Saturday, September 27, 2008

Medical spending and positional/context/prestige externalities

With regard to Mark Thoma's post on Uwe E. Reinhardt's recent column:

The general idea that it's good for a wealthy society to spend a large percentage of it's income on smartly run health care and medical research (and it will be far smarter under Obama and the Democrats) is true.

So much more money could be spent on this with very little or no loss of utility in other areas by essentially taxing positional/prestige externalities. This is a gargantuanly important issue for economic well being that's given far too little attention.

Mark, and the readers, I ask that if you haven't read it, please read Cornell economist Robert Frank's book on this, Luxury Fever. If you don't have time for that now, he has a very good summary op-ed from the Washington Post.

Friday, September 26, 2008

The government would have to pay more than the fair market price for these securities anyway. Warrants just make it less of a bad deal.

With regard to Mark Thoma's September 26th post, "Equity Warrants and Asymmetric Information":

The bigger reason is not asymmetric information; it's that the government would not be paying the market price for these securities anyway. They are worth too little -- in their real, fair market value, not just their fire sale value. It would too likely inject too little capital to prevent a severe liquidity crunch and recession.

It's not like these securities are worth $10, and that's what the government would pay, but when you add warrants that are worth $2, now the government will just have to pay $2 more, and so it gets them nowhere. The government was never going to pay $10 for these securities in the first place. They were going to pay like $15 for securities that were only worth $10 if they didn't want to take a significant risk of disaster. If you add the $2 of warrants it's better because the firms still get the $15 of capital that's necessary, but at least the government would now get $12 of value in return instead of just $10 -- It cuts down on how much the tax payers are giving away to the current managers and shareholders.

The best thing as I've said before would be just that the government buys (takes over) these companies for what they're really worth -- little or nothing -- then they inject the funds, buy the toxic securities, etc., and then sell the companies back to private buyers for a far higher price. This way the tax payers get the whole benefit of the huge cash injection, rather than the existing shareholders and managers.

Mankiw's a well trained and intelligent economist. He knows that Miller-Modigliani explanation was misleading. Why does he deceive for the Republicans? Well, I've listed reasons in the past which I'll reprint here:

There are several reasons why an economist might intentionally mislead for the Republicans:

1) There are relatively few successful university economists who support the Republicans, so there is much less competition for plum and high paying jobs in Republican administrations and propaganda tanks. Becoming a Republican crony can mean a lot of money and/or very high level government jobs, like Mankiw's job as Chairman of the Council of Economic Advisors in George W. Bush's administration. He's also currently a fellow at the American Enterprise Institute. Mankiw has a strong incentive to please the Republicans by misleading for them.

2) He may be an extreme Libertarian (more economic than social obviously), and very willing to mislead for that cause, even if he knows it hurts total economic, scientific, and medical growth greatly, and embarrasses him professionally.

3) He may be very Plutocratic, and very willing to mislead for that cause, even if he knows it hurts total economic, scientific, and medical growth greatly, and embarrasses him professionally.

4) He may have Slipperyslopeaphobia -- for details see my blog post.

5) A well intentioned reason -- He may think he can affect change to the historically disgraceful and brain dead Republican party better from the inside than from the outside, and in order to stay inside he can't displease those in control too much.

Tuesday, September 23, 2008

"government takeovers may be the only way to get the financial system working again"

With regard to Mark Thoma's September 23rd post, "Hold to Maturity versus Fire Sale Prices":

Mark writes, "If we reduce the future profitability of these firms at all (by that I mean the amount available to private investors), say by demanding a share of future profits for the government, that will make it harder for the firms to raise private capital since expected future profits will be lower. So, by having the government take a share of any upside, the result may be less willingness of the private sector to participate in recapitalization."

There's a relatively easy solution to this. The government just buys (takes over) the firms (Princeton economist Paul Krugman writes, "government takeovers may be the only way to get the financial system working again"). Then credit will flow because the government does not have a problem comming up with money to loan out. When the bad assets are removed from the books and the firms are in order, then the government sells them back to the private market. This has been done successfully many times, and it allows the taxpayers to reap the benefits of the massive government cash infusion, rather than the firms existing shareholders and managers.

Why not just do this appearantly better and more efficient solution? The same reason we don't do so many clearly better and more efficient solutions, simple-minded Republican ideology that's highly resistant and often downright hostile to logic and evidence (see Columbia Economist Jeffery Sach's recent article, "Anti-Intellectualism", Princeton Economist Paul Krugman's, "Know Nothing Politics" -- "Republicans, once hailed as the “party of ideas,” have become the party of stupid." -- and New York Times Columnist Thomas Friedman's, "Making America Stupid"). Republican ideology says government ownership of almost anything is bad. This has lead to massive inefficiency and complication in things from health care to student loans to the spiders web of extremely hard to monitor and control contractors and mercenaries in the military.

It takes a great deal of political pressure/danger to get the Republicans to deviate from their ideology. We'll soon see if there's enough here to get a good plan.

Friday, September 19, 2008

The pecuniary benefits of subsidizing education extend far beyond just allaying externalities

If an activity, like education, has positive externalities, it can be shown that relying on the pure free market will result in an allocation of it, and other goods, that is Pareto sub-optimal. That is to say, you will end up with an allocation where it's possible to make a trade (transaction), or series of trades, that make at least one person better off (higher utility), but no person worse off (as long as transactions costs and other frictions don't exceed the benefits)

Thus, a Pareto sub-optimal situation is clearly inefficient. And economists like to focus on Pareto optimality much too much to the exclusion of other measures of efficiency, or desirability, because it avoids the discussion of value judgments. People usually don't object to making someone better off if it makes no one else worse off, at least as opposed to the choice of doing nothing and leaving things as they are.

But for the vast majority of people there are a lot of other important economic criteria besides just Pareto optimality, and besides just inequality too, and some of these receive far too little attention in economics. One is just the total utility, or real dollar value of goods, of all of the people added together.

A situation where 1 billion people all have 0 utils (or units of goods), and one person has 100, is Pareto optimal if there's no way to make anyone better off without making at least one person worse off, like if you'd have to take goods from the person with 100. If you did move to a situation where now that one person had 99 utils, or units of goods, but all 1 billion other people went from 0 units to 98, then this is a Pareto sub-optimal move, but it explodes the total amount of goods in the world, or utils, from 100 to over 98 Billion!

It's not just that inequality decreased. Inequality can decrease with the total pie shrinking, or with the total pie only increasing a little. The point is there are economic criteria that are very important to the vast majority of people, myself included, besides just Pareto Optimality and inequality, that are given too little, or much too little, attention by the field, and one of them is total utils or total real dollar value of goods (I know the field doesn’t like to estimate utils cardinally, as opposed to just ordinally, because it's hard, but you can't avoid it -- your results will be consistent with some assumed cardinal numbers anyway, and you can often do far better if you actually put some thought into your estimate or assumption. It's like when a factor is hard to estimate, so many economists say, it's hard so we "won't estimate it"; then they call it zero. Hello?! Zero is an estimate. You can't avoid estimating, but if you had put some thought and effort into your estimate, in many cases you could have come up with one a lot better than 0, or a series of candidate estimates to examine in a sensitivity analysis.).

Ok, the point about education is that subsidizing it is not just to allay externalities. It is also that even beyond externalities doing so can tremendously increase the total pie, even if it's not Pareto optimal because some people might, even on net, lose a little from the taxes. And subsidizing education also decreases inequality greatly, as shown in the outstanding new book, "The Race between Education and Technology" by Harvard economists Claudia Goldin and Lawrence F. Katz.

An additional issue is inefficiency, shrinkage of the pie, etc. due to human imperfections. Many economic models assume that people have perfect information about what's best for them, and they have perfect self discipline too, so they will always make the decision that maximizes their utility. Such models can be useful aides if interpreted intelligently, rather than taken literally. Acting as though the real world really is exactly like those models is not intelligent. For many things these assumptions can be very far from the truth. Subsidizing and mandating education can get people – and especially children – to do things that greatly increase their utility, that they otherwise would not have done, because in the real world people do not always have the information, expertise, and/or self-discipline to do what is in their best interest. Often without government subsidization, nudging, encouragement, or mandating, taxation, discouragement, or outlawing, many people will do things that are far from utility maximizing for them.

Finally, there still are, however, enormous positive pecuniary externalities to education. The Vox EU article, and the papers it cites, miss much, and I have little doubt there are severe flaws with the models, econometric techniques, and assumptions behind them. But even in these studies, the article states, "The recent construction of state-level physical and human capital stock data has provided the opportunity to apply the macro-Mincerian model to US states. Chad Turner and his co-authors estimated a social return of 12% to 15%, while I estimated a slightly lower social return of 9% to 13%. The closeness of the estimates of the social return to the private return suggests that US schooling generates little to no external return.". Little return? What do you think that's 9-15% of? It's 9-15% of trillions of dollars every decade. That's not little, and it's still a gross underestimate of the true amount.

One thing which I hope to have time to write about in detail in the near future is the enormous positive time, or intergenerational, externalities. That is, when people become more educated today, advancing science, technology, and medicine more for future generations, that's a positive externality for those future generations. They benefit, but they are not involved in the transactions and payoffs which take place before their time, thus we can expect that their benefits are not fully considered.

I hope to find time to write more about all of this in the near future (and work on improving what I have written so far). It's very important.

Vox EU article is wrong and dangerously misleading

Here is the article.

Here is my reply:

I'm going to write up a less rushed response to this article on my blog, but given how quickly with the internet people can move on to the next topic, with dangerous misconceptions fully intact, I think it's important that I immediately enter at least a basic response to this.

The results of this modeling and testing are being grossly and dangerously misinterpreted in the implications made for the real world. And this type of mistake is one that academia has to be careful of. As I've said before, academic social science does immensely more good than bad, and it's the only game in town for the type of highly valuable advanced technical work it does, but it certainly has flaws.

The real world conclusion of this made here is grossly and dangerously wrong. There are massive positive pecuniary (material well being) externalities to education. If there were none, then it logically follows that my pecuniary wealth (material well being) would be the same if (A), everyone in the world for the last 300 years up to today, except for myself, were completely uneducated and illiterate, as it would be if (B), everyone in the world had a bachelors, and a graduate or professional degree.

In the first case, my infrastructure would be dirt roads, and my medical care would be herbs and leaches. My lifespan would be like it was in the 1700s, early 30s, and I'd probably experience the death of at least one of my children. By the time I was 30, I'd lose most of my teeth -- very painfully. I'd freeze in the winter and swelter in the summer in a primitive dwelling. Where would I buy a modern home from? No one else in the world besides me has the education to build anything modern, from a car, to an aspirin, to toilet paper, to soap, to toothpaste, to penicillin.

In the second case, everyone besides myself in the world has had a graduate or professional degree from 1708 right up until today. Could you imagine how much science, technology, and medicine would have advanced by now if that were true. Cancer would very likely be cured, as would many diseases from Parkinson's to Arthritis to Diabetes to Depression. Healthy lifespan would be immensely longer, with, for example, nanobots throughout the body constantly repairing cells. Robots would be extremely advanced, and we might have to a great extent robots building robots, creating immensely more material wealth. We might even have found a way to eat as much as we want without getting fat! I could go on and on.

Yeah, there's no material benefit to me when others get an education. There's no positive material externalities there. I'm exactly as materially well off in case (A), when others have no education, as I am in case (B), when others are highly educated. Think about how ridiculous this conclusion sounds – and is. You need only make the most minor and realistic assumptions about the world (immensely more minor and realistic than the assumptions relied on in most models and econometric techniques) to come up with chains of logic proving the conclusion in your paper to be tremendously far from the truth.

The more other people are educated, the more they create ideas, understanding, and invention, that is to say, the more they create things which have gigantic positive pecuniary externalities (especially for the young and future generations). Ergo, the more they create positive pecuniary externalities.

Now, you may say that you use a definition of pecuniary which is different from quality and quantity based material wealth. If so, then you better make this very clear in your conclusions so as not to mislead in a very dangerous way.

Listen to what top growth economist Paul Romer said in an interview with Reason:

It's so striking. Evolution has not made us any smarter in the last 100,000 years. Why for almost all of that time is there nothing going on, and then in the last 200 years things suddenly just go nuts?

One answer is that the more people you're around, the better off you're going to be. This again traces back to the fundamental difference I described before. If everything were just objects, like trees, then more people means there's less wood per person. But if somebody discovers an idea, everybody gets to use it, so the more people you have who are potentially looking for ideas, the better off we're all going to be.

"the more people you have who are potentially looking for ideas, the better off we're all going to be.". Yes, and the more people are educated, the more and better they are looking for ideas, and the more I will benefit from them.

The more educated a country or the world is, the more wealth it creates. The more wealth it creates, the more it can spend on pharmaceuticals. The more it can spend on pharmaceuticals, the more pharmaceutical companies will spend on R&D, and thus I benefit from others getting more educated in a big material way (and a way that doesn't show up well in the measure of national wealth your studies use, GDP, because GDP little includes increases in the quality of products, for example increased effectiveness of pharmaceuticals).

But it's much more than that. The more educated others are, the smarter they vote. For example, as people become more educated, it has been shown they become less likely to vote Republican. In general, they will vote for far smarter economic policy, including far more government investment in extremely high social return projects of the kind that the free market will underprovide due to free market problems like externalities, etc. These projects include alternative energy, other infrastructure, and basic scientific and medical research, which can have an enormous pecuniary impact. I'm far better off from this materially, and it's due to others becoming more educated.

You mentioned that higher education correlates with lower crime. Much of this won't show up in your GDP statistic because money spent on security, prisons, etc. is added to GDP, when in fact it should be subtracted. Likewise, GDP is flawed because, as I noted earlier, it takes technological and quality advance into account very little. One thousand 2008 dollars of medical care today is far better than one thousand 2008 dollars of it in 1920.

I could go on. Your real world conclusions from your data and tests are wrong and very dangerously misleading.

Thursday, September 18, 2008

Not having a profit incentive to mislead you, as is the case with the government, can sometimes be extremely valuable

With regard to Mark Thoma's September 18th post, "Risk Absorption as a Last Resort":

One of the great things the government can often do far better than the private sector is insurance, especially for things that involve very large and very dangerous loss, where you really want to make sure you'll get fully paid for the loss (minus the deductible).

For some very large and dangerous risks, there's just a very dangerous chance that a private company won't end up with the funds to pay, and it can be very hard for people and firms to tell if a private insurer is really safe. An insurance companies financials can be extremely complicated, and there's a huge profit incentive for an insurer to mislead about them, as well as about tricky stipulations written in fine print legalese in a long insurance contract that may result in a denial of your claim.

In such a case, not having a profit incentive to mislead you, as is the case with the government, can be extremely valuable when a risk is so great that you want to be absolutely sure that it will be covered. You won't be fooled be some legalese stipulation in the fine print that results in a denial of your claim, and you won't be fooled as to the financial strength of the insurance company, only to find out later that they only have enough money to cover a fraction of your claim.

There can also be huge economies of scale and transactions and advertising costs in insurance, which can mean a big cost advantage for a giant government insurance program.

In the real world, and known and accepted in economics for a very long time, there are sometimes severe free market imperfections. The world is not identical to simple models; among other important problems, asymmetric information, economies of scale, and transactions costs can be great, making it so that a strong government role can greatly increase efficiency, wealth, and welfare.

Bottom line: Would you rather have your old age social security payments and Medicare insurance guaranteed by the United States government or a private company that you hope will have the money to pay your checks and medical bills when the time comes, and won't go the way of Lehman Brothers, AIG, or Enron.

And even if you wanted to go with a private company, you might have to spend an enormous amount of time researching the companies, the programs, the legal contracts, etc. to decrease the odds that you will be fooled by these companies which may have a great profit incentive to mislead you. But with the government you can just much more quickly buy knowing that they don't have a profit incentive to mislead or trick you. This can save a very large amount of time if asymmetric information is great, and obviously time is money.

American's today spend a great deal of time researching financial and other products to make sure that they aren't taken. Much of this is time that could have been spent producing if there were better government regulation, guarantees, and/or programs. I know this time cost very well, as I assign a great deal of work every week in my personal finance courses.

Saturday, September 13, 2008

My answer to John Quiggin's puzzle

His puzzle.

My Answer:

The bottom line is that:

"real median US household income has risen by about 30 per cent." and "US GDP per person has more than doubled"

mathematically, would have to be explained 100% by:

"Average household size has fallen from around 3 to 2.6"


"inequality as measured by the ratio of mean to median household income"

if the following are true:

-- Assumption 1) You get rid of the "around"s and "more than"s and plug in the precise numbers. For example, you plug in the exact amount real median US household income has risen, rather than "about 30 per cent".

-- Assumption 2) You assume the income used in "GDP per Person" is the same as the income used in "Average Household Income". In other words:

a) GDP per Person = Total National Income/Number of People

b) Average Household Income = Total National Income/Number of Households

As long as Total National Income is measured the same for both of these, as long as it's the same number, then you're fine. If not, then this is a source of your problem, and a great lead. You should look at how these are measured differently.

-- Assumption 3) There's no measurement errors, math errors, or other mistakes.

Now, if all of this is true, then the following is true:

First, let's write what you want to explain in mathematical notation:

"real median US household income has risen by about 30 per cent." and " US GDP per person has more than doubled"

Can be written mathematically as:

(M1/M0) / [(I1/P1)/(I0/P0)] ; Let's call this Term 1,


Mi = The median household income at time i

Ii = Total National Income at time i

Pi = The number of people in the country at time i

Now, what are you trying to explain this Term 1 with?

a) "Average household size has fallen from around 3 to 2.6", this is the gross change in average household size. Mathematically, it can be written as:


where Ni = The average number of people in a household at time i.

b) "inequality as measured by the ratio of mean to median household income". Mathematically that can be written as:

[(I1/N1)/M1] / [(I0/N0)/M0] ; Let's call this Term 2,


Ii = Total National Income at time i.

Ni = The average number of people in a household at time i.

Mi = The median household income at time i

Next, if you do some algebra, you will see that:

Term 1 = (N1/N0) / (Term 2) ; let's call this Equation 1.

which shows that what you are trying to explain, Term 1, can, in fact, be completely explained, 100%, by the things you said couldn't completely explain it, and were wondering why, namely (N1/N0) and Term 2. These can, in fact, explain it 100%, but only as long as the assumptions 1-3 that I've made above are correct. So you want to look for problems in these assumptions.

Now, let's put our relationship equation, Equation 1, into words, to make things clearer:

Equation 1 means:

(The Gross Percent Change in Median Household Income) / (The Gross Percent Change in GDP Per Person)


(The Gross Percent Change in Household Size) / (The Gross Percent Change in the Ratio of Average Household Income to Median Household Income).

So, what's the effect if the Household Size stays the same -- meaning The Gross Percent Change in Household Size = 1, but the denominator doubles, that is The Gross Percent Change in the Ratio of Average Household Income to Median Household Income = 2?

If that happens, then the left hand side of equation 3 is cut in half; GDP Per Person grows twice as much as Median Household Income.

So, bottom line, what you have should explain everything, but only as long as assumptions 1-3 are true. The key assumption I'd look at is 2, the assumption that the income used in "GDP per Person" is the same as the income used in "Average Household Income". For example, they may not be including a lot of transfer payments in household income, or they may not be including all benefits, bonuses, and dividends and other capital income. And then there's income that people hide for reasons like tax evasion and other illegal activities.

Consider, UCLA economist Emmanuel Saez's March, 2008 paper, "Striking it Richer: The Evolution of Top Incomes in the United States (Update using 2006 preliminary estimates)" . He writes:

We define income as the sum of all income components reported on tax returns (wages and salaries, pensions received, profits from businesses, capital income such as dividends, interest, or rents, and realized capital gains) before individual income taxes. We exclude government transfers such as Social Security retirement benefits or unemployment compensation benefits from our income definition. Therefore, our income measure is defined as market income before individual income taxes. (page 1)

I don't know exactly what data sources you're using, but the answer to your puzzle certainly may lie in the details of how they are compiled.

Another point I'd like to add is that for income inequality, looking only at how quintiles have done is really misleading, because there has been so much increased inequality within the top quintile. It's in the top 1% and the top 1/10th of 1% that you really see an explosion in income inequality.

Saez's data series' (available at show that in 1978 the top 1% received 8 times the average income; by 2006, this soared to 23 times. For the top .01% the increase was from 86 times the average income to 546 times! And on top of this, Republican tax cuts starting in the Reagan administration and continuing through Bush II have made taxes far less progressive. The top federal income tax rate was cut by 35 points between 1979 and 2006. Average tax rates on the richest 0.01% were cut in half between 1970 and 2006, while taxes on the middle class were increased (From Princeton economist Paul Kurgan's most recent book, "The Conscience of a Liberal" (page 145) and his 2007 column, "Gilded Once More"). Another great source is the Economic Policy Institute's annual book, "The State of Working America".