Monday, June 30, 2008

Democrats turning record Republican deficits into record surpluses is valuable even if Republicans turn them right back again, for learning alone

With regard to Mark Thoma's excerpt of Brad DeLong's article, "The Democrat's Line in the Sand":

It's important to point out here that just because Republicans more than un-did all of the good of Clinton in turning their record deficits into record surpluses, in just 8 years, that doesn't mean that Clinton didn't do a very good thing, with lasting benefits.

He gave a stunning demonstration of how much better Democrats were in this important regard, that was glaringly obvious to almost all voters. If Obama again turns record Republican deficits into record surpluses, and a booming economy, just like Clinton did, will it all have been for nothing if a successive Republican administration just turns them right back again into record deficits? No way.

The first time that happened it severely discredited Republican brain dead economics. If it happened yet again, it would rightly devastate the credibility of Republican alchemy economics with the voting public. This learning would be very valuable to protect us in the future against the great economic inefficiency and costs of their ideology.

However, the biggest and most important thing Democrats can do is to pass universal health care. This would be like when the Democrats pushed through, over the Republicans, old age Social Security and Medicaid. The programs were enormously popular once they were enacted and people got a chance to see the truth of how good they were, rather than the Republican lies. They greatly improved our quality of life and now can (probably) never be taken away.

The same would be true of universal health care. Once it was enacted people would see just how much better, and less expensive it was, due to vast free market imperfections in this area, such as externalities, asymmetric information, great economies of scale and monopoly power, inability to patent, inability to price discriminate well (a very important market inefficiency, especially for products with a large idea/information component, that doesn't get enough attention), and more.

The Democrats gained enormous political -- and ideological -- capital after they passed the new deal and the vast majority of voters saw how much better it made their lives and the country. This moved the country, and thus by necessity, the Republican party, far in the progressive direction. The momentum lasted for decades, and some of the most important changes made are so embedded and clearly demonstrated to be of great value, like old age social security (of at least some substantial kind), that they will (probably) never be undone .

Likewise, the political capital Democrats would get from bringing universal health care to the American people, greatly increasing their security, wealth, and quality of life would be vast. It would greatly increase their ability to do good in any area. Global Warming may be the most important issue, but the best way to fight it is to pass universal health care. That would give Democrats the political capital necessary to pass far more ambitious projects to combat it, maybe even a Manhattan Project, or Moon race, to replace fossil fuels with alternative energy and nuclear.

There's nothing more important for Democrats than passing universal health care (which is not at all incompatible with running a budget surplus), and it's very doable...Stay tuned for my next post.

Friday, June 27, 2008

The tax increases are well worth it for what you get in return, even for a family with a $300,000 income

In response to Lane Kenworthy's June 24th post, "Making Ends Meet on $300,000 a Year":

Clearly this family is living very luxuriously, $500/month for a country club, $75,000 in cars every 4 years, $9,000 per year for vacations -- ever heard of camping, driving to Six Flags and staying at the Holiday Inn. And, a $600,000 house, with commensurate maintenance, insurance, and property tax costs. I know in Orange county, this just buys a very nice middle class house in a nice suburb, but in the vast majority of the country you need less than half this much for such a house.

A key thing though is, it's not that Obama would be making them pay extra taxes for no benefit in return. Even at their income level the benefits from Obama's tax increases would be substantial. These include a great decrease in their health insurance costs, and the health insurance costs of their employers, which should eventually be passed along in higher wages.

The tax increases would increase public health and safety, substantially benefiting the quality of life of them and their children.

College would become a lot more affordable, so their children wouldn't be saddled with $150,000 in student debt like they are, and they would have to save less for their children's education.

Public recreation would be better, so maybe they could play on the public tennis courts or send their children to a free public community center. And how about neighborhood public parks that families can freely go to, instead of so many people being walled off in gated communities. These neighborhood public parks were much more common before conservative Republicans took over 28 years ago.

The list goes on and on.

Even for a family this wealthy, I would guess the benefits substantially outweigh the costs, and this is overwhelmingly true for the median family.

The main reason is that Obama's and the Democrats spending programs, by and large, recognize what the scientific academic economics community learned long ago. An intelligent government role can greatly increase efficiency, wealth, and welfare, due to problems with the pure free market like externalities, asymmetric information, inability to perfectly price discriminate, inability to patent, large economies of scale and monopoly power problems, especially with idea, knowledge products, and more.

The Republicans of the last three decades have a hostility towards science, and thinking in general, when it interferes with their ideology, and their simple-minded, pure free market is always the best and magic, slogan economics, has cost us greatly.

One other thing, which is huge, is the prestige externalities, prominently researched and written about by Cornell economist Robert Frank.

The taxes would be paid by everyone in one's peer group, by and large, so if you ended up spending $5,000 less on your car, on average, so would your peers, so you wouldn't lose any prestige. As typically, the utility of a luxury car, versus an average one, may be at least 90% prestige, the utility cost of that $5,000 less in spending may by more like $500, but the whole $5,000 in taxes would go to health care, education, public safety, cancer research, etc. (inconspicuous consumption as Frank would call it).

The same goes for spending on clothing and accessories and country club, and even vacation hotels are highly context related in their utility.

Furthermore, if their income goes down X%, so does their peers who bid against them for homes, so there will be a savings in home prices. It's not a complete free lunch, because, for example, older couples moving from a larger home to a smaller one will on average pocket less of a difference, but there will be far more gainers from this than losers.

The blame for high gas prices rests on simple-minded Republican ideology not speculators

In Paul Krugman's June 27th column he writes:

"Why are politicians so eager to pin the blame for oil prices on speculators? Because it lets them believe that we don’t have to adapt to a world of expensive gas."

A perhaps even bigger reason why Republicans want to blame speculators for sky high gas costs is that they don't want the public to put the blame where it's really due – on them.

For decades Republicans have constantly blocked Democratic attempts to increase fuel mileage and many other efficiency and conservation measures. They've also constantly blocked or cut spending on alternative energy, all the while mindlessly chanting "Free market". The economics community had proven long ago that there are many situations and ways where a government role can add greatly to efficiency, wealth, and welfare, but this is a party that long ago refused to think beyond slogans. They acted as though not being simple-minded was a vice, liberal and un-American, when in fact, thinking, and believing in science, evidence, and logic is one of the things that made this country great, and the richest and strongest in the world.

Now we're paying a big price for Republican ideology in energy and so many other things. Had the Democrats not been outvoted, filibustered, and vetoed from enacting their "big government" mileage, conservation, research, and other energy measures over the last almost three decades, gasoline might be less than half its price today, and mileage more than twice as high, making the gas cost per mile less than a quarter of what it is now.

And, of course, it wouldn't hurt that this would have starved the terrorists,and some of the worst authoritarian regimes in the world of money, and greatly decreased the momentous risks of global warming, trivial benefits that aren't taken into account by the magical free markets. By the way, such things are called externalities by serious academic economists...There they go again, those elitist, liberal, academic economists and scientists with their fancy book learnin'.

Wednesday, June 25, 2008

You Don't Mess with the Krughan

In response to Arnold Kling's June 24th post:

Arnold, you're not wrong in saying that your misinterpretation of a Krugman quote is wrong. The problem is that Krugman never meant what you think he meant.

Here's the quote you refer to:

"Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price"

You're interpreting it as though Krugman said it has no effect on the spot price. He didn't say that. He said it has no direct effect on the spot price. And just two sentences later he goes on to say, "Any effect on the spot market has to be indirect...".

What did Krugman mean by all of this?

The Futures market and price is clearly related to the spot price, and can clearly affect it. You don't have to get all flowery and philosophical to see the key direct way, which is through arbitrage. The futures price cannot get too much higher than the spot price or else there will be arbitrage opportunities that are easy to see and will be jumped all over, bidding the futures price down and the spot price up.

For example, suppose the futures price of oil in one month were $140, and the spot (today) price were $130. An investor with good credit and access to funds could sign a futures contract to sell 100 million barrels in one month. Then, he could borrow $130 million and use it to buy 100 million barrels of He would store the oil for one month, and then sell it at the price guaranteed in the futures contract, $140/barrel. With no risk, he would guarantee himself a profit of millions because interest costs on the $100 million he borrowed for one month, and the storage costs of the oil for one month, will be less than the $10 million difference between 100 million barrels bought at $130, and sold at $140.

Arbitrageurs will jump all over this and keep buying at spot and selling at futures until the futures and spot prices get close enough that the difference between them won't be big enough to pay the interest and storage costs. So, the futures price can never get too much higher than the spot price. And when the futures price is bid up – perhaps by speculators, this will pull up the spot price with it – but notice how; through arbitrage, through speculators buying on spot and holding in storage – hoarding! Just like Krugman said.

Speculation is only going to boost the spot price if there is some hoarding.

But an important issue, still, is how much hoarding is necessary. I discussed this in my June 17th post, and Columbia economist Guillermo Calvo eluded to it as well in a June 20th post; the amount of hoarding necessary to push up the price a lot depends on how inelastic the supply and demand curves are in the short run, or very short run.

If you look at Krugman's graph in his May 13th post , he has the supply and demand curves drawn pretty diagonally, indicating a lot of elasticity in both the supply and demand. The empirical reality in the very short run might, however, be that those lines are very inelastic, very close to straight vertical lines. In that case, when you boost the price, the gap between them that develops is very narrow, indicating that not that much has to be hoarded.

So, if supply and demand in the short run, or very short run, are inelastic enough, then perhaps a small enough amount would have to be hoarded that it could go undetected by the oil inventory records. Theoretically, this is possible, but I'm just not expert in oil inventory recording and the empirics of oil elasticity, so I can't really say how likely this is in the real world.

In any case, Krugman is right that speculators can only hurt us if they're hoarding. That's the only way they can affect the price, and this is true for anything. Speculators helped bubble up housing because they bought homes and held them for like a year or more. They held them, hoping the price would keep going up. They didn't sell them the next day, and when they did start selling them that really helped deflate the bubble. Speculators helped bubble up tech stocks in the late 90s because they bought them and held them for like a year or more, hoping the price would keep shooting up. If they sold them the next day, they would not have contributed to that bubble.

Monday, June 23, 2008

No time to blog, but hey, it's homeownership!

With regard to Mark Thoma's June 23rd post, "Paul Krugman: Home Not-So-Sweet Home", there's really a lot I'd like to say, but I'll have to restrain myself. The fact is, I got into blogging largely because I was hired to design and run a personal finance website for the University of Arizona and thought knowledge of blogging would help, especially for inexpensive promotion. It's been great, but alas, at this point in my academic and business careers, I can't justify spending much time at it.

That said, some quick but I think important things regarding this post:

First, I promote it a lot, but I think my brief working article, "Let's Cut the Ammunition to the Housing Arms Race Permanently", really explains well some of the best things we can do to help homeowners over the long run.

Second, one of the most important things in deciding whether the government should promote something is whether it produces net positive externalities (and how much). I think home ownership does have large net positive externalities, but only for people in certain situations, not for all people in all situations. So government promotion of homeownership could be efficiency and welfare enhancing – if well designed.

Third, a huge issue which could really change things in as little as the next 10 or 20 years is advances in video conferencing and other telecommunications. It's possible that in 10 or 20 years video conferencing could get so good that 25% to over 50% of skilled jobs could be done from anywhere. You could imagine say business managers or engineers communicating with each other via life-size ultra-high resolution monitors with an array of extremely accurate computer controlled mobile cameras and microphones. And you could imagine this and much more amazing telecom equipment being relatively inexpensive.

At that point, many or most skilled people could do their jobs from home anywhere, in Oak Park, Michigan, Podunk, Nebraska, anywhere. And if they didn't want to work at home, they could work in a Kinkos rent-an-office, or small satellite office, or complex, anywhere. When this happens it will really change society. It will make it so that homeownership makes sense for many more people, as you typically have to live in a home for at least 3-5 years without moving for it to make economic sense. Extended families will be able to stay together, rather than parents having to move far from their parents, siblings, and old friends for work. There will be a great savings in energy and decreases in pollution. The implications are huge. This is certainly something academics should be studying heavily for many reasons, one of which is, with the great net positive externalities, how, and how much, should the government be supporting this, the advancement of these telecom technologies.

Fourth, a really common misconception regarding homeownership, that I even heard once from a top finance professor, is that a benefit of homeownership is the leverage. But with a home, the leverage actually works against you both in risk and expected return. It hurts you. A typical mortgage rate is about 6%, the average return on a home, historically, as in Yale's Robert Shiller's, Irrational Exuberance, 2nd Edition, is only 0.4% above inflation, so the leverage not only increases the risk, it lowers the average return too! The expected home price appreciation is about 3.4%, but you're borrowing at 6%. Of course, this can be worth it because of the savings on rent, but you save on rent buying even the cheapest home. Every extra $100,000 you spend after that on a home costs 6% per year and brings in only 3.4% per year in average home price appreciation, and that's not even counting additional maintenance, utility, and insurance costs (taxes are usually about a wash, with the benefit of interest deduction balanced by the cost of property taxes). Still, it may be worth the expense if you enjoy the more expensive home enough, but as Harvard's Elizabeth Warren and I advise, never let your Must-Have (fixed) expenses get above 50% of your after tax income (with rare exception, like if you're a student, even renting a cheap room in a house may push your Must-Haves above 50%, but this is a temporary situation. For more information I strongly suggest Dr. Warren's book, "All Your Worth: The Ultimate Lifetime Money Plan").

Friday, June 20, 2008

OPEC Conversation with Steve Waldman, Part 2: Optimize Revenue, and Invest It Well

Steve's reply to my previous post is here. I answer back here:

I agree that if all they care about is maximizing their own wealth, then they will optimize current revenue as monopolists, which usually means withholding some supply.

But they would do it only to increase current revenues, not to save the oil for later because they think it's better to hold as an asset, for like 40 years, than stock or other conventional assets they could have purchased instead.

And, if they hold the oil in the ground as a form of saving it as an asset, the only possible time horizon for that would be like 40 years. What if they say, oh, I'll hold it in the ground as an investment for just 1 year, then sell it? What return would they get? In a year they should just still sell the optimal amount for a monopolist to maximize revenue, and in a year they would still have way more than enough from other oil in the ground to do that, or to sell any feasible quantity, so that unit that they held aside as an investment would just sit there.

It would do the same thing next year, and the year after, and the year after. It would only make a difference and actually be sold in about 40 years when they ran out of other oil in the ground. So it would just sit and make no money for 40 years, and then make it's selling price 40 years later.

For that selling price to make even a paltry 1% real return, the real price of oil would have to go from $130 today to $194. And the odds are great that in 40 years the price of oil will collapse due to the advance of substitute and efficiency technology. From what I've read, reliable sources, plug-in hybrids and pure electrics should become inexpensive and common in only like 20 years or less, pushing average global mileage per gallon into the hundreds, if not thousands. And for electricity there's nuclear, solar (see the Scientific American article mentioned in my previous post), coal (hopefully with carbon sequestering), etc.

Investing the $130 in keeping the barrel in the ground is a terrible idea. Yes, there is risk to stocks, but it's reasonable. The risk to keeping that barrel of oil in the ground as an investment for 40 years is much greater than the risk with stocks, and the expected return is much lower. Any conventional investment is much better than this. If I had to, I would estimate that the marginal revenue from an additional barrel of oil would have to be way below $130 for keeping it in the ground to be a good investment.

With regard to how good an investment a diversified stock portfolio is over the long run, I'd say it is the best for any single asset class, not just due to the historical performance and the arguments of Siegel (not all of which I agree with), but due to a tremendous amount of other evidence, theory, and other logic, which would take about 50 pages to really explain well even at a basic level.

I would add that If you follow a balanced money plan (see Harvard Professor Elizabeth Warrens book, "All Your Worth") or my INDV 102 course syllabus, it's not that hard to sock away a substantial amount in a well diversified stock portfolio each month. Following Dr. Warren's Plan means keeping your expenses, especially your fixed expenses, low enough that if the market swings up and down 5, 10, even 15+ percent, most people won't feel that stressed because they will know that their savings are still quite high relative to their expenses and income. And, the modern stock markets of the U.S. and Western Europe are quite different from the ones of 1950 and earlier. The odds of a communist takeover and expropriation, or anything like that, are virtually zero. The odds of something like the great depression happening are very tiny with the learning, track record, and resulting support of Keynesian-type policies.

Finally, with regard to heavy investing by OPEC pushing demand for stocks up and risk-adjusted returns down. First, note that the world stock market is vast even relative to OPEC money, but also, I have a working paper on the issue of whether a substantial increase in stock demand would push down risk-adjusted returns, or push them down much.

The main idea is that mostly due to the high prevalence of constant and increasing returns to scale in many productive processes and endeavors, the supply curve of investment opportunities may be very long and flat even for amounts of stock investment much higher than today's level. It might even curve up for a while due to increasing returns to scale.

Not the best investment strategy for the OPEC countries

In response to Steve Waldman's June 19th post, "Market power, asset allocation, and oil prices":

It is possible that OPEC countries are thinking that it's more valuable to leave some barrels of oil in the ground than to sell them for $130, and use the $130 to buy western stocks, but this appears to be a huge mistake.

First, there's a gigantic time value of money issue. I don't have time to research this, but I recall seeing estimates of how long the world oil supply will last of like 40 to 50+ years. Suppose it's 40 years, then if the Saudi's leave a barrel of oil in the ground today, instead of running out 40 years later, they will have that extra barrel in the ground and can sell it.

Let's compare the two alternatives:

A) Sell the barrel of oil now, and get $130. Then, invest that $130 for 40 years.

B) Sell it 40 years from now.

Which will make them wealthier? It depends on the rate of return, and on the price of oil in 40 years.

Without loss of generality, let's talk in terms of real dollars. Suppose they invest the money in a diversified U.S. stock portfolio (say the Wilshire 5000) and get the historic average real return of about 7%. After 40 years the $130 they got for the barrel of oil in 2008 would grow to $1,947. Do you think the real price of oil will be $1,947 in 2048, or anywhere near that.

From what I've read, it looks likely that inexpensive plug-in hybrids and pure electrics will be the norm long before then, and hooked up to electricity supplied almost exclusively from nuclear, solar, and other non-oil sources. Scientific American has a great article by a noted scientist on a solar grand plan that would "supply 69 percent of the U.S.’s electricity and 35 percent of its total energy by 2050" for "$420 billion in subsidies from 2011 to 2050". That's a fraction of the cost of the Bush tax cuts for the rich over that period, tax cuts that John McCain wants to make permanent – Yes, more and bigger yachts and mansions would be better for the economy and the globe than a vast solar network. – I'm not saying you're for that Steve; that's just a general comment about disastrous Republican policies.

Suppose the stock market did worse than its historic average. First, note that according to Wharton Financial Economist Jeremy Siegel's data set, between 1802 and 2006, stocks have never had a non-positive 20 year return period (Stocks for the Long Run, 4th edition, page 24). But suppose that the real return over the next 40 years was just 3%; still, by 2048, that $130 from selling a barrel in 2008 would grow to $424.

And stocks are a great inflation hedge because they are claims on real assets. Moreover, over a period of 40 years, I would certainly expect purchasing power parity to approximately hold, at least for tradable goods.

So, if OPEC governments are savvy, it certainly doesn’t look like they would want to pump less than the amount that maximizes revenue in the short term. Doing otherwise seems not qualitatively better than investing long term in gold instead of stocks. By the way, adjusting for inflation, a dollar invested in gold in 1802 grew to $1.95 in 2006. That same dollar invested in stocks grew to $755,163.00! (page 11 of Siegel's book)

Thursday, June 19, 2008

There are better ways to help the financially distressed.

With regard to Martin Feldstein's Op-Ed, "A Home Price Firewall", the biggest thing to note is that, aside from issues like how quickly they drop, in the long run the dropping of home prices does far more good than harm, and the lower the better. Is it possible to go too low? You wouldn't like to be able to buy a beautiful home in the suburbs for $1,000? For $1? You can't go too low. Those who own homes still get to live in them. Those who don't, get to buy them for a lot less, and can be far more financially secure.

Sure, speculators would lose, as would some others, like an elderly couple selling a large home to buy a smaller less expensive one for retirement. If before their old home was worth $500,000 and the new one $200,000, they would get to pocket a $300,000 difference. If instead housing prices dropped by 50%, so would the amount of the difference that they get to pocket. Now, the old house is worth $250,000 and the new one $100,000, so they only get to pocket a $150,000 difference.

But there would be far more gainers than losers over the long run. I have a working article that I think covers well the home price issue as well as the general epidemic of financial distress, "Let's Cut the Ammunition to the Housing Arms Race Permanently".

Regarding the issue of stopping "prices from overshooting on the way down in the same way they did on the way up.". I think it's better to err in the direction of prices going too low, than not going low enough. The real median home prices is still almost 80% higher than it was in 1970, according to National Association of Realtors data.

Certainly, we should give more aid to those in financial distress, whether they are homeowners or not, but higher priorities should be things like universal health insurance, universal free preschool, and far more college aid, so students graduate with far less student debt, which is strangling a generation and inhibiting the young from taking risks and innovating, as well as starting families.

Finally, as Mark Thoma mentions, there's the issue of default. Feldstein's would make these government loans full-recourse, but they could still be discharged in bankruptcy. Given today's epidemic of financial distress, and that these loans are for large amounts (20% of the value of a home), many would be discharged in bankruptcy.

And, it would be horrible to go further down the Republican-lead path of making debts non-dischargeable in bankruptcy. The bankruptcy laws were enacted by our founding fathers to end lifetime indentured servitude, yet in the 2005 BAPCPA law even fully private student loans were made non-dischargeable in bankruptcy (with extremely rare exceptions). These are loans without the protections of government student loans like payments limited to 15% of disposable income or less, and low capped interest rates. The New York Times has an excellent article on this.

Wednesday, June 18, 2008

There are huge positive externalities to serious, in-depth, investigative reporting. So should the government subsidize it?

With regard to Paul Krugman's June 17th post, "Nothing has been learned":

In the Bloomberg article it states, "He said Obama's plans would subject 21.6 million small- business owners to income-tax increases.". Note the "He said", with the "he" being McCain.

It's just another example of the media's bias against reporting important truths in a non-misleading way and towards being "even -handed", i.e. We'll report the Republicans say, "The Earth is flat", and the Democrats say, "The Earth is round", but we'll never tell you that scientists have conclusively proven it's round.

Part of it, though, is just that the media is under-resourced. They often don't have the time to check with experts. And it's hard for reporters and editors to verify economics facts because they usually have little or no economics expertise themselves.

It's important to note the absolutely enormous externalities associated with the media product -- for good if they do it well, and for bad if they do it badly. In such a case, it can greatly add to efficiency (if it can be done well) for the government to subsidize or otherwise encourage the positive externality creating activity, which in this case is quality reporting. Clearly, the government must be careful about favoring any specific media company, but perhaps some kind of tax credit scheme for non-entertainment news reporting might enhance societal efficiency and welfare.

If structured well, it could give serious news media a lot more resources to check facts with experts, investigate in depth, and just do their job better, leading to a better informed public, which hopefully will elect less W.s. There's no way you can tell me that won't increase efficiency. It also might make it economical to spend the money to hire reporters and editors with greater expertise, like degrees in both journalism and economics.

An excellent example of the great inefficiency that comes from the private sector not taking into account the media's great externalities is what's happening right now at the Los Angeles Times. The new owner, Sam Zell, appears to only care about maximizing his profits, and so is gutting the serious news reporting. This may be ok with the people who buy and read the paper, and with Zell if it increases his profits, but it really harms others not involved in the newspaper buying/reading transaction (that is others who are external to that transaction -- thus you can see why economists coined the term externality).

And those who are external to the transaction are the rest of the country and the rest of the world. Everyone is affected when out of ignorance conservative Republicans are elected, and the costs are great. A good article on the gutting of the L.A.Times serious news reporting is by Washington Post columnist Harold Myerson, "The L.A. Times Human Wrecking Ball".

Tuesday, June 17, 2008

Speculation and hoarding

With regard to Mark Thoma's June 17th post, "The Enron Loophole":

Paul Krugman has asked many times, if speculation is pushing up oil prices, why is there no evidence he can find of hoarding, of increased inventories? (see here for a good example)

Some have argued that the records of inventories are not that accurate; that it's still possible to hide a substantial amount of hoarded oil. I have little expertise in oil inventory recording, so I don't want to offer an opinion.

But a point I would like to add is that if the supply and demand curves for oil in the short run (or very short run) are very inelastic, then you wouldn't have to hoard much to push the price of oil up a lot. And if you only have to hoard a relatively small amount of oil, then it might not be that hard to have it not detected in the inventory records.

Imagine (or draw) supply and demand curves (like in Krugman's graph) that are almost straight lines (Again, I'm thinking in the short run, or very short run. In the long run, the demand curve at least is very elastic). In that case, if you move the quantity that gets to the market back just a little bit, by putting it in storage, the price jumps a lot.

Monday, June 16, 2008

It's important to have the key supplementary laws and institutions, but let's not forget, overall free trade does far more good than harm

In response to Dani Rodrik's June 16th post, "Stolper-Samuelson for the real world":

I think the key overall point to make is this:

You can think of funny situations where one nations total GDP goes down from an increase in free trade. But, in the vast majority of real world situations, free trade will increase the total GDP of both sides -- and often tremendously over the long run.

But the free trade agreement will sometimes have to be intelligently constructed, and it's important to have some good key local laws and institutions in both countries to make the free trade work well. It's important to realize that with free trade there will be losers in each country, but in each country, in the vast majority of cases, the gainers gains will outweigh the losers losses – and often by a huge amount.

This will especially be true if you have the agreement well constructed and with good supplementary local laws and institutions. But usually, even if you don't, trade will do a lot more good than harm. The main reasons are it allows for greater economies of scale, efficient specialization, greater competition, and less corruption.

Now the last two don't have to result from free trade. You can think of situations where the opposite will happen, but in the real world, it's more likely than not that freer trade will lead to more competition and less corruption. But this is precisely where the side agreements, local laws and institutions are so important – for example, smart anti-trust law with good enforcement.

It is also important to redistribute some of the gains of the gainers to the losers. The gainers gains almost always will outweigh the losers losses, so you can give some of their gains to the losers so that no one loses and everyone gains. This will also increase support for free trade, and make it more likely. Of course, try explaining this to today's Republican party, which believes that thinking beyond simple sound-bites is liberal and un-American.

An excellent case in point is Mexico. Total GDP has increased substantially due to a great increase in free trade, but the income of the vast majority who are poor has hardly increased. Almost all of the gains from free trade have gone to the wealthy. If Mexico had much more progressive taxes, as it should, it could be taxing those gains and using them to invest in education, infrastructure, public health, etc. for the vast majority. This would make essentially everyone gain from free trade, and these high return public investments would make the country much wealthier over the long run.

Dani, I think it's important to stress these things, along with the legitimate criticisms of free trade that you make. I know you make these criticisms not because you're against free trade overall, but because you want to make it better, with better constructed agreements and supplementary laws and institutions. But without stressing at the end that you think free trade is good overall, you risk doing a lot to help those who are fervently against it, and want extreme protectionism, which would hurt every country and devastate the poorest.

Thursday, June 12, 2008

Was it sexism or clintonism?

In reading today's New York Times Article, "Critics and News Executives Split Over Sexism in Clinton Coverage", I asked myself, was the medias bias against Hillary mostly sexism or clintonism? My initial conclusion, although after just a brief amount of thought, is that it was about 80% clintonism. The worst biases, though, were the bias against substance and towards the superficial, and the bias against reporting important truths in a non-misleading way and towards being "even -handed", i.e. We'll report the Republicans say, "The Earth is flat". The Democrats say, "The Earth is round", and we'll never tell you that scientists have conclusively proven it's round.

Monday, June 9, 2008

"Objective" numerical formula evaluation is not necessarily objective, and is often grossly inaccurate

With regard to Paul Krugman's June 8th, 2008 post, "Column inches":

This is just another nasty result of the "objective" fever that's swept so much of society, including academia, where you use "objective" measures to evaluate quality and results, like number of inches, or for academia, number of publications, or something like 5 points for a publication in a top tier journal, 2 points for a publication in the next tier, and 1 for the third tier.

So an Einstein-like publication gets the same 5 points as just a very good publication in a top tier journal, and a professor who works for 5 years and produces one Einstein-like publication would be denied tenure (essentially getting fired), under such an "objective" system, but a colleague who produced one just very good publication and two fairly minor ones would get tenure, even though he had contributed far less to the field and to society.

Moreover, it doesn't even consider how much skill and competency the professor has, and her expected value production over the next 30+ years. A professor who spent years learning deep intuition for advanced continuous time modeling might have had little time left over to publish in those five years, but this understanding is extremely valuable to future contributions to the field and society. But it's not in the simple "objective" publications formula, and it's not even possible to accurately put it in any simple "objective" formula. And, even a formula that's a page long, or a computer program of many pages (and try entering important, but not simple, information into a computer), is simple relative to the advanced, ultra-high dimensional, flexible thinking of logical human brains, using formulae and data only as an aide.

This "objective" fever's simple-mindedness is often very inefficient and harmful. For example, it has caused great harm to the effectiveness of the CIA. Former CIA spy Lindsay Moran writes in a 2005 New York Times Op-Ed:

Simply put, the directorate of operations needs to clean up its own act before it can recruit and, more important, retain quality employees.

Part of the problem is that the agency's culture rewards quantity over quality. Career advancement depends on the number of foreigners an officer is able to recruit, rather than the quality of information derived from them.

What if an operations officer made only one recruitment during the course of his career - but that foreign agent were, say, part of Osama bin Laden's inner circle? That would be an enormous benefit to the nation. But the years required to make such a plum recruitment would render this officer's career stagnant. Conversely, a clandestine officer who recruits a dozen potentially useless foreign assets like truck drivers and falafel-stand owners with no real information but a lot of opinions is likely to have a successful career.

It's hard to say exactly how this "objective" fever developed. Part of it is that society has become so rushed, and using simple-minded formulas, although they can be highly inaccurate for what we truly want to gauge, are quick and take no thinking. Part is an increase in litigation; you are usually ok if you say you didn't discriminate because you applied the same "objective" simple formula to everyone. And another part of it is just the explosion of data in recent years and computer advances. This has allowed easy and quick access to lots of numbers that can be used in simple "objective" formulae and criteria.

It's important to note that just because you use some simple-minded "objective" numerical formula for evaluation doesn't mean you're being objective. There's always the possibility for a great deal of subjectivity in your choice of which the numbers and formula to use. If I base my grades on the "objective" formula that the tallest student gets the highest grade, the next tallest student gets the next highest grade, and so on, is that really objective? Is that really fair? Is that really smart? Just because it's based on "objective" numerical measures and applied equally to all doesn't mean it's an accurate reflection of merit, fair, efficient, or truly objective.


My first term at the University of Michigan MBA program, I turned in what I thought was an outstanding paper, but I only received 85%. When I asked the professor why, he showed me the simple formulaic grading technique he had a teaching assistant follow. It was something like this: 40 points for mentioning core competency, 20 for mentioning alliances, 10 for mentioning diversification, etc. I had what the professor agreed was one of the best discussions of alliances he had ever seen from a student, but I didn't mention a few of the minor points on the laundry list and so lost the 15 points assigned to them. It's not that I didn't understand those points; they were just pretty obvious and less important, so I left them out and focused on the more important issues in depth.

I further found out that his teaching assistant wasn't discriminating based on quality of understanding at all. If a student said one simple sentence on core competency he got the same 40 points as a student who gave Einstein-like ideas and insights on it. It was just another check on the list. So the Einstein-like student who didn't mention a few minor points could get an 82, while a student who understood everything poorly, but wrote on a long laundry list of things would get 100 -- looking at the grades, employers would think he understood business better!

I, in fact, just gamed the system after that, using what I called the "Kitchen Sink" approach -- throw every point into the essay but the kitchen sink, and you're sure to get every check on the list. And, the simple formula the student graders were told to follow didn't take off any points for mentioning something not on the list -- even if it's, "I think they should spend $1 billion on alchemy research" -- so I almost always ended up with 100% (It would have been always, but sometimes I just put in very little time for these things).

When I first protested about this horribly inaccurate grading system (if you want the grades to reflect competency), the professor said it was "objective"; it was applied equally to all students. And you could see why almost all professors used it. They were super busy at a top university, where they were evaluated almost exclusively on publications, and this system was simple enough that an undergraduate could do all of the grading for them. Furthermore, they could easily handle complaints by saying it was an "objective" formula applied equally to everyone. They didn't have to spend a lot of time and effort explaining problems with the quality of your arguments. they could just say, "Didn't mention outsourcing, negative 7 points; didn't mention anti-trust negative 5 points; that's why you got 88."

So, even at a top university, they predominantly used highly inaccurate simple "objective" evaluation. But again, is it really objective? Is that really fair? Is it really accurate for what we actually want to measure? Just because it's based on "objective" numerical measures and applied equally to all doesn't mean it's an accurate reflection of merit, fair, efficient, or truly objective.

Saturday, June 7, 2008

Individual volatility can be very different from average, or group, volatility

In Mark Thoma's June 5th post, "The Great Moderation and Household Income Volatility" he writes:

David Beckworth looks at a paper by Steven Davis and James Kahn that tries to solve a puzzle. If, as shown by the Great Moderation, aggregate income volatility is decreasing, how can individual household income volatility be increasing as many have claimed? Shouldn't the increased stability in GDP cause household income be more stable? Not necessarily

One of the fundamental reasons why this can easily happen, and has actually happened big time, is that large independent risks faced by many individuals and their families (called idiosyncratic risks), even very large and devastating ones, can average out for the statistics for the group, especially for a large group. And our economy consists of a very large group of workers, over 100 million. I'd like to explain this phenomenon more concretely and clearly by going through a hypothetical example:

Case A – All 100 million individual workers have a wage that's based on a separate coin flip for each with:

Heads: $10,000/year

Tails: $70,000/year

Case B – All 100 million workers get paid $40,000/year no matter what.

In case A, individual workers have massive income volatility. In case B individual workers have no income volatility, but in both cases the income volatility for the aggregate economy, the economy as a whole, will be essentially the same. It will be virtually zero in the first case, and exactly zero in the second case.

In case A, although individual workers can have massive volatility in their earnings, and face massive risk, and decrease in the quality of their and their family's lives, including perhaps the inability to pay for medical care, the aggregate average earnings in the economy are $40,000/year, with a standard deviation of just 0.3 cents per year!

The intuitive reason is, as you'd expect, that if you do as many an 100 million independent coin flips, the odds of getting anything more than a micro percentage over 50% being heads, or a micro percentage over 50% being tails, are infinitesimal. The odds are for all practical purposes zero. So the economy as a whole always has average income stably at $40,000, even though individual workers incomes vary massively over the years, and they face devastating risk to themselves and their families, and cannot plan well and efficiently long term.

The moral of the story: Individual volatility and aggregate volatility for the economy as a whole can be very different. Each individual can face massive risk and volatility, but in the economy as a whole, at the end of the day, the individuals who had good luck can average out the individuals who had bad luck and really suffered, so that the average looks ok and is always about the same. But as an individual you don't want to be exposed to these kinds of ups and downs, this kind of risk, and you certainly don't want your family to be exposed to it – that's real family valuing.

Especially with the economics of ideas, let's use our heads

With regard to Paul Krugman's most recent New York Times column (June 6th, 2008), "Bits, Bands, and Books":

Some key issues: First, and in general, let's use our heads and not follow anti-thinking, anti-science, Republican slogan "economics" which says any government role or action is inefficient and the pure free market is always more efficient and better.

As acclaimed growth economist Paul Romer points out in a nice interview in Reason, the economics of ideas (understandings, writings, formulas, etc.) is very different from the economics of physical things (and products, etc.). Unlike physical things, ideas have little or no marginal cost (the cost of letting an additional person have and use them). So, for efficiency, widespread distribution is very important, and that often means the government doing it (or the government paying universities or private firms to do it), and then releasing it free over the internet. Or the government having some other important role.

Suppose some firm gains an important understanding of how a gene works. They will want to keep it secret so that their competitors can't use it. And they can't sell it, because once it gets out, it can be told to anyone for free. Moreover, you really can't patent a basic understanding or idea. Legally it's way too costly to adjudicate bazillions of lawsuits to determine did product X result 1/1000 from this patented understanding, or 1/5000, and so on.

In addition, aside from that, there is the issue of the inability to price discriminate well. Even if the idea, or understanding, or knowledge is patented, and they charge $1,000 for it, then there may be 100,000 scientists who won't have access to it because their marginal utility for it is $999 or less. But that's inefficient, because you could have provided it to them for zero marginal cost.

So basically, if the government pays for it, it's put on the internet and used by, in many cases, 1 million scientists and technicians, instead of just the perhaps 100 scientists and technicians in some private company keeping it secret. The gross inefficiency of the underutilization can be enormous.

So some government role is often crucial to efficiency when it comes to production and utilization of ideas, either the government doing it itself, or paying universities or private firms to do it, or providing key rule and regulations. So this is no area for us to turn off our brains and become Republicans.

Tuesday, June 3, 2008

"Don't get fooled again!"

The most recent Gallup poll finds a 55% majority saying their families are worse off financially than they were a year ago, the highest number ever recorded in the history of Gallup polling since this question was first asked in 1976.

Has The Who's rock anthem "Don't Get Fooled Again" ever been more appropriate? Please America, please, don't let us "Meet the new boss, same as the old boss".

This would be a great theme song for the Democratic nominee!