous pressure to spin the recently nationalized GSEs off again and no guarantee that it will be done properly this time.

6) Low ratings for rating agencies. Of the many institutions responsible for the financial crisis of 2007-8, the big U.S. credit rating agencies rank among the most odious because they profited by giving high ratings to securities that ultimately proved nearly worthless and practically impossible to resell. The agencies’ original business model closely aligned the incentives of the rating agencies and investors. For the first half century or so of their existence, the agencies sold ratings to investors, who continued to purchase them only if they were generally accurate. Unsurprisingly, early ratings were as reliable as market prices and other performance indicators. But in the 1970s two disasters struck. The advent of cheap photocopying made it easy for illicit entrepreneurs to make a fast buck by selling photocopies of ratings for a fraction of the price they cost the rating agencies to produce. That cut into revenues and profits, which sent the rating agencies scurrying for a new business model. Unfortunately, the one they hit upon – charging issuers -- was highly problematic to say the least. No sensible person or business bites the hand that feeds them. The new model therefore transformed rating agencies from pro-investor watchdogs into pro-issuer lapdogs. Before that happened, however, the government bailed out the agencies by designating five of them as Nationally Recognized Statistical Rating Organizations or NRSROs. The government also effectively perpetuated that cartel by barring new entry and forcing institutional and public investors, like public pension funds, to rely on the NRSROs’ ratings when making investment decisions. Unsurprisingly, over the next few decades the quality of ratings deteriorated. In 2006, the government passed legislation that facilitated new entry and abolished NRSRO-status. It did nothing, however, to change the perverse incentives at the heart of the system and does not appear prepared to nudge agencies back toward the original subscriber model, one that computerization has again made viable.

7) Managerial entrenchment. Common stockholders these days have very little say in the management of the corporations they own. That was not always the case. Before the Civil War, stockholders reigned supreme. The situation changed in the second half of the nineteenth century, however, so that by the Great Depression Adolph Berle and Gardiner Means could rightly complain about the separation of ownership and control. At the same time, government regulations purposely stripped institutional investors of their governance rights due to some overblown fears about J. P. Morgan and his crew. As a result, we have a system of weak owners and strong managers. It is not surprising that those strong managers rigged the game in their favor with big bonuses, golden parachutes, and perks galore, including $35,000 dollar commodes. And what has the government done about this deplorable situation? Exactly nothing. Instead, it threatens to limit executive pay itself, a policy that could have devastating effects.

8) The Importance of Incentives. The structure of executive compensation, on the other hand, is a matter of public interest because of its clear connection to financial system stability. If their compensation structure rewards them for making short-term profits but doesn’t punish them for making long-term losses, managers will take big, short-sighted risks, thus greatly exacerbating systemic fragility. The proper policy here is fairly simple. Managers should not receive bonuses on the basis of alleged accounting profits. Such a system is too easy to game, either by manipulating the accounting assumptions or by deliberately backing projects that are short-term winners but long-term losers like -- oh I don’t know – subprime mortgages, CMOs, and other risky projects. Deferred compensation, clawback, bonus-malus -- call it what you will – they all mean no more big paydays today on the basis of loans or other contracts with 15, 30, or more years to run. Stockholders liberated from the straitjackets I just described would push for more incentive-compatible contracts but while they rebuild their management monitoring skills the government should step in and force compensation deferment. And it should get other governments to sign on too, lest we lose some of our most innovative financiers and most important financial companies to London, Zurich, or Shanghai.

9) Static regulatory cling. Regulators are problematic for many reasons but primarily because they breed complacency. Why most investors believe that salaried government bureaucrats care more about their money than the investors themselves do is a difficult question to answer. I suspect that many people reason that because the U.S. government has the capability of putting a man on the moon, destroying the planet 100 times over, and so forth, it can surely stop financial fraud. Of course such reasoning is a tragic non sequitur. Regulators are not rewarded for stopping fraud or crises so they don’t do it. They are rewarded for upholding the letter, rather than the spirit, of the law, so that is what they do. Like generals, regulators are prepared to fight the previous war rather than the forthcoming one. Sarbanes-Oxley was the Maginot Line of the 2008 financial panic. In the 1990s, companies incentivized managers with stock options. Some managers responded as hoped and increased the efficiency of their firms by lowering costs, expanding into new markets, gaining market power in established markets, and so forth. Others, however, found that to be too much work and instead increased stock prices with shady accounting practices. Sarbox stopped that from happening again, just as the Maginot Line prevented the Nazis from invading France directly. But it didn’t stop the other major way of getting stock prices up, by undertaking risky projects. Just as the Germans swept through the Ardennes and the Low Countries and from there moved into France, U.S. financiers simply outflanked the regulators sitting complacently behind Sarbox.

10) Too Big To Fail policy. There is a notion, not necessarily a bad one, that the government should prevent the financial system from freezing, exploding, or otherwise causing negative externalities for economies foreign and domestic. The Federal Reserve was created, in part, to serve as a so-called lender of last resort, as a safety net for the financial system. As part of that mission, the Fed announced in the mid-1980s that it would allow small banks to fail but in times of trouble it would step in to save the 11 largest banks on the grounds that their failure would threaten the stability of the entire financial system. The problem with the policy -- which is still in effect and has metastasized into investment banking, hedge funds, and insurance – is two-fold. First, because the government still offers its guarantee free of charge those institutions that are clearly “too big to fail” can pursue risks with reckless abandon, safe in the knowledge that ole Uncle Sam has their back. Second, those institutions that think that they are close to being considered “too big to fail” have major incentives to grow bigger so that they too can reap the rewards of taking on more risk – free of cost and, ironically enough, free of risk!

11) Government Hubris. Bureaucrats and politicians thought that they could raise homeownership rates by implementing a number of policies, including the tax breaks and GSEs formerly alluded to. Via policies like the Community Reinvestment Act, they also encouraged lenders to make loans to weaker borrowers when they should have instead eased entry requirements for credit unions and community banks. The government also allowed the doctrine of secret liens to erode, thus enabling the growth of “silent second” and “piggyback” mortgages, or loans for down payments. When you let a borrower borrow the down payment you don’t really have a down payment, which was traditionally the number one defense against default because it served as a sort of life jacket that kept the borrower above water or with positive equity. Finally, the government allowed the development and proliferation of non-recourse loans. Essentially, it gave borrowers a free put option on their homes by allowing them to walk away when they are under water or in the bucket -- or in other words have negative equity – and to do so without serious adverse consequences. Such largesse certainly did increase homeownership rates, however temporarily, but did not increase the total amount of equity in homes. The put options, the silent seconds, and the Community Reinvestment Act all remain more or less intact.

Clearly, then, the government has done nothing to redress the root causes of the financial crisis of 2007-8. Fair enough. But it should not use the opportunity, as many term it, to foist their pet reform projects upon a still shaky economy and financial system. I think if anything needs reformation it is Congress. I would like to see two changes:
1. Truth in lawmaking. Bills and laws ought to accurately state their contents, including both their objectives and the path to achieve them. Too often the titles of our laws are nothing more than political spin or marketing ploys;
2. Effectiveness monitoring. No bill should be allowed to pass until it is scientifically proven that its provisions will probably lead to the intended outcomes. All laws should be subject to review at 1, 3, and 5 years to ensure that they are in fact furthering their stated goals. Finally, all laws should automatically expire after 10 years unless explicitly renewed.
Until such reforms are implemented, all new government policies should be eyed with the utmost suspicion. The world is a complex place, too complex for half-wits, especially those up for re-election.

On that note, thank you for your time and attention and have a wonderful afternoon.

Is the Financial Crisis Over or Just Beginning?

2009-10-28T02:11:00.002Z

This is the text of a speech I gave today at the South Dakota Chamber of Commerce's Third Annual conference on the economic outlook in Sioux Falls, SD.

Let me answer that question in three words: I don’t know. Unlike my erstwhile colleague Bruce Bueno de Mesquita, I do not try to predict the future. I do have something to say about the question, however, much more, in fact, than I could possibly say in the time allotted. Although I rarely teach history courses per se, I am an historian by training so my approach to the future is to look to history for analogous situations and then outline the paths that the economy may take while assigning rough probabilities to each.

The first path or scenario I call The Fairy Tale because the gist of it is that they all lived happily ever after. In other words, the economy is going to rebound robustly and we won’t experience another major financial panic during our lifetimes. To be perfectly blunt, I think the Fairy Tale scenario is about as likely as a scullery maid getting to wear glass slippers in a coach and four created from a pumpkin and four rats. Or, if you prefer, about as likely as an adolescent girl with 40 feet of hair capable of bearing the weight of a full grown prince. The U.S. financial system suffered major crises in the 1760s, 80s, and 90s, the 1810s, 30s, 50s, 60s, 70s, 80s, and 90s, the 19 aughts, teens, 20s, 30s, 70s, 80s, and the two thousand aughts. There is absolutely no reason to believe that we have reached the end of financial history and one very big reason to suspect that another crisis will hit us again, sooner or later: to date, none of the causes of the most recent financial crisis have been mitigated, much less rectified.

I have a book coming out next year called Fubarnomics that discusses the causes of economic sectors that are FUBAR – which is an acronym that stands for fouled up beyond all recognition, at least in polite circles. You know, hyper-dysfunctional sectors where costs consistently outstrip inflation such as construction, retirement savings, healthcare and insurance, higher education, and the like. Such monstrously messed up sectors all result, I conclude, from hybrid failures, or complex combinations of market failures like asymmetric information, externalities, market power, and public goods, AND government failures such as inappropriate and ineffective regulation and highly distortionary taxation. Despite partisan narratives from the Left that focus exclusively on market failures and from the Right that concentrate on government failures, the financial disruptions of 2007 and 8 were actually caused by eleven hybrid failures, not one of which has yet been adequately addressed. First,

1) The housing bubble. It’s pretty clear that in 2005 and 2006 many Americans paid waaaaaaaay too much for houses, especially in the New York City metro area, parts of Florida, Vegas, Southern California, and other hotspots. Nevertheless, many economists still believe that asset bubbles are impossible, that prices always reflect so-called fundamentals like interest rates and expectations of future prices. Following their lead, the Federal Reserve does not try to identify bubbles ex ante, which is to say before they burst and cause trouble. No other part of the government does much of anything to prevent or deflate bubbles either. That might not be such a big deal if it were not for:

2) Numero Dos -- rampant financial illiteracy. The U.S. economy works despite the fact that very few Americans understand economics. We’re sort of like the dog that manages to consistently catch a thrown Frisbee in its mouth. The dog can’t describe the physics involved but it doesn’t need to in order to get what it wants, the approbation of its owner and a Scooby snack. American consumers know that it is better to buy low than to buy high, and to sell high rather than to sell low, and that is enough to ensure reasonably efficient markets for most physical goods, professional and semi-professional services, and labor. But finance is different. It is more like rocket science. Just as the dog will never get a Frisbee into orbit, America will never have a stable financial system until most citizens thoroughly understand at least the bare basics of investing. At present, they clearly don’t. Many confess to dumb mistakes like putting all of their savings into a single investment such as Enron, staying invested in stocks as their retirement looms, and, like Buzz Lightyear, extrapolating trendy trends to infinity and beyond. They are so daft that they believe that traditional stockbrokers provide sound investment advice. Many institutions, including the Museum of American Finance, with which I am associated in various ways, are trying to increase financial literacy but the going is tough. Because it controls most education K through 12 and even much of the college market, the government could work wonders here, but it hasn’t. Most people never take a course in finance, a subject that is so little understood that most people who learn that I teach financial history and political economy are dumbfounded at the very notion that such disparate concepts as finance and history or political and economy can be combined into a course of study. Which leads me to:

3) Macro-incentives. Although many Americans are ignorant enough of finance to be easily suckered into fueling asset bubbles, be they tech stocks or spec houses, they are not stupid. They can be taught and they do follow their self-interests when the rational path is unambiguous. When the government basically told them via the IRS code to borrow to the hilt on their houses in order to invest in the stock market, they did so. I refer, of course, to the combination of the mortgage interest deduction and the ability to make pre-tax contributions into 401ks, 403bs, and other retirement accounts. No longer rewarded for striving to own their homes outright as they once were, Americans in the final quarter of the last century increasingly rented – for lack of a better term -- their homes from mortgage lenders and bought equity shares in corporations over which they had no control. The ability to put little or nothing down and to easily tap accrued equity through lines of credit of course fueled the real estate bubble and made the resulting downturn in the housing and stock markets much more traumatic than they traditionally would have been. Those tax distortions have not been addressed and are unlikely to be anytime soon. Moreover, many other potentially destabilizing distortions undoubtedly lurk in our massive tax code, awaiting only the right circumstances to sally forth and bite the economy in the posterior. I don’t know whether to laugh or cry when people claim that the recent crisis shows that free markets don’t work. They were far from unfettered. In addition to distorting macro-incentives there was also the problem of:

4) Macroeconomic (mis)management. Low interest rates provided yet another macro-incentive impetus for the bubble. From 2001 until 2005, the Federal Reserve and world trade patterns kept interest rates extremely low, which is just another way of saying rewarding people and firms for borrowing. Recently hurt by the bursting of the tech stock bubble, many investors used the opportunity afforded by the low rates to speculate in housing, a tangible asset that could not possibly lose value, or so many believed. By raising interest rates in 2005 and 2006, the Fed effectively punished new borrowers and those who had borrowed short-term via adjustable-rate mortgages. That of course decreased demand for houses and increased defaults, both of which led to the price collapse. Overnight interest rates are now near zero and the Fed shows no signs of increasing them anytime soon. So once again the government is encouraging investors to borrow to the hilt in the apparent hope of ending the ill effects of one bubble with yet another. It isn’t yet clear which assets will puff in price, but gold and the so-called rare earth elements are currently hot, hot, hot and insurance-linked securities, like catastrophe and death bonds, bear resemblance – or should I say resemble bull resemblance? -- to the securitized mortgage products that Wall Street banks and their apologists were all agog about just a few years ago. I should note here, again, that I see all of these causes as hybrid failures, not pure market or pure government failures but rather failures of both. Nowhere is that clearer than in:

5) Government Sponsored Enterprises or GSEs. Colloquially known as Fannie Mae and Freddie Mac, the GSEs were privately owned but publicly backed and as such were abominations of nature that should never have been countenanced, much less nurtured for decades. In his veto of the Second Bank of the United States, America’s second major GSE, President Andrew Jackson noted that QUOTE the powers, privileges, and favors bestowed upon it in the original charter, by increasing the value of the stock far above its par value, operated as a gratuity of many millions to the stockholders. UNQUOTE Such a subsidy, he argued, was an unwarranted redistribution of wealth from taxpayers to stockholders. Moreover, the bank was unconstitutional because it was neither necessary nor proper. The same argument can, and in fact has, been made against Fannie and Freddie. The GSEs did provide an important service, securitization, or the bundling of individual mortgages into bonds for resale to institutional investors worldwide. It is not at all clear, however, why the market for such securities needed to be duopolistic and subsidized with the full faith of the U.S. government, or in other words with taxpayers’ wallets. The original Fannie Mae was a government agency and should have remained as such. Or, conversely, securitization should have been opened up to free entry and no government guarantees granted to Fannie, Freddie, or any other mortgage securitizer. The government again nationalized the GSEs after their failure in 2008. Their future, however, remains murky. Fannie was spun off in 1968 to get it off the government’s books, which were under a bit of pressure due to LBJ’s Great Society programs and the Vietnam War. With the government’s financial position again rather tenuous – have you seen the budget deficit and the size of the national debt recently? -- there will be tremendous pressure to spin the GSEs off again and no guarantee that it will be done properly this time. Another prime example of the mixed or hybrid nature of the financial crisis is:

6) Government protected credit rating agencies. Of the many institutions responsible for the financial crisis of 2007-8, the big U.S. credit rating agencies (Standard & Poor’s, Fitch, and Moody’s) rank among the most odious because they appear unworthy of the trust many investors reposed in them. The agencies profited by giving high ratings to securities that ultimately proved toxic, or in other words nearly worthless and practically impossible to resell. An overabundance of such assets ultimately killed Bear Stearns, Lehman Brothers, AIG, and other major financial services firms and touched off a financial panic the likes of which had not been witnessed since the darkest days of the Great Depression. In addition to injuring investors, who lost trillions, the agencies’ errors also harmed many innocent bystanders who lost their jobs in the sharp worldwide recession caused by the financial system’s woes. The entire melancholy episode raises several important questions: Why do rating agencies exist? How did they come to have such power? What should be done about them? Financial securities are as old as the nation itself. During the Revolutionary War, government bonds lost most of their value because the rebel state and federal governments could not borrow or tax enough to make scheduled interest payments. The bonds traded only occasionally and at pennies on the dollar until after passage of the Constitution, when Treasury Secretary Alexander Hamilton took them in exchange for new bonds solidly backed by tariff revenues. The new bonds soon rose to par and traded frequently in the nation’s nascent securities markets in Philadelphia, New York, Boston, Baltimore, and Charleston, S.C. They were soon joined by the equities of scores, then hundreds, then thousands of business corporations, including banks, insurers, manufacturers of numerous stripes, mining companies, utilities (water and later telegraph and gas), and transportation companies like canals, turnpikes, and, eventually, steamship lines and railroads. Many of the last mentioned group also issued prodigious quantities of bonds. By the Civil War, over 20,000 corporations had formed and most of them issued at least one type of security. The markets for most early corporate securities were local or regional, however, so investors usually dealt directly with issuers. Before the Civil War, most companies sold securities themselves through a direct public offering or DPO rather than through an investment bank-intermediated initial public offering or IPO. Investors could assess the risk posed by securities without outside help because they often knew company organizers personally, understood the issuer’s business plan, and/or thoroughly knew its market. As companies, particularly manufacturers and railroads, grew larger and more complex in the second half of the nineteenth century, however, investors increasingly relied on third parties. Investment banks sprang up to intermediate offerings and information sources -- including industry journals and investment manuals -- proliferated. The best of them quickly grew more comprehensive and sophisticated. In the 1860s, for example, railroad journal editor Henry Varnum Poor and his son Henry William began the annual publication of the financial statistics of almost all U.S. railroads. In 1909, John Moody went a step further and began to rate bonds, or in other words to evaluate their risk of default. In 1916, the Poor Company also made the leap from information provider to securities evaluator. In 1941, it merged with Standard Statistics to form Standard & Poor’s, which McGraw-Hill acquired in 1966. The ratings business thrived because collecting and assessing financial information was costly and difficult. It therefore made economic sense for specialized firms to do it and to sell the results to investors. The original business model closely aligned the incentives of the rating agencies and investors. If the ratings were generally accurate, investors would continue to subscribe. If they were not, investors would switch to another, more accurate rating agency. Due to those incentives and that competition, ratings were as reliable as market prices and other performance indicators. Through the first three quarters of the twentieth century, the rating agency business was pretty sleepy. The rating agencies weren’t blamed for the Great Depression and shouldn’t have been. They completed their analyses, published their increasingly mammoth ratings books, and collected their subscriptions, increasingly from institutional investors like insurers, savings banks, and pension and mutual funds. But then two disasters struck. The advent of cheap photocopying made it easy for illicit entrepreneurs to make a fast buck by selling photocopies of ratings for a fraction of the price they cost the rating agencies to produce. That cut into revenues and profits, which sent the rating agencies scurrying for a new business model. Unfortunately, the one they hit upon – charging issuers -- was highly problematic to say the least. No sensible person or business bites the hand that feeds them. The new model therefore transformed rating agencies from pro-investor watchdogs into pro-issuer lapdogs. Before that happened, however, the government aided the then-struggling rating agencies by designating five of them -- the aforementioned big three and niche players A.M. Best and Dominion Bond – as Nationally Recognized Statistical Rating Organizations or NRSROs. The government also effectively perpetuated that cartel by barring new entry and forcing institutional and public investors, like public pension funds, to rely on the NRSROs’ ratings when making investment decisions. Even large, well-known issuers like General Electric had to pay for their securities to be rated or face loss of the institutional market. With such strong government support and an almost complete lack of market competition, rating agencies waxed complacent while the financial instruments they ostensibly graded grew ever more complex. The agencies even began to bill companies for unsolicited ratings! Since the late 1990s, a number of observers, including law professor and former investment banker Frank Partnoy, financial historian Richard Sylla, and hedge fund manager David Einhorn have argued that the new institutional arrangements dulled rating agencies’ incentive and ability to accurately assess the risk of issuer default. Ratings downgrades almost always occurred only after adverse news caused large price declines, many noted. Critics’ views gained credence when the rating agencies grossly overrated the securities of Enron, Worldcom, and other companies headed for bankruptcy early in the Third Millennium. On 29 September 2006, the government responded by passing the Credit Rating Agency Reform Act. The legislation, which quickly and easily sailed through Congress, facilitated new entry and abolished NRSRO-status. It did nothing, however, to change the perverse incentives at the heart of the system. The Reform Act of 2006 was a good start but in retrospect was too little, too late. The ideal regulation would support competition, freedom of choice and action, and transparency. Anyone who wants to rate corporate securities should be allowed to. Anyone who wants to use those ratings should also be allowed to, provided they properly disclose that fact to their investors. Nobody should be forced to use the ratings of any particular agency or agencies or indeed any ratings at all, again provided they disclose their practices if applicable. In addition, rating agencies should be free to sell their services to issuers, investors, or both but they should have to disclose the sources of their income. They should also be able to choose if, when, and how to guarantee their ratings. Agencies should not be forced to disclose their methodologies but book authors, journalists, bloggers, brokers, and others should be allowed to freely discuss the information the rating agencies disclose -- or don’t as the case may be -- and the pros and cons of their business models. An open approach like that just advocated would make the money and capital markets freer and hence less distorted, more like the svelte models of financial economists and less like binge and purge realities of the last three decades. It would also give rating agencies incentives to find less corruptible business models and perhaps even return to their original, investor-based model. Photocopies are cheaper than ever but encrypted databases are difficult to crack and nearly impossible to monetize. They can also be infinitely partitioned, from full, unlimited access for a big hedge fund to a single query on a single security by an individual investor. As soon as investors, especially institutional ones, make clear that they will no longer invest based on ratings that issuers have paid for, change will come rapidly and will be more efficient than reforms mandated from on high. The government is unlikely to follow the path just described, however, because rating agencies have large incentives to prevent it. Businesses generally dislike competition and typically expend much money and effort to avoid it – when it comes to themselves and not their suppliers or distributors, of course. Collectively, investors would benefit from fighting such special interests but a collective action or free-rider problem will likely prevent them from doing so effectively. It is possible, however, that a few large institutional investors could pull together and encourage more competition. The scope and nature of any new legislation or other policy changes are therefore difficult to predict but history suggests that the odds of marked improvement are low. The same could be said of:

7) Pathetic corporate governance. Far be it for me, or anyone else for that matter, to dictate how much a corporation pays for its talent. Unless, that is, I’m a stockholder. Then it seems like I should have some say. A lot of say in fact. But I don’t, and neither do other stockholders, unless they are controlling ones or the government. In fact, common stockholders these days have very little say in the management of the corporations they own. That was not always the case. Before the Civil War, stockholders reigned supreme. Small stockholders were protected from large ones by so-called prudent mean voting schemes, where the number of votes any one stockholder could cast was capped or where it took 5 or 10 more shares to get another vote in director and other corporate elections. Back then, directors consulted stockholders about everything important, including their wages. Stockholders could and frequently did call special meetings and conduct thorough investigations of the doings of managers and Board members. The situation changed in the second half of the nineteenth century, however, so that by the Great Depression Adolph Berle and Gardiner Means could complain, and rightly so, about the separation of ownership and control. At the same time, government regulations purposely stripped institutional investors of their governance rights due to some overblown fears about J. P. Morgan and his crew. As a result, we have a system of weak owners and strong managers. It is not surprising that those strong managers rigged the game in their favor with big bonuses, golden parachutes, and perks galore, like $35,000 dollar commodes. And what has the government done about this deplorable situation? Exactly nothing. Instead of making it easier and cheaper for stockholders and institutional investors to look after their own property themselves, it threatens to limit executive pay, at least at the companies that imbibed deeply of the government’s largesse last year. Of course all that it may end up doing is inducing those companies to return the government’s money ASAP, even if it threatens those companies’ recoveries. As for more general limits on executive pay, I hope that the government will never have the temerity to go there. But don’t get me wrong -- that doesn’t mean that some governmental oversight of compensation isn’t need to combat:

8) Distorted executive compensation systems. The structure of executive compensation, as opposed to the amount of compensation, I take to be a matter of public interest because of its clear connection to financial system stability. If their compensation structure rewards them for making short-term profits but doesn’t punish them for making long-term losses, managers will take big, short-sighted risks, thus greatly exacerbating systemic fragility. The proper policy here is fairly simple. Managers should not receive bonuses on the basis of alleged accounting profits. Such a system is too easy to game, either by manipulating the accounting assumptions or by deliberately backing projects that are short-term winners but long-term losers like -- oh I don’t know – subprime mortgages, CMOs, and other risky crapola. That’s not a technical term by the way. Deferred compensation, clawback, bonus-malus -- call it what you will – they all mean no more big paydays today on the basis of loans or other contracts with 15, 30, or more years to run. Stockholders liberated from the straitjackets I just described would push for more incentive-compatible contracts but while they rebuild their management monitoring skills the government should step in and force compensation deferment. And it should get other governments to sign on too, lest we lose some of our most innovative financiers and most important financial companies to London, Zurich, or Shanghai. And please do note that I refer here only to publicly-traded financial services companies, not to closely-held family firms or partnerships, which can take care of themselves as the big investment banks did from their formation in the nineteenth century until the 1980s and 90s, when they switched to the joint-stock form without, apparently, giving any thought to the implications for management incentives. Here again, the government has not even begun to move us in the right direction. Even if it does, there is still the problem of:

9) Static regulatory cling. Regulators are problematic for many reasons but primarily because they breed complacency. Why most investors believe that salaried government bureaucrats care more about their money than the investors themselves do is a difficult question to answer. I suspect that many people reason that because the U.S. government has the capability of putting a man on the moon, destroying the planet 100 times over, and so forth, it can surely stop financial fraud. Of course such reasoning is a tragic non sequitur. Regulators are not rewarded for stopping fraud or crises so they don’t do it. They are rewarded for upholding the letter, rather than the spirit, of the law, so that is what they do. As currently constituted, the government can no more stop financial fraud than it can catch Osama bin Laden. Like generals, regulators are prone to prepare to fight the previous war rather than the forthcoming one. With that analogy in mind, Sarbanes-Oxley was the Maginot Line of the 2008 financial panic. In the 1990s, companies incentivized managers with stock options. Some managers responded as hoped and increased the efficiency of their firms by lowering costs, expanding into new markets, gaining market power in established markets, and so forth. Others, however, found that to be too much work and instead increased stock prices with shady accounting practices. Sarbox stopped that from happening again, just as the Maginot Line prevented the Nazis from invading France directly. But it didn’t stop the other major way of getting stock prices up, by undertaking risky projects. Just as the Germans swept through the Ardennes and the Low Countries and from there moved into France, U.S. financiers simply outflanked the regulators sitting complacently behind Sarbox. Meanwhile, some observers complained that if only the government hadn’t repealed Glass Steagall, the New Deal legislation that separated investment from commercial banking, the crises of 2007 and 2008 would have been averted. That is a little like saying that if only French soldiers had stood in a line and fired their muskets in a volley at the German tanks and airplanes Paris would not have suffered the indignity of four years of German occupation. The Fed had already rendered Glass Steagall a dead letter by the early 1990s. Besides, the real culprit in the most recent crisis was not the large size and complexity of financial services firms per se but rather:

10) Too Big To Fail policy. There is a notion, not necessarily a bad one, that the government should prevent the financial system from freezing, exploding, or otherwise causing negative externalities for economies foreign and domestic. The Federal Reserve was created, in part, to serve as a so-called lender of last resort, as a safety net for the financial system. As part of that mission, the Fed announced in the mid-1980s that it would allow small banks to fail but in times of trouble it would step in to save the 11 largest banks on the grounds that their failure would threaten the stability of the entire financial system. The problem with the policy -- which is not only still in effect but has apparently metastasized into investment banking, hedge funds, and insurance – is two-fold. First, because the government offered its guarantee free of charge those institutions that are clearly “too big to fail” can pursue risks with reckless abandon, safe in the knowledge that ole Uncle Sam has their back. Second, those institutions that think that they are close to being considered “too big to fail” have major incentives to grow bigger so that they too can reap the rewards of taking on more risk – free of cost and, ironically enough, free of risk! The government thinks that it can offer the Too Big to Fail guarantee because of:

11) The Hubris of Planners. The government thought that it could raise homeownership rates by implementing a number of policies, including the tax breaks and GSEs formerly alluded to. Via policies like the Community Reinvestment Act, it also encouraged lenders to make loans to weaker borrowers when it should have instead eased entry requirements for credit unions and community banks. It also allowed the doctrine of secret liens to erode, thus enabling the growth of “silent second” and “piggyback” mortgages, or loans for down payments. When you let a borrower borrow the down payment you don’t really have a down payment, which was traditionally the number one defense against default because it served as a sort of life jacket that kept the borrower above water or with positive equity. Finally, the government allowed the development and proliferation of non-recourse loans. Essentially, it gave borrowers a free put option on their homes by allowing them to walk away when they are under water or in the bucket -- or in other words have negative equity – and to do so without serious adverse consequences. Such largesse certainly did increase homeownership rates, however temporarily, but did not increase the total amount of equity in homes. The put options, the silent seconds, and the Community Reinvestment Act all remain more or less intact.
Clearly, then, there is no Fairy Tale in our future. In fact, we should count ourselves lucky if our story ends they all lived rather than they all lived happily ever after.

At long last we come to the second scenario, which I call “Turning Japanese.” In this scenario, the financial system achieves stability but the economy remains stagnant, with an extended period of low or no growth, much like the Japanese economy has experienced for about two decades now. That is a sobering prospect but I believe that the probability of the U.S. economy turning Japanese, while greater than the “Fairy Tale” scenario, is nevertheless low. The people who most fear this scenario are macroeconomists fond of talking about liquidity traps, the inability to push on strings, and similarly inscrutable concepts. I think Helicopter Ben Bernanke of all people knows that he can lower real borrowing costs by increasing inflation expectations and the actual price level in a variety of ways even if overnight lending interest rates are near zero, something the Japanese could never quite bring themselves to do.

Moreover, I believe the stagnation of the Japanese economy runs much deeper than monetary policy. For starters, I think the Japanese economy simply outran its educational system, which focused far too much on rote memorization at the expense of creative or integrative thinking. America’s educational system, from K to Ph.D., is far from perfect but it does a much better job of nurturing creative genius. The United States also enjoys much more flexible labor markets and a superior system of entrepreneurship. It also traditionally did a better job of preventing the government from meddling too much in the economy, generally avoiding the trap of thinking that the economy needs the guidance of a Ministry of International Trade and Industry. If the U.S. economy does stagnate, it will be due to the ossification of overzealous bailout initiatives like that ridiculous [insert the name of your least favorite bailout here].

The third scenario I call “Louisville, 1839.” In 1837, the United States had been rocked by a financial panic so severe that many people, like O. D. Battle of Kentucky, could not even afford postage. By early 1839, the economy appeared poised to rebound so merchants in Louisville and elsewhere began to stock up in expectation of a strong recovery in 1840. You might think that their optimism was self-fulfilling, that their orders put factory and dock hands, clerks, and others back to work, and that those workers, paychecks in hand, increased employment for barbers, waiters, lawyers, and so forth in a virtuous and self-reinforcing cycle. ‘Twas not to be. Another round of financial troubles struck later in 1839 and quickly squelched all hope of quick recovery.

By 1840 things were so bad again that when Dr. Thomas C. Mercer of Louisville begged Norvin Green, who would later create Western Union, for a $25 loan, Green replied on the same sheet of paper that QUOTE so impoverishingly pinching are the Van Buren times that neither am I able to comply with your very urgent wishes, or to furnish a sheet on which to reply UNQUOTE and then he beseeched Mercer QUOTE pray don’t reply til fall when I shall probably be better able to pay the postage UNQUOTE. As one observer later recalled, early optimism actually delayed recovery because it meant that merchant shops bulged with goods purchased on credit that customers would not or could not buy. The streets of Louisville remained nearly deserted and real estate prices remained on the decline for several years after. As late as 1842 every day looked like Sunday in the streets of Louisville and other market towns as nominal per capita incomes fell from $97 in 1837 to $83 in 1843.

My fear, of course, is that another round of financial troubles will strike while the economy is still recuperating from the events of last autumn. The 1890s, 1930s, and 1980s also witnessed multiple financial crises spaced a few years apart and so-called double-dip recessions, long recessions with a period of slight growth in the middle. The most important questions we face, I believe, are: When will the next crisis occur, where will it strike, and how severe will it be? Again, I don’t make predictions but I am reminded of an old song by Merle Haggard called If We Make It Through December. <> Unfortunately, I don’t know which December will signal the all clear. Certainly not this one, but maybe next. Of course that will not mean that we’ve landed in the Never, Never Land of the “Fairy Tale” scenario, merely that we’ve avoided “Louisville, 1839” and probably also “Turning Japanese.”

That leads me to the final scenario, which I call “Return to Normality.” In this scenario, the economy is not subject to any major shocks -- financial, swinish, or otherwise -- and slowly returns, with some relatively minor ups and downs, to full employment right about the time the Mayans – the Hollywood version anyway -- say we are all going to be dead anyway. Of course I don’t really believe the Hollywood Mayans are right because if I did I would be surrounded by fishing poles, guns, beer, and women right now. In any event, employment is a lagging indicator so if and when the unemployment rate gets back to around 5 percent we can close this unhappy chapter in our economic history and look forward to the next unhappy chapter.
The only other scenario that I can think of is that a major war might break out and quickly drive the economy to full employment, much as World War II did. I sure hope that doesn’t happen as it is better to suffer from high unemployment and remain at peace than to suffer the deaths and dangers of full scale conflict, especially in this nuclear age. Placing a probability on large-scale war is notoriously difficult. On the eve of World War I many people argued that a major power war was impossible because globalization rendered it too costly. Boy were they wrong.

In conclusion, obviously I am not in the Obama administration. But if I were, I would strive to achieve the “Return to Normality” scenario. That would basically entail allowing the recession to run its course while simultaneously trying to foresee and prevent or at least mitigate potential shocks. To date, the government appears to have done a good job combating the swine flu and restoring some confidence in the financial system. The administration’s ill-conceived healthcare agenda, however, has created uncertainty and distracted attention from the desperately needed financial reforms that I discussed earlier. Cap and trade has the potential to do likewise. I conclude, therefore, that businesses should prepare for both the “Louisville, 1839” and “Return to Normality” scenarios. We could well muddle through this one without further incident but we might also face another large financial crisis and concomitant recession.

On that note, thank you for your time and attention and have a wonderful afternoon.

Finance and Economic Growth

2009-10-25T17:32:00.002Z

A week ago in Mexico City John Lipsky, IMF First Deputy Managing Director, made some interesting remarks on finance and economic growth. During the speech, he cited work by Richard Sylla, Peter Rousseau, and yours truly:

"The Wealth of Nations Rediscovered, by Robert E. Wright,16 is a fascinating and convincing portrayal of information efficiency in early (pre-1850) American capital markets, that in fact were subject to very light regulation."

No wonder Cambridge University Press has (finally) brought WONR out in paperback!: http://www3.cambridge.org/uk/catalogue/catalogue.asp?isbn=9780521120395
and
http://www.cambridge.org/us/catalogue/catalogue.asp?isbn=9780521120395