Capital markets and just desserts

Last night’s was one of those posts one regrets immediately after hitting “publish”. Somehow, those always attract notice. (Thanks Felix!) But, sometimes when one puts more cards on the table than one intends, it’s a good way to start a conversation. In fact, unintended candor is one of the great blessings of the blogosphere, and we must be thankful for that, even when we are our own victims.

Anyway, let’s continue the conversation. Who deserves to get paid in capital markets? I wrote…

Bears who were right deserve to get paid just as much as bulls who were right, and justice delayed is justice denied for shorts.

Felix Salmon‘s rejoinder:

[T]here’s only one species of investor who “deserves to get paid”, and that’s an investor with a contract which guarantees him money. I think they’re called bondholders. If you buy a security in the hope that its price will rise, or sell a security in the hope that its price will fall, you don’t “deserve to get paid” anything, whether you’re right or whether you’re wrong. Markets are not some kind of primary-school sports day where prizes get awarded to the most deserving. In the words of parents worldwide, “life’s not fair”.

Life is not fair, and Felix is quite right to note that markets don’t exist to mete out some kind of wise and just reward to each and every trader. But at the same time, markets ought not be poker games or casinos, where it is the lucky who are compensated, or those whose talents have to do with games disconnected from real events. Market outcomes are supposed to attach to external referents. It is no tragedy when the winds of randomness overtake any particular trader. But on the whole, for a capital market to be “good”, in a strong normative sense, it ought to compensate predominantly those who make wise judgments about the application of capital to real world enterprises, and to punish those who make poor judgments. Capital markets, actual, historical, and conceivable, are not all alike, and it is quite possible, and quite right, to make normative distinctions between. A capital market is not good because its prices go up. Nor do happy investors and happy fund-seekers define a good markets, in and of themselves. As Martin Wolf recently wrote, “Finance is the brain of the market economy.” What distinguishes a good capital market from a bad capital market is how well it does the economy’s thinking.

Bondholders absolutely do not “deserve” to get paid, any more than stockholders, or holders of derivatives, or any other financial position. A bondholder who lends to profligates to fund consumption, for example, absolutely deserves to lose, coupon and principal. And an investor who finds a firm that needs capital, and who correctly judges the firm’s activities and management as being of the sort that could put capital to good real world use, absolutely deserves to be paid, regardless of whether that payment comes in the form of capital appreciation, dividends, or interest. The purpose of capital markets is to compensate managers of capital for putting scarce resources to good use, and to punish managers who squander what is precious. Markets needn’t and can’t offer perfect justice. But if they fail on the whole to compensate the deserving and punish the wasteful, then we might as well banish them to riverboats.

Many of the best and brightest of this giddily corrupt moment err by forgetting that capital markets are human creations subject to wide variation in design and behavior. They mistake whatever some prominent market does for “the market outcome”, and forget that alternative arrangements in security design, regulatory regime, macrostructure of financial instititions, and microstructure of trading systems are all possible, and might produce very different outcomes, all of which would have equal claim to being “market-determined”. And the fact of a market doesn’t absolve us from making judgments about whether outcomes are good or bad, even though our nonmarket means of evaluating the world are at least as flawed as our markets. Failing to subject markets to reality checks, relying on them entirely for all of our economic thinking without letting other measures of economic sense weigh in at all, invites corruption.

I write not to attack markets, but to defend them. Dani Rodrik has suggested we must save globalization from its cheerleaders. It is equally urgent that we save capital markets from their cheerleaders. I believe that well-designed markets generally are the best way to make most large-scale economic allocation decisions, and that market-like systems could be productively employed in a variety of other contexts as well. But current capital markets are frankly off the rails, in a manner that most people not subject to ideological blinders are perfectly capable of seeing. I could be wrong. I’m not a market, after all, so perhaps I have no standing to opine. But even still, I could be right.

Which gets us back to the bit about short sellers. If I am right about bad things down the road, good capital markets should, on average, compensate me if I trade on my superior-to-market knowledge of future bad outcomes. The repricing brought about by my trading and the trading of many others who see what I see should work to make those bad outcomes less likely and less damaging. The “on average” is important here. I can be right, but foolish in execution or just unlucky, and get wiped out. That’s life. But markets that are systematically biased towards integrating positive information and ignoring negative information (until sudden “Wile E. Coyote” moments), that have institutional biases against short-selling or that delay price declines because some actors have more at stake in market prices than real-world referents, may, on average, fail to compensate shorts. If so, then rational people won’t short, prices far higher than reasonable economic value will be stable for long periods of time, “greater fool” strategies of investment will be profitable, and “adjustments” will come sharp, large, and painful when underlying economic realities can no longer be papered over. Markets compensate next-to-last fools in preference to wise allocators of capital, and leave everyone else with a mess. That, unfortunately, is the world we live in today.

Felix writes:

Steve is living in cloud cuckoo land if he believes in the “real-world meaning of market prices on the basis of direct valuation of the assets being traded”. If that was really the case, then there would never be any price difference between voting shares and non-voting shares, for starters. Capital markets, in this sense, have been failing for as long as they have existed. And a lot of smart, long-term investors have made a lot of money by arbitraging those failures. On the other hand, a lot of smart, long-term investors have also lost a lot of money by attempting to arbitrage those failures. Being smart and right is not enough to make you rich.

Although I plead guilty to living in cloud cuckoo land, I do not actually believe that actors trade only on the basis of real-world valuation. I do, however, believe that to the degree actors trade for “strategic” rather than fundamental reasons, they are corruptors of price signals, creators of noise, and that well-designed market systems will work to punish rather than compensate their behavior. To the degree there are “limits to arbitrage” that systematically pay off game-players and punish those who price the real world accurately, that’s a real problem that should be fixed. Felix is right that being smart and right will never be enough to make one rich in capital markets. Life is uncertain, and luck always matters. But if on average people who are smart and right about underlying realities lose, that’s a problem.

Felix:

But the surprising thing is precisely that there is some efficient allocation of real resources – not that there is inefficient allocation of real resources. Real resources have always been allocated inefficiently, and they always will be. Just look at the fashion industry.

No human institution is perfect. A glass is always empty or full by some fraction. But, when the glass seems so empty that you think lots of people are going to die of thirst, looking on the bright side is not the appropriate response. Maybe, hopefully, I’m just mistaken. But if one sees capital markets as broken in ways that could cause serious hardship and perhaps outright catastrophe, pointing out the flaws, even ranting a bit, is not entirely uncalled for. Or so I like to think.


On a personal note, my previous post was perhaps too “heartfelt”. The fate of my own portfolio doesn’t matter that much, even to me. I’ll not starve when I’m forced to cover my shorts. I only personalized the tale because, after telling others they should be ashamed of themselves, I felt ethically bound to reveal that my scolds could be taken as self-interested and manipulative.

I’ll end with a bit of Keynes, which resonates with my view of investing, short or long:

I should say that it is from time to time the duty of a serious investor to accept the depreciation of his holding with equanimity and without reproaching himself. Any other policy is anti-social, destructive of confidence, and incompatible with the working of the economic system. An investor is aiming or should be aiming primarily at long period results and should be solely judged by these.

Update History:
  • 14-July-2007, 3:40 p.m. EET: Replaced wordy “bears no relation to” with “disconected from”, “external reality” with real events”.
  • 19-July-2007, 4:52 a.m. EET: Removed the ungrammatical “s” from “a good capital markets”.

A sprawling rant inspired by an urban legend…

The story referenced below (hat tip Felix Salmon) may well be apocryphal. It has the feel of an urban legend, and I think I’ve read variations of the tale before, but without the topical Bear Stearns reference. Watch me take the bait, swallow, turn bright red.


From CDO Pool PMs – Just Chillaxing:

Asked how [a CDO pool portfolio manager] is doing, he says “nothing.” I ask, “What do you mean nothing, I hear all these stories about CDOs and losses (Bear Stearns for example)?” He shrugs and says nothing will happen until the rating agencies do something. Asked about losses, he says they are there but he doesn’t have to mark to market his portfolio until someone discovers it or the rating agencies force his hand. So his plan is to lie low and collect the management fees (and bonus) and pretend as if there are no losses…

He says he has the best job in the world and says there is really no work to do every day. Just wait and hope that the rating agencies don’t downgrade his CDO pool and voila, at the end of the year, he and his partners can split the $10 million spoils (minus the expenses for one Park Avenue office, and a secretary).

If this is real… Just two words. Jail time. If you take your 50bps on unimpaired values of assets that you know or should know are likely to be inflated, jail time is what you should get. And not just a little. That goes double (quadruple and 40?) for hedge fund managers taking fees on phantom value.

Do think about this while you’re “chillaxing” (in DealBreaker‘s colorful slang). Of course, you have your defenses. You rely on standard industry practices. You can claim that writing down assets prematurely would be unnecessarily damaging not only to you, but to your investors, to CDO investors as a whole, your mom’s pension fund, and the Western financial system. Of course your lawyers are confident the charters, prospecti, indentures, whatever are airtight, that valuation procedures are clearly spelled out, and everything is hunkydory if you can just hold back the tide a few more months. But it’s amazing how little the lawyers can do for you once transit workers’ retirements and university endowments go up in smoke and pitchforks. It’s like China, with this guy just executed for making a buck looking the other way on food safety. Probably lots of similar players got away with deadly corruption. Maybe a dispassionate look at the odds of getting caught said this was a rational game to play. But somebody somewhere is gonna get unlucky, gonna get smoked. It might as well be you.

Here’s another word: Shame. Aren’t you at all ashamed to take money from your investors in this way? Would you take a Rolex from a jewelry store window if you could get away with it? Don’t give me that crap about professional investors and big boys who know what they’re getting into. Asset managers (CDO pool, hedge fund, whatever) don’t have an adversarial relationship with their investors. They have a fiduciary relationship. That is, they have an ethical obligation to do what is in investors’ best interest even if it conflicts with their own. I believe that’s a legal obligation, by the way, even if it’s not spelled out in contracts and founding documents. A judge surveying the wreckage might take that into consideration, if you get my drift. Especially when the big boys you “out-traded” were themselves fiduciaries for thousands of ordinary broken dreams.


Now before I go finger-wagging too much — shame, shame — I should emphasize that I have a dog in this fight. Here’s “full disclosure” in the lingo. I belong to a maligned, belittled, battered and bruised species, the unhedged speculative short. I don’t have positions directly related to CDOs or hedge funds or housing — I’m a broad macro pessimist kind of guy. (I am short financials, short semis, short the Dow, short USD, long gold, an FX basket, TIPS.) Should I be ashamed? Am I just talking my book? Trying to provoke an apocalypse for thirty silver coins? Felix claims that “courts are unlikely to have a huge amount of sympathy for short-sellers.” Everybody thinks that we’re the bad guys.

But I’ll tell you what. Short sellers are the good guys in financial markets. We’re the guys who take risks that by most people’s lights are simply irrational. Markets generally do go up and inflation does inflate. Nine times out of ten, a short is just a subsidy to a long. Short sellers are the true idealists. People like me, we’re not traders, we don’t backstop. We hold our positions and payout dividends until our margin runs out, and then we die (metaphorically), simply because we believe that assets are overpriced. We believe that prices are not numbers you trade, but references to real-economic facts. If prices are out of whack, in order for financial markets to work, someone has to try to arbitrage them back, and it might as well be us. We do hope to make a buck. We have our evil dreams of profiting just when everyone else is taking losses, and thereby being well positioned to buy value when it finally comes around again. But objectively, that’s never a good bet. At some level, being a short is a vote for how financial markets ought to behave, rather than how they do behave. In the late 1990s, most unhedged shorts were right, and were slaughtered for the privilege. I fully expect that in the late 00’s, I will have the same experience. But my sense is that the consequences of the capital market mispricings we have been unable to correct this time will be much more painful than the aftermath of the 1990s. We shorts don’t want to see a “financial armageddon“. After all, we’d never collect our paper profits from bankrupt brokerages and clearinghouses. We become shorts because shorts are supposed to be the mechanism by which catastrophic misalignments (and the distorted real-world incentives that accompany them) are prevented. Ordinary investors are pulled by fear and greed. “Buy and hold” shorts run on greed and idealism (and, many would suggest, sheer idiocy). Fear doesn’t matter. We generally start losing money the day we take our positions, and we keep losing money until we can’t. We are irrational, because we believe that markets should be rational. We believe that market prices have consequences, and that exaggerated asset prices do at least as much damage to the real economy as depressed prices.

I’ve been at this for a couple of years. I may be wrong about the fundamentals, in which case I’ll take my losses with a shrug and rebuild my wealth in a healthy economy. I don’t advocate fire sales, and am glad to see loan workouts and liquidity support that allow unwindings of positions to last more than a few days. But I have no patience with those who claim that the best thing to do is not acknowledge financial asset impairments that would persist even over a month-long auction (in contrast to a day long liquidation). Asset values can always change, but at some point you’ve got to concede that the issue isn’t liquidity but uncertainty-adjusted value. Bears who were right deserve to get paid just as much as bulls who were right, and justice delayed is justice denied for shorts. Similarly, investment banks who knowingly overpay for assets in order to prevent larger losses on derivative positions are market-manipulators, and should face consequences for that. As should central banks and sovereign wealth funds, if their trading in markets other than their own debt is driven by anything other than direct return maximization as ordinary price-takers. There is no theory that lets us give real-world meaning to market prices when price-setters are driven by second-order side effects rather than direct valuation of the assets being traded. We have no reason other than blind faith or ideology to believe that anything resembling efficient allocation of real resources would occur in an economy driven by capital markets with bizarre feedback loops. I think we are watching capital market failure happen all around us, and it will work out badly.

Failing to take write-downs and tolerating central bank subsidies will eventually drive all us bears away. But that won’t mean good times as far as the eye can see any more than all the successful 5-year plans of the Soviet Union meant that socialist paradise was at hand. Sometime within the next few years, today’s shorts and chicken littles will be vindicated. But we’ll still be poor, along with the rest of you. And that’s too bad, for all of us.

Free trade in the 50 states?

Tyler Cowen invokes a case frequently made (among Americans) in favor of free trade:

…I am still waiting for someone to defend trade barriers across the 50 states.

It’s important to note that even among the 50 states, textbook “free trade” does not exist. There are no tariffs, but the United States is riddled with internal “export subsidies”. When a state or locality puts together a deal to attract a factory, retain a corporate headquarters, or support a local industry, what is that about? Those tax breaks, underpriced loans, and infrastructure buildouts are explicit subsidies whose purpose is to ensure some economic activity happens “here rather than there”, for reasons that elude sterile Econ 101 models of trade. They are usually granted to firms or industries that produce for markets much larger than the subsidizing locality, and, as with export subsidies, the benefits are shared by far-flung shareholders, managers, and customers, while the direct costs are borne locally by taxpayers. Yet they are still popular. States worry openly and realistically that they may lose industries without competitive incentive packages. The usual justifications for these programs precisely match the arguments for export subsidies — jobs (first and always), fighting poverty and blight, creating “clusters” (“Silicon”-everywhere in the late 1990s), and defending against depredation by other localities. Lots of governors, mayors, state legislators, and city councilman routinely defend these trade barriers across the 50 states.

Using the United States, plural, as a standard-bearer for “free trade” argues for a world with few tariffs, but a whole lot of strategic government subsidy. That might be a good model, actually, but it is not the model free trade ideologues usually have in mind.

Update History:
  • 12-July-2007, 5:15 a.m. EET: Gently reorganized sentence beginning “They are usually granted…” (for style, not substance).

Synthetic greater fools

Yves Smith at Naked Capitalism, riffing on a post by James Hamilton, ponders the question of why some CDO investors might have bought securities that were “losers at the start”. Hamilton suggests that investors must not have understood what they were doing. As Yves puts it, “[H]ow could investors be so dumb? The buyers were institutional investors, after all. These guys are supposed to be pros.” Yves suggests that underwriters, sometimes believing their own hype, sometimes with adroit porcine cosmetology, did a great job of selling iffy paper. Here’s another explanation, on the buy-side.

Do you remember the “greater fool” theory of investing from the late-1990s? For many high-flying internet stocks, the disconnect between stock prices and “fundamental” valuation was so obvious that buyers knew they were purchasing securities which, if held for the long-term, offered negative expected return. But it was quite rational to buy them anyway, so long as it seemed likely that someone else, a “greater fool”, would buy them at an even higher price than the one you paid. Most serious players understood there would be a reckoning someday, but that there was lots of money to be made today regardless. The risk-return tradeoff on playing the fool for just a little while was quite favorable. Those willing to take big chances for a short time, and smart enough not to try to play “double-or-nothing” indefinitely, did very, very well for themselves.

At first blush, today’s markets look nothing like the heady stockmarkets of the 1990s. After all, many of the securities that seem overvalued now rarely trade: structured credits backed by mortgages, commercial debt, credit cards, etc. Generally an underwriter sells an offering to institutional investors, who may plan to hold the paper to maturity. If secondary markets are thin, if no one is buying or selling, who could be the greater fool?

But, in fact, it is not “institutions” that buy this paper, but managers who are paid for performance. And from a manager’s perspective, all these securities do trade, about once a year, when bonuses and performance fees are taken. During bonus season, hypothetical valuations of illiquid securities become converted into liquid nonrefundable cash, just like during an ordinary sale. Institutions effectively purchase securities from themselves, at arbitrarily high prices, and pay their managers a commission for the privilege. Financial innovation truly has been a wonder these last years. Institutions have cut out the middlemen and become their own greater fools, to the benefit of managers and the detriment of other stakeholders.

Many managers would be quite content with short, lucrative careers followed by long, wealthy retirements. They are faced with opportunities to “earn” money on so grand a scale that a rational person, looking at historical norms, would sacrifice a lifetime’s wages for a few good years. At extremes, shame and legal risk constrain manager behavior. But, to the degree individual managers can attribute self-interested behavior to evolving norms and standards in their profession, they are protected. A “safe” position, from a manager’s perspective, is one in which losses to the portfolio they manage are likely to be accompanied by widespread losses elsewhere, so that blame attaches to vast, vague “systemic” problems, and not to the manager personally, who was, after all, only one person, doing her job like so many others. Surely no liability, and no great ostracism, should attach to that.

Like a polluter earning immediate visible profits but exacting diffuse, hard-to-measure costs, managers at hedge funds, endowments, and pension funds are producing cash and “diffusing” risk whose costs will eventually be borne by someone. Institutions may now be their own greater fools, but the rest of us, apparent bystanders, may turn out to be the greatest fools of all.

The Bear and the Dragon

Gather ’round ye cassandras and dark oracles, nigh the time is come! The wounded bear roars and writhes, and surely, surely! his claws at last will prick the green tumescence of the credit pimple, and a pustulence of default and devaluation will gurgle across the land!

Or not. The crisis at two hedge funds managed by Bear Stearns has all the markings of a systemic-crisis-threatening event. (If you’ve not been following, tsk. Naked Capitalism has been doing a phenomenal job covering the story.) But I don’t think anything bad is going to happen, because the bear and his friends in the forest (hedgehogs?) are, ultimately, protected by the Dragon.

First let’s review the what happened. Bear managed a hedge fund that made leveraged bets in illiquid CDOs backed by subprime mortgages. That was a winning strategy for a long time, so, by popular demand, Bear opened a second fund taking on even more (um, “enhanced”) leverage to reap those juicy mortgage yields. But, things have gone suddenly wrong in mortgageland, and the funds were forced to inform investors that they had lost a lot of money. Investors found themselves locked in, with lenders demanding that the funds put up more collateral or face forced liquidation of their assets.

Forced liquidation would have been, um, bad, from a green-pustulence-flowing-in-the-streets perspective. There are lots of hedge funds holding illiquid, hard-to-value synthetic debt based on iffy mortgages. With help from debt-rating agencies, fund managers are employing the strategy Wile E. Coyote would have followed, if he were smart enough to understand Gaussian copulas and stuff. It’s called “Don’t Look Down!” Since exotic securities don’t trade very often, there is no clear market price, no clear value to which funds have to “mark” their portfolios. So hedge fund managers use models to make educated guesses of what their securities are worth. Since managers earn fees by seeming to perform well, they tend to use models that, lo and behold, spit out optimistic, all-is-well valuations of their portfolios. However, a “fire sale” at Bear would put Wall Street Panglossians under pressure, as all of a sudden market prices, not very nice market prices, would be attached to securities quite similar to the ones in their own portfolios.

Let’s understand what we mean by “pressure” here. Imagine you’re a hedge fund manager sitting on a pile of leveraged rocket science that you privately think has lost much of its value. You have two choices. You can use a model that captures your intuition, and mark down the assets, forfeiting any performance fees and your seven figure job too. Or you can hold tight, keep the faith. If you make it to the end of the year, you get a big performance fee, which you get to keep even your faith turns out to have been misplaced and your investors lose money. This is a no-brainer, right? Keep da faith!

But there is a wrinkle. If you take that hefty bonus, but you really did know that the fund didn’t perform as advertised, well, there are technical terms for that. Theft. Fraud. The language of high finance can be arcane, but maybe you get my drift here. Currently hedge funds are relying on safety in numbers. If “industry best practice” is to value CDOs and XYZPDQs optimistically, then, hey, you can’t be faulted for following “industry best practice”, can you? But if anyone can make it stick that you knew, or should have known, your portfolio was trash… well, that’s bad. Plausible deniability is the whole game here. If very low asset prices from some hedge-fund yard sale get published in the Wall Street Journal, some fund manager might get nervous, and mark down his assets too, bragging about “integrity” and other unprofitable hogwash. All of a sudden, “industry best practice” is what he’s doing, and you’ve got to follow along or take a chance on Sing Sing. With each capitulation, each markdown, investors get more and more nervous, more and more inclined to remove funds, forcing more sales, liquidations, lower prices, a death spiral, the Great Depression.

There might have been some danger of this sort of thing happening on Friday, but the danger has passed. Bear put up 3.2B of its own money to save one of its funds. (Well-collateralized repo financing we are told, but if the collateral is trash… let’s just call it a “mezzanine tranche”.) That seems to have been enough to persuade creditors, some of whom had threatened to pull the plug abruptly and start selling, to give Bear some space to work out the debts of the other (more toxic) fund at, um, a measured pace. Does that matter? After all, if the assets are impaired, fire sale or no, they’re not going to fetch a good price, right? It might go slo-mo, but the same scenario should unfold eventually, no?

I don’t think so. Here’s where the dragon comes in. Several years ago, Nouriel Roubini and Brad Setser warned very plausibly that the United States’ current account deficits were unsustainable, that developing countries like China would not be able to fund America’s huge and growing deficits for very long at all. They were (quite honorably) wrong. Among other things, they expected that China’s central bank would be unwilling or unable to accept the future financial losses implied by massive purchases of US debt (which is likely to lose value in terms of the China’s Yuan). China has instead accelerated its USD purchases, proving its willingness to accept very large losses (or else high future inflation) in order to meet its primary objectives: stability and growth.

Stability and growth remain China’s objectives, and a financial crisis beginning in New York is every bit as threatening as a stock market crash in Shanghai. China could not have acted fast, as the US Fed did during the LTCM crisis. But, so long as only a few funds are in crisis and the unwindings are “orderly”, I think China will find it in its interest to be a “bagholder of last resort”, purchasing a few assets at prices high enough to prevent cascading markdowns or defaults against margin lenders. Fund investors will still lose money, but that rarely has systemic implications. As hedge fund proponents frequently point out, hedge fund investors are hedge fund investors because they can afford to lose money. (That’s not really true, but we’ll let it go here.) China won’t buy anything directly. Look for secretive hedge funds claiming that US mortgage assets are undervalued, great opportunities, despite the continued freefall of housing. Just as fire sales threaten to puncture confidence and lead to mass markdowns, apparent arms-length purchases at high prices reassure that optimistic models are fine, permitting fund managers to do what they want to do — report good performance and take their fees without jeopardy.

Of course, if confidence in valuations does break, no one could bail out the whole market, it is too big. Eventually there may be some kind of reckoning. But the logic of the moment, in New York, Washington, and Beijing, is that in the long-run we are all dead, so let’s put stuff off as long as possible and hope for the best. Anything that can be bailed out will be bailed out. The money is there, eager, and ready.

The Economics of Subsidy

Here’s Dani Rodrik on export subsidies:

[T]he economic case for countervailing duties is extremely weak. (The standard economist’s line is that you should respond to other countries’ export subsidies by sending them a thank-you note, not by shooting yourself in the foot in return.) But presumably there is some (second-best or political) reason why WTO rules sanction countervailing against subsidies.

This paragraph struck me as delightfully odd. Two facts that don’t get along are stuck together and left to eye one another warily:

  1. Export subsidies are so widely perceived as harmful to recipient nations that the World Trade Organization, a body whose “overriding purpose is to help trade flow as freely as possible“, countenances trade barriers to combat them.
  2. Standard economics suggests that an export subsidy represents a windfall to recipient nations, an opportunity and a boon, not a harm at all.

What gives? In the wide and wonderful field of economics, is there no room at all for the commonplace observation that a subsidy often does harm to its recipient?

In everyday life, we know that in order to do more good than harm with a subsidy, we often need to make predictions about how the recipient will respond to the grant. Offering to cover an 18-year-old’s college tuition is very different than cutting a no-strings-attached check, even if the money’s the same either way. Some 18-year-olds would be better off with the cash than a paternalistic tuition grant. But most probably would not be.

This sort of analysis is a priori out of bounds to any economics that views people as rational maximizers. If the best thing a teenager could do with a couple hundred thousand dollars is to turn it into a four-year annuity for college, the utility maximizing teenager will do that. If she chooses to do something else, by revealed preference, that must be the better choice. Right? No.

We reject this kind of reasoning in real-life, even when considering fully competent adults. If we can understand why it is not nice to put a slice of apple pie on a struggling dieter’s plate, or why very low introductory “teaser rates” on a home mortgage can entice borrowers into dangerous situations, why can’t we understand that certain kinds of subsidies increase the likelihood an economy will trade short-term gains for long-term harms? Of course we do understand that, even the WTO understands it, but economics as a discipline has a remarkably hard time coming to terms with the intuition. Human choice is endogenous and stochastic, not exogenous and rationally determined.

There’s an important distinction between noting that certain subsidies increase the likelihood of bad outcomes for a recipient and suggesting that the provider of a subsidy is therefore culpable for the outcomes. It’s usually counterproductive to blame someone else’s generosity for ones own poor decisions, even if the generosity was cynical and the bad consequences were anticipated by the donor. A crucial feature of subsidy is that it may be refused. A dieter may prefer not to be tempted by the sights and smells of heaven à la mode. But if a host insists on offering, she should still refuse the pie. At the national level, things are more complicated. An export subsidy likely to cause long-term harm to a nation may unambiguously benefit some individuals. How does a nation “refuse the pie”?

By enacting countervailing import tariffs, according the the WTO. But that seems like poor table manners, like raising a middle finger when a simple “No, thank you” would do. If only they could get over the logic of “might as well eat”, economists would have little trouble devising polite but firm ways of saying no.

We’d still miss the pie. But maybe that’s for the best.

Felix Salmon on Inflation

Felix Salmon has a very nice take on core vs headline inflation:

[I]t does seem clear that there is a significant and positive gap emerging between headline inflation (which includes food and energy prices) and core inflation (which strips them out). The gap is essentially a tax on poverty.

The poor spend a much larger percentage of their income on food and energy than the rich do, and they don’t benefit much from large drops in microprocessor prices. If this gap is sustained going forwards, then the real income of the poor is going to be eroded by inflation much more quickly than the real income of the rich. Not that there’s much the poor can do about it. The rich, on the other hand, have the Federal Reserve on their side, since the Fed targets the core inflation rate.

Combine this analysis with the Fed’s particular vigilance against rising wage costs (the only thing that helps poorer people get richer) and you might wonder whether the Fed is a beneficent, technocratic manager of monetary policy, or a covert agent of class warfare against the poor.

OK. That’s a bit much. There are very good reasons for stripping out food and energy prices out of inflation measures, and paying special attention to wages. Inflation is bad not because some particular price level is ideal, but because some prices are sticky. A rapidly changing general price level will leave many prices glued to non-equilibrium values, impairing price signals in the economy and harming efficiency. Food and energy are not stripped out just because they are volatile. (There are lots of techniques for smoothing or averaging time series. Trimmed means and medians can be used to get a smoother view of distinct monthly datapoints.) Food and energy are left out of the core because their prices are not sticky, so price changes in these sectors are unlikely to distort the real economy.

Similarly, wages are particularly sticky, and can almost never go down in nominal terms. When wages rise above equilibrium levels, the Fed finds itself between a rock and a hard place. If it maintains price stability, overpriced wage levels exert a drag on the real economy. To get the economy chugging at full potential, the Fed will have to “accommodate” some inflation to bring wages back down in real terms. But a jump in the price-level may create self-fulfilling inflation expectations among workers and firms, leading to a “wage-price spiral” that is hard to slow down once it gets going. It’s better for everyone, therefore, if the Fed is diligent about not letting wages get ahead of themselves to begin with.

That’s all well and good. But aren’t house prices downward-sticky too? There are indeed very good reasons for the Fed to pay less attention to food and energy, and very much attention to wage levels.

But isn’t it odd that right and proper theory somehow requires that the Fed to tilt the playing field towards capital and the already wealthy, and to fight any increase in the bargaining power of people who neither speculate nor to borrow, but who work every day and live off the proceeds?


Note: I’m pretty sure I first read the justification outlined above for stripping food and energy from core measures somewhere on David Altig’s excellent macroblog. I can’t find the specific post, but alotta love to him anyway. (It’s possible, since I can’t find the post, that I’m misattributing this argument to Altig. If I am, sincere apologies, but good vibes anyway for his very thoughtful blog.)

Update: It looks like the argument about stripping food and energy from core inflation may have been cribbed from Mark Thoma rather than David Altig. All the brilliant econobloggers kind of look the same to me. Anyway, see this post by Mark Thoma.

Update History:
  • 15-June-2007, 10:00 p.m. EDT: One really should get ones attributions straight before posting. Anyway, replaced my vague attribution to David Altig with a specific attribution to a Mark Thoma post.
  • 15-June-2007, 10:25 p.m. EDT: Added a comma.
  • 16-June-2007, 12:15 a.m. EDT: Tightened up the text a bit (last paragraph of the main essay).

Orthodox Economics: Descriptive, or Tranformative?

Like you, dear reader, I was transfixed by last week’s lovely debate on heterodox economics. One of the subtexts of that conversation was a simple question: Why can’t we all just get along? Nearly all the heretics conceded that orthodox economics is useful and interesting. The defenders-of-the-one-true-faith generally conceded that there are deep, unresolved mismatches between fundamental tenets of mainstream economics and how people actually behave. In fact, as the orthodox-but-still-hip Dani Rodrik suggested that the usefulness of orthodox economics comes from exploring precisely how and why neoclassical fairy tales don’t come true.

But if that’s the case, it seems odd that one admittedly broken paradigm would so ruthlessly dominate the profession. Why is it that, as Thomas Palley notes

Orthodox lefties (e.g. DeLong, Krugman, and Rodrik) believe the Arrow-Debreu framework not only provides a good starting point for thinking about the economy, [but that] it is the only point.

After all, there are a lot of flawed approaches to economics that we could use to help us think about what we cannot understand. Why is the neoclassical error so special that, as Max Sawicky points out

The duty of orthodoxy is clear: deny departmental positions and resources to inferior research programs and purify the top journals of incorrect thinking, all understood as maintaining high standards. After you deny them professional positions, standing, resources, and exposure, the only thing worse that could be done is to commit errant economists to mental institutions.

That characterization may be over the top. But even defenders of the mainstream concede that pursuing other approaches is an uphill battle. Here’s Mark Thoma:

If you choose the heterodox path, you will be on the outside, and you need to understand that going in. You might get lucky and gain respect over time, and if you make a really big splash economics departments may then start hiring people in the area, but don’t expect that because it’s unlikely to happen. At best, you might become part of a small group with common ideas and interests, but larger acceptance will be elusive (though not impossible). It will be harder to publish, your colleagues will wonder why you’ve drifted so far out of the mainstream, the work you do publish won’t get the respect you think it deserves either within your department or in the profession more generally — it’s likely to be a frustrating experience on a lot of fronts. That’s how it’s going to be.

Why? What’s so special about one broken framework that those who choose other approaches must toil like monks under a vow of obscurity?

There are lots of possible answers, many of which were hashed over last week. But it strikes me that perhaps we are all missing the point. Perhaps orthodox economics isn’t even trying to describe how the world works. Perhaps the project is really about how the world should work. If life can imitate art, why couldn’t life imitate a model?

Here’s a famous bit from Marx:

The bourgeoisie, wherever it has got the upper hand, has put an end to all feudal, patriarchal, idyllic relations. It has pitilessly torn asunder the motley feudal ties that bound man to his “natural superiors”, and has left no other nexus between people than naked self-interest, than callous “cash payment”. It has drowned out the most heavenly ecstacies of religious fervor, of chivalrous enthusiasm, of philistine sentimentalism, in the icy water of egotistical calculation.

So, as a writer, this guy is a bit overwrought. But there is a powerful idea here. Marx does not claim that human beings are “naturally” given to egotistical calculation. Instead he claims that however “man” might have been, social change is possible that transforms him into what we now refer to as a “rational maximizer”. The assumptions of neoclassical economics are not a priori true in this view, but they can be made true.

Think about that. Mull it over. And while you do, let a photomontage play upon your inner eye. Here’s Adam Smith, with his beneficient invisible hand. Now David Ricardo is explaining why selfish nations trade, and how trade has no losers but makes everybody better off, and interdependent. Slip forward in time and admire the elegant theorems of Coase, Arrow, and Debreu. This is a happy story. This is a great story. If only Marx were right, if only human beings could become something like efficient, selfish, rational maximizers, then we can prove, prove, that we would end up with the best of all possible worlds, by a certain definition.

Viewed in this light, the vehemence of the orthodox project makes a certain sense. It is not interesting to harp on the fact that people are not as they ought to be, and therefore our theorems and models don’t accurately describe the world. We know that. We build models to make sense of the deviations, so we can correct the “market failure”, the human flaw. Our job is not to describe the world as it is, but to understand how it is different from what it ought to be, and to fix it. The “MIT Keynesians” are open to using government to remedy human error, while more traditional neoclassicals view the Leviathan as a wildcard too large and dangerous to risk. They imagine that some more decentralized process — something more like the dynamic Marx himself described — could effect the necessary transformation. Both groups agree, though, that the project is to make the hopeful logic of economics actually work in this messy and often hopeless world.

What would a “heterodox economist” have to offer here? Those weird lefties who, contra Marx, think that Homo Economicus is so unreal as to be irrelevant, who view the world through prisms of power, institution, race, caste, or gender, amount to nothing more or less than fatalists. It is not the accuracy of alternative descriptions that is at issue, but where they lead — conflict, grievance, and struggle. For heterodox economists the end of history is where it began, nature red in tooth and claw.

By the way, I write not to bury but to praise. I think Marx was right about the transformational nature of capitalism, about its capacity to hew egotistical calculators out of flesh, blood, and claw. I sit at my desk surrounded by health insurance forms, bank and brokerage statements, tax documents. My colleagues come from everywhere, from I don’t know where, I can’t keep track of whether a hundred years ago their grandparents tried to kill my grandparents or vice versa. The orthodox, or bourgeois, project has succeeded marvelously, and for all that has been lost (and much has been lost), I am glad of it. I’ll go with the neoclassicals or with the MIT Keynesians, whatever. Whatever works.

But (more Marx) orthodox economics contains the seeds of its own destruction if it fails to recognize the degree of its own delusion. When Ricardo’s lovely story is not in fact working out, we should admit that to ourselves. Our goal is to create the preconditions whereby our optimistic models would actually predict. If we have failed to do that, then clinging to the behaviors that our models prescribe may lead to outcomes, um, inconsistent with general welfare. We may have to fly by the seat of our pants for a while, and then try again to get it — that is, us — right.


Bloggers mentioned:

Update History:
  • 15-June-2007, 09:20 p.m. EDT: In light of this, added attributory links, for various allusions. “Leviathan” alludes to Thomas Hobbes, and “nature red in tooth and claw” is taken from In Memoriam by Tennyson.

Nations are places

It’s obvious that nations are places, right? But somehow that fact is lost in much of the debate over trade and immigration. Instead, the argument usually goes something like this: Trade and immigration help some people and hurt others, though gains should exceed losses in the aggregate. How do we weigh benefits to winners against harms to losers?

But trade and immigration policy don’t just affect people. They affect places. Why should that matter? Places experience neither pleasure nor pain. Places do not love. If you prick them, they do not bleed. Isn’t it right that economists ignore places, and focus on how policy affects human beings?

No, it is not right. It is dangerously obtuse. You will often hear economists laud the indirect benefits of market economies. Where markets flourish, virtues such as tolerance, diligence, entrepreneurialism, and creativity thrive as well. Markets depend upon trust, and market-based societies tend to develop unusually strong habits of trust between unrelated strangers, as well as institutions for punishing violations of good faith impartially. Where there are markets, there is industry, human capacities are exercised, and profitable collaborations are encouraged. Markets promote wealth, and affluence leads to beautiful private spaces, and then beautiful neighborhoods and vibrant cities for all. Markets create incentives for human beings to improve themselves even more than their homes, filling the world with interesting, passionate, talented people.

These indirect effects of economic activity amount to what I’ll call “emergent public goods”. These are distinct from (but complementary to) traditional public goods, like roads and parks, that governments explicitly purchase. But here’s the thing: In successful nations, access to emergent public goods is the single greatest asset most citizens have. Why would so many people from broken countries give up whatever wealth they’ve accumulated to live in the United States or Western Europe? Because access to the public goods on offer in those places is worth more than all that they own, and more than the awfulness of having to start over in a strange place, confused, mute, and alien. Even when direct public goods are withheld (for example, from illegal immigrants), emergent goods flow like air to everyone, simply by virtue of where they are. “Opportunity”, the fudge by which economists turn the pain immigrants endure into net-present-value enhancing rationality, is nothing more than an emergent public good. And opportunity, like other emergent public goods, is attached to place.

I am (very reluctantly) trade-skeptical at the moment, and not because I think that the United States’ present aggregate losses are larger than its gains from trade. On the contrary, I wish to see Americans’ current debt-for-goods trade stop despite any aggregate gains, because I think that this trade pattern is undermining America’s capacity to sustain and enlarge its portfolio of public goods. It is not that unbalanced trade is hurting people (although of course it is hurting some and helping others). Unbalanced trade is hurting the place, and the place, the privilege of living in this extraordinary country, is the most important asset Americans have, however long they’ve lived here.

Trade in services (i.e. outsourcing) and immigration have broadly similar distributional effects. There is little economic difference between a programmer in India writing code very cheaply and the same individual coming to the United States and doing the work for less than the local prevailing wage. Nevertheless, I’m inclined to favor the immigration, but not the trade, under present circumstances. Why? Because when a worker immigrates, the productive economic activity happens here, in this place, and that is oxygen to America’s portfolio of public goods. When Americans trade debt for services performed overseas, the good side effects of human industry happen somewhere else, and the bad side effects of accumulating debt happen here. It’s all the same to the people. But unbalanced trade hurts the place.

Nations are places. Quality of place is incredibly valuable, and potentially fragile. Any consideration of trade or immigration that tallies up gains and harms to people is incomplete if it fails to take into account how different economic arrangements affect the quality of places.

Update History:
  • 04-June-2007, 02:25 p.m. EDT: I’ve cleaned up several small grammatical errors and tightened the text a bit since first posting.

Carbon Tax & Trade

Would it be possible to design a carbon tax that the public would enthusiastically support? That would be progressive, rather than regressive, imposing greater costs on the rich than the poor? Is it politically possible to strictly limit the total amount of carbon emitted, without rewarding past polluters with windfall emissions permits? Yes, it is. And it’s fun! Politicians — Here’s an opportunity to give money to your constituents, and save the world too! It works like this:

First, enact a carbon tax. Nothing fancy here, just your usual I’m-Greg-Mankiw-Wanna-Join-My-Club? “Pigouvian” carbon tax. Embedded in what drivers pay at the pump, added as yet another surcharge to heat and utility bills, would be a new Federal tax on carbon sold or used as fuel. That was easy.

Unfortunately, a carbon tax is regressive. It imposes disproportionate burden on the poor, as the higher cost of driving to work and heating a home takes a much bigger bite out of a burger-flipper’s paycheck than a hedge-fund manager’s “capital gain”.

But, here’s a trick. Just as flattish taxes are regressive, flattish subsidies are progressive. So, when we enact the carbon tax, we grant citizens the right to a refund of the tax on a fixed quantity of carbon consumed. We distribute those refunds equally among all taxpaying US citizens annually. And, we permit citizens to sell any refunds they won’t need to use.

Suppose, in the beginning, we set the amount of refunds to be equal to the total expected carbon tax, given 2007 US carbon consumption. This seems dumb, right? In the aggregate, we’ve just created a system whereby the government collects a tax and sends it right back out again, exacting a net cost of zero from the private sector for its profligate use of carbon. All the government has done is caused transfers within the private sector. Yes. But from whom to whom? Light users of carbon end up receiving cash, from the excess permits they sell, while gas-guzzle-monsters pay up! That’s likely to mean that most poorer people earn cash from their allotment, paid for by the people whose Hummers they can’t see over. Moreover, note that our refunds are distributed only to taxpaying humans, not to businesses, but businesses are still subject to the tax, and can purchase refunds. That means that on net, the government will have underwritten a transfer from businesses to voters households. The vast majority of human beings will see ka-ching positive net wealth from this scheme, without any cost to the government. People who conserve more will earn more, people who conserve less will earn less, or even have to pay. Businesses will buy refunds from households, so long as the cost of the refund is less than the cost of the tax. When there are no more refunds left to buy — when aggregate carbon consumption exceeds the refund allotted — some users will have to pay the tax outright, at whatever rate the government has set.

Now of course a tax on business is indirectly a tax on households. But this is a tax businesses can minimize, by reducing their carbon footprint. That is, after all, the point, to change behavior. Plus, taxing indirectly via businesses, rather than taxing households directly, increases the progressiveness of a tax. Not all costs are passed on to consumers. Some costs take a bite out of profits, harming relatively well-off capital-owners disproportionately. (That’s why we have things like corporate taxes.)

The political economy of this scheme is interesting. Since this is a tax that creates an income for most voters (earned, of course, via parsimonious use of carbon), voters might be expected to support increases in the level of the carbon tax, as this increases the value of their refunds. Increasing the tax level faster than the refund allotment makes most voters richer, and helps save the world. It also creates strong incentives for businesses to conserve carbon. As the tax level gradually grows very large, the scheme converges to a cap-and-trade, because it becomes prohibitively expensive for anyone to pay the unrefunded tax.

Would this scheme be hard to implement? Not terribly. Remember, we begin with a simple carbon tax, and we start small and build gradually, so that the refund infrastructure has time to evolve. For a while, lots of refunds would go unused. (They needn’t expire quickly.) The government maintains a system of accounts, linked to taxpayer IDs, and encourages private-sector actors to implement trading systems. Carbon consumers claim refunds by submitting proof of taxes paid (bills and receipts), which the government reimburses with a deduction from the claimant’s refund account. The process would be quite analogous to the value-added tax reimbursements of businesses apply for in many countries. Consumers who are too busy or disorganized to deal with the paperwork can just sell their refunds and pay the taxes (though they lose some by doing this). Initially, a small industry would spring up to ease the process of claiming refunds, in exchange for a cut. Eventually businesses would find competitive advantage in automating the process. Gas stations, for example, would have every incentive to electronically submit claims on behalf of customers, so that customers see a discount right at the pump. Fraud would be an issue, as it always is. There would be problems, scandals, and solutions.

There’s been a lot of debate among the pious, which is more godly, carbon tax, or cap-and-trade? Here’s a scheme that starts as a carbon tax and evolves into a cap-and-trade, that creates incentives for consumers, businesses, and politicians to reduce carbon use, that can be implemented gradually, that doesn’t reward past polluters, and that leans just a little bit against inequality. What do you think?


Update: For a similar but much simpler idea, see Softening the Impact of Carbon Taxes. The paper proposes a fixed cash rebate of carbon taxes collected, rather than tradable refunds. Thanks to commenter (and author) Dan for pointing this out.

This idea was inspired by Martin Feldstein’s Tradeable Gas Rights proposal, via Mark Thoma. I first suggested something like this as a comment to Mark’s post.

Update History:
  • 26-May-2007, 08:35 p.m. EDT: Added update linking to Carbon Tax Center whitepaper.