Market-Based Management®

History Repeats Itself?

I was putting together some clips for a friend of mine to share with her students. Trying to find something accessible to high school students, but still representative of economists I admire and find relevant, I came across the famous Milton Friedman Interview with Phil Donahue. I'm certain I've seen these before (but it's probably been 4-5 years), and listening to the first one, I was amazed at how this could be aired today and be relevant.

Here it is. Go here if you want access to the whole thing.

This was filmed in 1979. If the production quality (and fashion) was better, it could have been filmed a year ago. Anyway, this is a great interview. Did you find anything particularly striking? Are there other Friedman interviews you know of that are timely?

A glimpse at government-managed healthcare...

From today's NY times...

"Eventually, we may well have to decide against paying for expensive treatments with only modest benefits."

Coolest Website of the Month

Here is one of the most interesting and useful websites I have come across in a long time.  Be careful, you may end up spending hours there. 

Quoting from Wolfram|Alpha's site:

"Today's Wolfram|Alpha is the first step in an ambitious, long-term project to make all systematic knowledge immediately computable by anyone"

Mathematica has grown into an awesome product.  This application of it is inspiring.

Enjoy.

What is Liberty?

One of my favorite movies is The Princess Bride - and I especially enjoy the character Inigo Montoya, who after listening to his boss Vizzini say the word "inconceivable" for the umpteenth time in reaction to several events, says, "you use that word a lot... I do not think it means what you think it means."

The latest Cato Unbound will be devoted to the meaning of Liberty.  It's a cherished ideal and a word we throw around a lot... and Inigo's lament might apply more often than we'd be comfortable admitting.

So if you're curious, head on over to Cato Unbound and watch the discussion unfold.  The lead essay is by the authors of "A Brief History of Liberty," David Schmidtz and Jason Brennan.  Participants engaged in writing reaction essays and participating in the debate will be Tom Palmer (Atlas Foundation, author of Realizing Freedom), John Christman (Penn State), and Philip Pettit (Princeton).

Someone Finally Takes the Time to Analyze the Housing Bubble

In an age where everyone seems to boil complex issues down into simple platitudes, such as “greed,” it is nice to see that Dr. Arnold Kling has taken the time to dissect the Financial Crisis of 2008. Of course, any comments I have on the paper will do it little justice, but (with apologies to Dr. Kling) I will endevour to try and provide some summary for our busy blog readers who may not have the time to read the entire paper.

Although there are many insights in the paper, perhaps the most profound is Dr. Kling’s discussion of how the regulatory remedies for past financial crises ended up contributing to the future ones. For example, after the record number of bank failures and home foreclosures in the 1930s (a problem exacerbated by regulatory prohibitions on bank branching), the government began encouraging 30 year mortgages, introduced the mortgage tax deduction, and added depositor insurance. Although very popular (the mortgage tax deduction is very popular with me), these measures rewarded indebtedness and encouraged folks to spend more on housing. If we fast forward to the rampant inflation of late 70s and early 80s, we find savings and loans holding portfolios of 30 year mortgages whose values were rapidly being destroyed by inflation. Additionally, the S&Ls were forbidden from raising the interest rates they paid above a specified “Q” rate. As potential depositors could get more for their money in money markets with the same amount of liquidity, they withheld their funds from the S&Ls. Subsequently, the S&Ls found themselves in the lose-lose situation of holding imploding assets and facing a dry creek for cash flow. Desperate, and with the knowledge that the government insured their customers’ deposits, many S&Ls went “long” on high risk deals with the potential to save them. Eager to keep these institutions open, regulators complied (another underlying current in Kling’s article is that the supposedly “un-greedy” regulators appeared at best indifferent and at worst played cheerleader to the actions of “greedy” bankers). After many S&Ls went bust, regulators started to explore ways of avoiding what had caused the S&L Crisis. The Q rate was phased out, but the problem of inflation eroding mortgage assets remained. The solution was to encourage the securitization of mortgages.

Securitization promised increased lending to poorer potential homebuyers while supposedly spreading the risk. However, the Basel Accords (an agreement reached in 1988 among the central bankers and regulators of ten countries including the U.S.) inadvertently increased the risks associated with securitization. As far as I can tell, the Basel Accords included a provision which attempted to set standards for capital reserves held by banks. However, banks often held reserves in many different forms (cash, government bonds, corporate bonds, and mortgaged-back securities). Basel tried to get regulators to agree on how “valuable” each of these different types of reserves were according to their risk, which was assessed by a risk multiplier against their face value. For example, as cash and government bonds hold little risk, every dollar of cash or bond counted as a dollar in capital reserves. Since corporate bonds are considered riskier than government bonds, a bank holding corporate bonds in reserves could not count them at face value but at a discount. For example, $1 in corporate bonds may only count as $0.50 worth of reserves. Although not in the top tier of gash or government bonds, guess which type of financial instruments were considered to have the next least risk? Yes, mortgage backed securities! Accordingly, the banks loaded up on them. This overvaluation of mortgaged-backed securities essentially allowed banks to lend more and keep lower capital reserves. Unfortunately, when the price of these mortgage-backed securities collapsed, banks’ reserves fell below minimum requirements leading to what is best described as the insolvency of the banking system.

Of course, there are many more worthy points to mention (for example how in 1968 the government used Fannie Mae and Freddie Mac as vehicles to keep government subsidized housing debt out of the federal budget deficit and thus avoid a budgetary procedure that allowed Congress to challenge appropriations for the Vietnam War), but the core of Kling’s argument is that over the course of seventy years the government created a regulatory environment that elevated mortgage lending above other forms lending (commercial lending for example). All that being said, I do not want to make out that the article is a government-bashing blame game; the article is an impartial look at the incentives created by regulatory structures. As a society and through a free and fair political process, a majority decided that we valued housing enough to subsidize it. Unfortunately, the realities of economics dictate that when you subsidize something, you tend to get too much of it.

Infrastructure, Markets, and Commerce

There is a lot of talk afoot of the need to rebuild the nation’s infrastructure, and a favourite charge of anti-marketeers is that markets cannot provide complete, integrated networks of roads, bridges canals etc. However, while the market may not provide transportation networks as extensive as those built, subsidized, or sponsored by government, the market would be more likely to provide transportation infrastructure where it would bring the most benefit to the most number of people, while maximizing the efficient use of society’s scarce resources. Of course, those wishing their teeny village a multimillion dollar bridge would be fresh out of luck. Furthermore, the public would be denied admittedly impressive but value-destroying white elephants, such as the Channel Tunnel or the Big Dig. However, this is not to say that the government cannot build worthwhile projects (anyone who has flown into Reagan National Airport can tell you it really needs a much longer runway), but the question remains that even if the market fails to produce a worthwhile public project, then will the politicians and the planners get it right?

I was recently reminded of this quandary while working my way through Tim Blanning’s The Pursuit of Glory: The Five Revolutions that Made Modern Europe: 1648-1815, which includes a chapter discussing the nature of roads and road-building in seventeenth and eighteenth century Europe. Relying on contemporary accounts, Blanning begins a typical historian’s gush about the grand nature of French road-building and the colossal task undertaken by tens of thousands of workers and vast expenditures by the central government. However, unlike most historians, he digs a little deeper and discovers that, for all the highways’ grandeur, few people bothered to use them. Consider the following quote from Arthur Young—an Englishman touring France in the early eighteenth century. Although much (and grudgingly) impressed with the French roads, he observed that they had emptied a mere ten miles out of Paris and while moving south he observed:

“In 36 miles, I have met one cabriolet, half-a-dozen carts, and some old woman with asses. For what all this waste of treasure?”

So why had such massive roadworks failed utterly to encourage commerce? The answer lies with who decided where the roads went. Eager to impress important persons at court, ministers built roads to serve the latter. Accordingly, the Duc de So and So might have a beautifully paved road running to his remote country chateau, while a major commercial hub went un-serviced. In addition to serving the powerful, the royal roads had also been built to convey the king’s post, edicts, and orders to the far corners of the realm. Thus, the French roads tended to shoot out like spokes in a wheel from Paris towards the regional centers of administration. Unfortunately, while this ensured a straight shot from Paris to many locations, getting from anywhere to anywhere else in France by royal road meant going through Paris. The Sun King’s roads may have radiated out from Paris, but they allowed little in the way of lateral movement, which greatly reduced their commercial utility (a fine road is of little value if one cannot get to it). Despite the dearth of traffic, Frenchmen could rightly take pride in their roads, but often reproducing Young’s fair-mindedness, French travelers to England declared her roads just as fine—If not better—than their French counterparts. According to visitors (French and otherwise), the problem with English roads was that they were too crowded with a steady movement of carriages and carts that one Frenchman described as “magical.”

So why were the English roads crowded and the French roads bare? A logical suggestion might be that the English government employed smarter planners or had a better road-building bureaucracy than the French. However, the truth of the matter is that while the French government dedicated huge amounts to road construction, the British government hardly lifted a finger. True, English locals did owe a customary duty to keep the roads in their district in repair, but this custom had long since degenerated into farce with the gatherings of workmen quickly degenerating into a combination of shirking, drinking, and brawls (not necessarily in that order). This all began to change in 1695 when an entrepreneur petitioned the British Parliament to allow him to build a road upon which he might charge a toll, which would be collected at either end and admission granted through the turning of a pike. No doubt encouraged by a share of the promised revenue, Parliament rapidly agreed. Seeking to maximize the volume of his turnpike, the entrepreneur picked a location that would serve the most traffic. Furthermore, in order keep the revenue flowing fast and furious, he made sure that the road remained in top condition and that the maximum amount of traffic moved smoothly. Following the profits of this first trail-blazer, numerous entrepreneurs began petitioning Parliament for the right to serve the public for a nominal fee. While the turnpike acts came slowly at first (only 25 passed in the 1730s), the improved roads apparently made it easier for members of Parliament to get to London to pass more turnpike acts. The number of turnpike acts increased to 37 in the 1740s, before exploding to 170 during the 1750s and an additional 170 the following decade. By 1770 an estimated 15,000 miles of roads had been built in Great Britain, while the traveling time between most places in the British Isles declined by a factor of four.

What was true in the eighteenth century is true today. Markets can and will provide infrastructure provided they are allowed to. Meanwhile, government sponsored infrastructure is more likely to serve the interests of politicians than the people. History is littered with “bridges to nowhere,” and that trend is unlikely to change anytime soon.

The Role of the Federal Reserve and the Housing Bubble

We recently received the following excellent question about our post on the current mortgage crisis.

Question: One of the solutions we have seen to the economic recession we are now in is to push down interest rates for home loans to help out the housing market. If these loans are once again made with implicit or explicit government guarantees to home buyers with less than perfect credit are we setting ourselves up for another crash?

Great question! The short answer is yes, but I would wager that we not dig ourselves a bigger hole this time (largely because the financial steam shovel that dug it is decidedly out of commission). I neglected to mention the role played by the Federal Reserve in the earlier post because everything already appeared complicated enough. However, the Fed played a very important role, which definitely deserves its own post. In the previous post I mentioned how depositors leave money in banks, which is then lent out as mortgages, which are then sold to Freddie and Fannie, who then sell them to investors. Thus, the cycle is fed by both ends as money from investors works its way (via Freddie and Fannie) back to the banks where it mingles with more money from depositors and is leant out again to begin the cycle afresh. What I did not mention is that banks have a third source of funds—the Federal Reserve. Essentially, the Federal Reserve lends money to banks (either through buying bonds from them or direct lending). The money supplied by the Fed is the source of the nation’s money supply and is simply created electronically and dwarfs the amount of physical currency in circulation, which is determined by the rate at which people want their electronic dollars turned into tangible ones. The Federal Reserve began its current policy of lower interest rates in 1997. Part of this policy was due to the fear that the Asian Financial Crisis would trigger a credit crisis in this country, which did not materialize (although there was a mild credit crunch). A less well known reason for this policy was a quiet agreement between the Federal Reserve, President Clinton, and the Republican Congressional leadership. Concerned about government deficits, Alan Greenspan persuaded the government to rein in spending. Politicians, however, were concerned that less government spending would slow the economy, so Greenspan agreed to offset any economic pain caused by budget cuts with lower interest rates. The lower interest rates fueled an economic boom, which turned to bust in 2000-2001 and was made worse by the dot.com bubble and 9/11. The perceived need to stimulate the economy has kept interest rates very low since then, which, of course, added more fuel to the monstrous circle of lending and buying mortgages.

But will these lower interest rates create a new bubble? As mentioned above, they probably will. However, we must recognize that this time the vicious cycle discussed in the earlier post should not re-materialize or do so on a much smaller scale. For starters, banks are being careful of whom they loan to, and Freddie and Fannie are broke and can’t buy the mortgages off the banks. Furthermore, having been badly burned, investors won’t be buying the mortgaged-backed securities that poured cash into Freddie and Fannie, which then made its way into the banks and resulted in more poor lending. That being said, this does not mean we will not see a bubble. No matter how noble the intentions, the economic paradigm remains—when something is subsidized you get too much of it. This is true for everything from credit and housing to ethanol. It was true in the 19th century, when government subsidization led to a railroad bubble and in the 21st when cheap credit fueled the dot.com and housing bubbles. Anyway, hope this answers your question, and thank you very much for sending it. While we don’t get a lot of comments, several hundred people read this blog every day. While this is flattering in itself, we would feel even better if we got more questions.

The Mortgage Mess Explained (Sort of)

I get a lot of questions in class regarding the current mortgage mess and subsequent credit crisis. While I try my best to answer, I think the honest truth is that no one really knows what exactly has happened and whatever the truth is often distorted by pundits and ideologs. So here it goes—my best effort to explain this mess the best I can, and, as always, corrections and knowledge sharing is more than welcome.

One thing must be made clear—the mortgage market is not a free market—it is pricked and prodded at nearly every point by government activity that has distorted the process. True, there is much involvement by private entities, but we shall see how their actions merely responded to incentives offered by government manipulation of the market.

So it all begins with depositors leaving their money with the bank. Since deposits are insured by the Federal Deposit Insurance Corporation (FDIC), depositors need not do due diligence on the financial institution they leave their money with and don’t care if the latter make silly loans. Flush with cash from reassured depositors, the banks look to loan it out. Say Joe Schmo wants to buy a home, but Joe has lousy credit (we will avoid the usual credit points system and just give Joe a CCC rating). If Joes was a company looking to borrow money, then the bank may think twice, but there are no worries with the mortgage—Joe may not even have to put any money down—just pay the fees and Joe has his loan. Why would the bank do something so foolish? Because, it is not foolish. The bank doesn’t have to hold onto the mortgage and wait for Joe to default. In fact, the bank probably wants to get rid of Joe’s mortgage as fast as possible. Luckily for the bank, there is always a willing buyer for troublesome mortgages like Joe’s. Fannie Mae and Freddie Mac (two technically private entities chartered by the federal government) will buy the mortgage from the bank. The bank now has more money to lend out to the Joe Schmo’s of the world (who also may or not be real estate speculators) and also has the incentive to repeat this cycle over and over again.

However, Joe’s mortgage does not stop with Fannie and Freddie. Fannie and Freddie take Joe’s loan and combine it with other mortgages to create mortgage-backed securities, which they then sell to investors. Fannie and Freddie then use the money to buy more mortgages from banks who loan the money out again. So what self-respecting investor would buy a security backed by shaky mortgages? The answer is a conservative investor adverse to risk. “Huh?” you say, “why would a conservative investor buy something backed by a bunch of mortgages taken out by folks with lousy credit?” At this point the investor neither knows nor cares about Joe and his credit. When Fannie and Freddie sell a mortgage-backed security to an investor, they guarantee the mortgage payments. As far as the investor is concerned, the mortgage-backed security is sound as a pound. It was for this reason that mortgage-backed securities proved popular with traditionally risk adverse financial institutions such as insurers (like AIG) and hedge funds. Since a mortgage-backed security guaranteed a stream of interest payments, investors found all sorts of uses for them. A common use was as an interest rate swap, where a company looking to hedge against cash flow difficulties would swap its cash flow for the guaranteed stream of interest payments from the mortgage-backed securities. In short, mortgage-backed securities appeared to be a great way for companies and financial institutions to hedge against risk.

Unfortunately, what looked to be a firm foundation ended up being made of sand, because behind all those “good as gold” mortgage-backed securities lay Joe Schmos with rotten credit. The problem was that when credit rating agencies looked at mortgage backed securities, they didn’t see Joe and his CCC credit but guaranteed financial instruments which gleamed AAA and imparted this shine to the institutions holding them.

So what happened? Many of the loans had been made at adjustable, rather than fixed, rates. Since many folks had borrowed much more than they should of, even a small increase in interest rates meant big increases in mortgage payments. Not surprisingly, more and more people began defaulting on their mortgages as rates increased. Conventional wisdom had held that this would not be such a big deal for the holders of defaulted mortgages. After all, the house could always be sold to cover any losses. However, the prolonged slump in the housing market meant homes sold at greatly reduced prices or not at all. Entities such as Fannie and Freddie found themselves held to guarantees that they could not meet. Deprived of their guaranteed interest payments from mortgage-backed securities, investors (and the credit rating agencies) began to see what really backed the securities—homeowners with poor credit living in much depreciated housing.

This is when the house of cards fell down. No longer able to simply make dodgy loans and sell them to Freddy and Fannie, the banks started being more careful about who they leant to. The tightening of credit led to even less home buying and further depressed the market, which pushed the value of mortgage-backed securities even lower. Meanwhile, at the other end of the spectrum, investors discovered the real worth of the mortgage-backed securities they held. Many venerable institutions suddenly found themselves writing off billions of dollars in assets, and some, like Bear Stearns, simply imploded. To make matters worse, the use of interest rate swaps meant that companies with no real connection to the mortgage market saw their cash flow hedges dry up. In the meantime, consumers started worrying about paying their mortgages and fiercely reined in their spending, which caused the economy’s aggregate demand curve to shift back (or to the left). The subsequent evaporation of demand is now driving down prices, eroding profits, and producing layoffs, which are, in turn, leading to more defaults and further depressing consumption. To be blunt, we are in for a very rough tide. However, barring nuclear war, things always get better over the long-term. The good news about sharp recessions is that they are often over the fastest. Furthermore, as I blogged about earlier, the government’s reaction has been nowhere near as pigheaded as in the past, but will more government oversight stop this from happening again? Probably not, the chief culprit behind this mess has been the government’s thirty year drive to encourage homeownership in America. While this is a worthy goal, it depends on cheap credit given to those who may not be entirely credit-worthy. Somehow, I do not think this policy will change anytime soon, and it will only be a matter of time before those on Capitol Hill call again for easy lending, and then we start all over again.

This is NOT another Great Depression

Times are not good, but pundits should really stop talking about us being in another Great Depression. Sure there is a banking crisis on, but they have happened before. Sure the government is doing silly things like bailing out industries and passing ineffectual “stimulus” packages. However, the government reaction to the current crisis is by no means comparable to the combined stupidity of the Hoover and Roosevelt Administrations. When the Great Depression hit, the government sprung into action (especially Hoover who is often wrongly labeled as doing nothing). Unfortunately, the government proceeded to take the worst possible actions. Below is a list of three broad categories of actions taken, which, if they did not make the Depression worse, certainly prolonged it:

1.Higher Taxes: The Revenue Act of 1932 raised taxes across the board with the top rate going from 25 to 63 percent. The law also doubled the estate tax and raised the corporate rate to 13.75 percent. Subsequent revenue acts in 1935, 1936, and 1940 added further increases with the top rate eventually reaching 79 percent. Although corporate taxes only rose to 22.1 percent, the 1936 Act provided for the taxation of undistributed profits (those not paid out in dividends). Furthermore, the 1940 Revenue Act created a 50 percent top rate on “excess” corporate profits. Despite these draconian tax measures, the hikes produced little in the way additional government revenue, nor did the nation achieve any significant gains in the way of decreasing inequality.

2.Higher Tariffs: Passed in 1930, the Smoot-Hawley Tariff raised tariffs on 20,000 items to record levels. Foreign governments retaliated with tariff hikes of their own, and world trade contracted an astronomical 66 percent between 1929 and 1934. Both U.S. imports and exports declined dramatically, and the breakdown of international comparative advantage took a heavy toll on the world’s total economic activity.

3.Tight Credit: Although it is difficult to characterize the government’s confused monetary policy in the 1930s in a single paragraph, the end result was that the money supply contracted by about one-third, which led to deflation. Furthermore, as government had pressured businesses not to cut wages, deflationary pressure on wages manifested itself in massive unemployment. Rather than easing rates, the Federal Reserve raised interest rates, while insisting that banks hold higher reserves. Those banks that did not fail (and prohibitions on branching meant that thousands did) ceased lending.

With the disasters above in mind, let us take a look at what is being done now:

1.No (or fewer) Higher Taxes: Congress has apparently lost its stomach for higher taxes, and talk has shifted away from raising taxes and towards postponing any pending rollbacks of the Bush tax cuts. Even if taxes were to be “unlowered,” then the top rate would revert to the old rate of 39.6 percent, which, while steep, ain’t 80 percent. At 35 percent, American corporate taxes are already some of the highest in the world, so there is not much room for them to go higher. Furthermore, the stock market slump has promptly silenced most calls for an increase in the 15 percent capital gains tax, which would—at worst—revert to the old rate of 20 percent in 2011.

2.No Higher Tariffs: While valuable free trade deals with South Korea and Columbia are on hold, no Smoot-Hawley-like tariffs appear in the works. In fact, the one solid thing to come out of the recent G-20 Summit was a pledge by member nations not to raise tariffs. Even if nations do begin to raise tariffs, unlike in the 1930s, the World Trade Organization (WTO) exists to moderate disputes and hopefully prevent the catastrophic trade wars of the 1930s. U.S. tariffs are low and will likely remain that way. Despite the tough anti-trade rhetoric of the presidential campaign, it is likely just rhetoric. When a campaign pledge to renegotiate NAFTA caused concern in Canada, Ottawa was essentially told privately that it really was not serious.

3.Ample Credit: Rightly or wrongly, the Federal Reserve and the Treasury have provided ample liquidity to financial institutions. Despite cries that the credit market has “seized up,” inter-bank lending remains high. Banks are willing to extend credit to those with good credit ratings—just not as much to those who should not be lent money in the first place. Although the current crisis springs from many causes, a major implication is that the repackaging and backing of mortgages created an unnaturally high mirage of widespread credit worthiness, which (considering that these mortgages were backed by valuable assets—as in homes) was perhaps not altogether unreasonable. Yes, many banks are in trouble, but the credit will be there to stave off most collapses, while drastic deflation (despite huge drops in demand) is unlikely to materialize.

Of course, there is much to write about this subject, which is complicated and even not fully understood. However recessions happen. They can be sharp and quick or long and shallow. The deciding factor is often government reaction. The Great Depression did not just happen, poor policies took a recession and stretched it out for 11 to 20 years (depending on who you talk to). So while we complain about the bailouts, it is important to remember that much dumber things have been tried in the past. The current economic slump maybe painful, but it will not be another Great Depression. Markets are tremendously creative and resilient forces. They will always fix themselves—as long as they are allowed to.

Making Money the Old Fashioned Way

This would be hilarious were it not also tragic (HT: Coyoteblog). PickupPal is an internet site that allows would be carpoolers to meet online and coordinate travel plans. Drivers post when and where they are going, while passengers post where they want to go and how much they are willing to pay. Sounds like an ideal win-win situation—the folks save money, gas, and reduce congestion. However, not everyone was thrilled with PickupPal, and an Ontario bus company sued alleging that PickupPal operated as an unregulated transport company. The bus company won. The Ontario Highway Transportation Board fined PickupPal $11,000 Canadian dollars and ruled that ridesharing is only legal if it is between home an work, does not cross municipal boundaries, and is with the same driver each day (who can only be paid no more frequently than weekly).

While prosperity springs from multiple sources, at its core lies the amount of freedom that people have to exchange with one another. When this freedom is circumscribed by legal boundaries, then society is almost always worse off. Of course, while we as a society may wish to limit some exchanges (arms dealer and terrorist for example), restrictions like those placed up PickupPal are both silly and destructive. The bus company is better off, but the good people of Ontario now have a slightly lower standard of living. We may laugh at this example, but all over the world consumers have their choices by similar legal boundaries. Paradoxically, most of these laws are championed by “consumer advocates,” who advocate for consumers by limiting their choices. Needless to say, companies are more than happy embrace laws that protect them from additional competition. While the title of the article is “I’ll Never Let Canada Live This Down: Evil Carpool Startup Fined,” I cannot help but think that we will see PickupPal sued south of the border soon. Cities and states won’t stand for the loss of revenue or the lucrative practice of selling taxi cab monopolies. The excuse will be lame—probably something having to do with quality or the service will be blamed for the inevitable traffic fatalities or some sort of carpooling serial killer—but it will come; and we will all end up a little poorer.