The True Conservative

Regulating the Ratings Agencies: Low-Hanging Fruit?

Among all the furious post-almost-apocalyptic discussions of financial industry regulation (i.e. here, here, here, here, and here), I'm stunned how rarely people mention the single biggest leverage point: regulation of ratings agencies.

If Moody's et al had rated mortgage-backed securities properly, we simply wouldn't be in the fix we're in now. Those securities would have been cheaper and harder to sell, and as a result mortgage writers would have found it more difficult and expensive to pawn off their risks. This in turn would have forced them to be more prudent and sensible in their lending practices.

At the very least, regulators could mandate a cigarette-pack-type warning on each and every rating: "This rating was paid for by the issuer of the security being rated, and was prepared in consultation with that issuer." (The SEC seems the natural entity for this job. No need to inflate the Fed any further right now.)

This might lead market mechanisms to improve the situation: ratings that include that warning would be discounted in the market (yes, they're free, but they're quite possibly worthless), opening market opportunities for purveyors of more objective ratings.

In the big scheme of schemes being floated, this is an easy win. Why isn't anyone talking about it?

(This highlights a key area where--contrary to knee-jerk anti-regulation zealotry--government regulation is both efficient and essential: insuring that all, or at least more, information is known. Absent regulation to ensure transparency and disclosure, the market may be "free," but it's certainly not efficient. Market-generated incentives and constraints if anything encourage players to ensure that information is not known. It's a quintessential, inevitable, and never-ending "free-market" failure. This is just one example out of zillions where government-imposed incentives and constraints--regulations--make the market more efficient than the market would.)

Another Free-Market Straw Man

I get so tired of reading these pointless free-market commentaries that do nothing but state the obvious and grind the axe.

Today's find: William Easterly's Financial Times article, "Trust the development experts – all 7bn of them."

Easterly ridicules a recent (rather impressive, though judicious and occasionally mealy-mouthed) World Bank report on development, arguing that we should "give up on the experts," trusting in the hallowed free market to solve all development problems.

Roberto Zagha responds well and at length, concluding that "much of Easterly’s critique is directed to self-constructed claims and assertions rather than drawn from the report."

His response could be condensed, however, into two words:

Straw man.

Mr. Easterly admits to as much in his own response:

Economists give great guidance on everything from trading systems to macroeconomic stabilization to auction design to financial regulation. Keynes in a famous quote said it would be splendid if economists were thought to be as competent as dentists. I think we are getting close to Keynes’ ambition, and all of the things I just cited where we can be good dentists will contribute to economic development. Let’s just not make the enormous leap to the absurd and counterproductive presumption that we dentist-economists can come up with an expert plan that will achieve rapid growth for a whole society out of poverty into prosperity.

Nobody has suggested such an absurd leap. The judicious, understated tone of World Bank report—the very thing that Mr. Easterly ridicules—embodies the very opposite of such a position. It's hard to overstate  the astounding irony of his argument.

Mr. Easterly was, however, quite clear in making the equally absurd claim--frantic backpeddling in his response nothwithstanding--that experts should be ignored, and that we should rely instead only upon the invisible hand(s) of 7 billion people.

In short, the World Bank report tells us quite a lot about what we can do to promote development. Mr. Easterly's commentary tells us nothing beyond the trivially obvious truth that everybody already knows and agrees upon: the market is a (the most) powerful force for development.

As my 15-year-old daughter would say, "No duh."

Manzi (and Me) on Equality and Prosperity

Jim Manzi was nice enough to drop me a note in response to one of my comments, and he pointed me to his National Review piece, "A more equal capitalism: preserving the free-market consensus." I ended up writing some lengthy responses, and not being one to waste perfectly good copy, I decided to post them here.

Dear Jim:

Thanks very much for the pointer. I'm delighted to see a right-leaning opinionator saying that we should be thinking about prosperity and equality--that there's lots we can do to promote both. When I hear that on the right, the tone is usually one of somewhat grudging acknowledgement of the need for some equality bolt-ons. (The best of the left, OTOH, embraces both wholeheartedly, and in a unified way, trying find paths and policies that can achieve them in tandem.) Your piece is a nice exception--a perfect example of where we can find common ground and agreement.

Responses to random bits:

It is hard to exaggerate the strength of the U.S. competitive position in the world economy in June 1945

So true. Damn I was lucky to be born in America in 1958.

As you point out though not exactly this way: In the ensuing 25/30 years (albeit with a huge amount of US aid and supported by US-incepted institutions [is incept a verb? don't think so...]), European real GDP per capita went from less than 50% of the US to 75% (OECD data), while they simultaneously built the social support systems that are supposed to be so debilitating to growth and prosperity. Counterarguments: It's been stuck around 75% ever since. (Countercounter: it hasn't lost any ground.) And, the more-rapid growth '45-'78 is probably largely attributable to the catch-up effect--technology transfer, capital infusion, etc. But the high taxes didn't prevent it. (Or are we suggesting that without those taxes, Europe would have kicked our asses?)

over the past 25 years the U.S. has reemerged as the acknowledged global economic leader. Economic output per person is 20 to 25 percent higher in the U.S. than in Japan and the major European economies, and the U.S. economy dominates in size and prestige.

"Has reemerged as the acknowledged global leader" is quite a statement, and I find it hard to support. (Though we obviously are and have been the leader since World War II.) By your chosen measure--U.S. GDP per capita compared to other developed countries--the results are pretty ambiguous. There have been big swings, but compared to Europe the 26-year trajectory starting in 1980 (the end of Europe's long catch-up period) is flat:

(Interestingly, OECD data shows far less volatility in this graph.) Asia's Per-Cap GDP has never broken 4% of the US's, but that ratio's been skyrocketing since the late eighties. Yes, we've kicked Japan's ass. But it's hard to argue that it's attributal to American supply-side policies...

Overall global economic dominance, as measured by share of world GDP, is also ambiguous, especially regarding presumed causes and effects:

As for growth in America's "prestige," check out Pew surveys. Over the last seven years at least, they show precipitous decline throughout the world. The only places where America's president has been warmly cheered lately are in Albania (thanks to what Clinton did) and Israel.

Absolute income equality, a.k.a. communism, is a poor goal, but if inequality becomes sufficiently extreme it undermines the social support required for a democratic and capitalist society to flourish.

Right, I understand your need to put in that caveat. Nobody's suggesting that CEOs and professors be put on collective farms.

Question: does this extreme inequality also slow long-term growth? The econometrics I've seen suggest a small positive correlation—barely or not statistically significant—between inequality and growth in developed countries. So it's hard to say; I've seen nothing that analyzes today's rather extreme situation, for which we have no real precedent in modern, developed economies. But looking back on the small six-figure inheritance that gave me the courage to go entrepreneurial without risking my kids' futures (or ignominious, debilitating failure), I can't help but imagine the power of tens of millions of naturally entrepreneurial (native and neo-) Americans given a stable springboard from which to leap. I talked about that in Wealth and Innovation: The Freedom to Do Cool Shit.

it's generally not a good idea to keep pulling bolts from an airplane in mid-flight just because it hasn't crashed yet.

Nice!!

The Democratic party has never assimilated the need for an increasingly market-based economy, so their "solutions" are a recipe for decline....How do we continue to increase the market orientation of the American economy

I think a better description: Democrats have never accepted the belief that all market-based solutions are a priori better, or that a headlong trajectory toward purely market-based solutions is good for the country or the world. That doesn't mean they don't believe in market solutions and their power to increase prosperity.  Just one example among hundreds: The Pro-Growth Progressive by Gene Sperling, head of the National Economic Council under Clinton. These Democrats (count me among them) are in favor of the very kind of growth-and-equality initiatives that your article is calling for.

Your language suggests that "the need for an increasingly market-based economy" is a given, which simply needs to be "assimilated." Given our national economic performance since 1980, a lot of reasonable people can very reasonably question whether that is a given. (Krugman gets at least one thing right:: markets "should be seen as a tool, not an object of religious devotion.")

"Increasingly" and "increase" here, is I think the sticking point. Why not "maintain and manage"? It's a far more "conservative" position.

A reasonable common goal: harness the natural powers of the market (the things that the market is good at) and the natural powers of government (i.e., setting and enforcing the necessary rules, and providing common goods that the market won't provide)--an ox-team pulling in tandem. (Though they sometimes pull in different directions--that's exactly what we want to solve by judicious use of reins and occasional whips.)

There's no evidence that government-imposed constraints are, a priori, any worse than market-imposed constraints--any more than natural selection is in some way superior to artificial selection (i.e. breeding) just because it's "natural." I wrote about this in Lane Kenworthy's Big Idea.

There's plenty of evidence, of course, that government-imposed constraints/incentives are sometimes/often bad, at least in their sum effects. But the same is obviously true of market-imposed constraints/incentives. Enron. Moody's! Your invocation of international institutions as one cause of America's post-war prosperity is spot on; ditto for the SEC and the Fed, and the Consumer Product Safety Commission. (And tangentially, I'm personally very fond of the National Parks.)

As we have seen in the private economy, only markets will force the unpleasant restructuring necessary to unleash potential.

Simply not true, but it's mainly that your case isn't stated right. See above. See the SEC, and your SEC-like proposal for education reform. Good stuff! (And don't get me started on schools of education--my ex-wife went to one albeit some decades ago, and described a class on "The Ten Ps of Pedagogy": a week on Punctuality, a week on Preparedness...) It's true that markets have far more power to effect huge change. But the government can exert the force that causes them to do so, and do things that they won't do under their own direction.

It's important to leave behind the knee-jerk gag reflex for regulation (while keeping a judicious eye on its net effects—and on mixed metaphors too). Planning and direction is not the same as the state owning the means of production. ("Central planning" is hate speech on the right, but we do all approve of the executive branch having an "economic plan," right?)

Going all the way back to the comment I left on your post, I hope you'll give real consideration to my posts on tax burden vis-a-vis growth.

Twenty-nine of the thirty OECD countries--the rich, succesful, modern economies--tax between 27% and 50% of GDP. Only four tax less than the U.S.: Greece (27%), Japan (27%), South Korea (27%), and Mexico (21%). None is exactly a model for U.S. emulation. Some of those on the high end (think: Scandanavia) arguably are.

At 28% of GDP, it's not insane to wonder whether our current tax base has us teetering on the bottom end of the range in which a modern, stable, developed society can prosper and thrive.

If you haven't already, take a gander at this post, where I point out that far better-credentialed souls than I agree with me regarding taxation and growth. The consensus of the data is pretty resounding: in developed economies in current taxation ranges (25-50% of GDP), tax burden and growth rate don't correlate.

Put that shibboleth aside, and we can start having really interesting and productive analysis-based conversations about *which* taxes, how much of each, how much in total, etc.

Thanks again for writing, and thanks for listening.

Europe vs. US: Who’s Winning?

People love to cherry-pick statistics to show that the US, or Europe, is winning the growth game. That got me curious: if you look at all the possible growth periods, who's ahead (most)? Short answer: no clear winner.  The results look pretty random. Over the longest periods, Europe is consistently ahead. But some shorter but still lengthy periods give the US the advantage.

It's interesting to note that the two stretches showing US predominance begin in 1982 (Reagan) and 1992 (Clinton). Both seem to result from big two-year leaps—82-84, and 92-94. Go figure.

Change in real GDP per capita (PPP), difference between EU and US
US growth percentage minus EU15 growth percentage (positive numbers=US ahead)
Starting years at left, ending years, top. Gray is >29 years. Outline is >19 years.

Here's the same table expressed as a percentage difference.
(US growth %-EU growth%)/EU growth %

All data is from the OECD. I just did the arithmetic.

McCain's Economic Advisor: More Taxes?

A CNN Money article on the candidates’ advisors quotes McCain's economic advisor Douglas Holtz-Eakin saying (as I read it) that we're really going to have to raise taxes:

The country's "current fiscal policy is unsustainable, as even draconian restraint in the annual spending on defense and nondefense programs are insufficient to guarantee that the current level of taxation will be sufficient to cover promises to seniors in retirement and health programs."

As my fifteen-year-old daughter would say, “no duh.”

Okay, it’s actually a quote from a policy paper where he recommends that we need to—wait for it—cut taxes. I guess the Straight-Talk Express isn’t really about keeping promises.

 

Does Inequality Result in Prosperity?

Lane Kenworthy lays out yet again the stunning rise in inequality in America since 1950, and especially during the period since the early eighties when supply-side economic thinking took effect. Meanwhile Greg Mankiw is presenting more don’t-worry-be-happy data.

Supply-siders will tell you that we need to embrace or least tolerate this inequality, because it’s necessary if our economy is to grow.

So, how's that theory working out?

Hmmm....

Lane Kenworthy’s Big Idea

Attributing the robust state of modern economies to the “free” market is like saying that Arabian stallions, champion Rottweilers, and freshly-picked sweet corn are the result of mutation.

Would you and your family rather live with a wolf, or Good Dog Carl?

That’s the thought I come away with after reading Lane Kenworthy’s chapter on “The Efficiency of Constraints” in his book In Search of National Economic Success: Balancing Competition and Cooperation (1995).

Kenworthy’s been getting a lot of well-deserved attention in the econoblogosphere lately. But I wonder if any of those bloggers have read his books. I really wonder if any of the mainstream economists are reading his books. I really really wonder if Obama’s advisors are reading his books.

I’ll get back to that. But first, The Big Idea. After quoting Smith’s seminal “invisible hand” passage, Kenworthy says:

The reason actors engage in economically beneficial behavior, according to the [neoclassical] theory, is not that they have unlimited freedom of choice, but that they must choose within a particular set of constraints—the constraints imposed by market competition. ... It is this constraint, rather than freedom of choice, that is the crucial efficiency-generating mechanism in a capitalist economy.

In other words, extolling the “free” part of free markets is like getting all drippy about mutation without selection. More Kenworthy:

The issue is not free choice versus constraints, but what type of constraints produce economically productive activity.

Natural selection—in this case the constraints imposed by the natural and human environment and by  other free-market agents—is a powerful force. But Kenworthy asks, quite reasonably, whether it is always more efficiency-producing than artificial selection (a.k.a. human-directed selection, a.k.a....breeding). In many cases, the visible hand of government creates more efficient markets.

Free-market advocates tend to ignore the reality that market-generated constraints often act directly against the formation of efficient markets. To choose what is perhaps the most obvious example: competition creates huge incentives for market participants to make sure that all information is not known. Disclosure regulations address that inefficiency, and result in the kind of robust open markets we see today in prosperous countries. Kenworthy gives three more (detailed and well-analyzed) examples in his chapter.

Even Adam Smith doesn’t assert that market constraints have some a priori claim to superiority. Says Kenworthy, quoting Smith,

...an individual who “intends only his own gain” is

“led by an invsible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”

“Nor is it always.” “Frequently.” Cherry-picked, it verges on a mealy-mouthed endorsement. Smith, in his wisdom, is not nearly so categorical as his latter-day disciples.

Kenworthy’s attention to constraints—market-imposed and otherwise—strikes me as a profound insight, cutting straight to the heart of the laissez faire philosophy that has increasingly dominated mainstream economics in recent decades. But the idea has not been taken up or even considered, apparently, by mainstream economists—or really by anyone else aside from Kenworthy’s colleague Wolfgang Streeck (who Kenworthy credits with inspiring his chapter in the first place).*

This might be partially Kenworthy’s fault. He’s pretty much invisible on both RePEc  and SSRN—the big publication/author databases for economics and social science, respectively. Each service turns up one of his papers and none of his books, and he doesn’t even appear on RePEc’s author list. A few hours’ work posting papers and personal info could get him a lot more attention, readership, and—the gelt of academe—citations.

Kenworthy also has the profound disadvantage of being a clear and cogent writer who’s accessible to (truly interested) laymen and policy wonks. His work is largely unpolluted by gratuitous academese. (You need to know some stats to understand and judge his arguments, but nothing more than an inquisitive soul can pick up on Wikipedia.)

These issues aside, I also wonder whether his chosen fields of sociology, political science, political economy, etc.—sideshows in the eyes of mainstream economists—cause those economists to think little of his work or simply be unaware of it—undeservedly so, because his work consists of unremittingly rigorous, top-of-the-game economic analysis. And it’s empirical analysis (well-informed by theory)—actually trying to tease out how real-world economies work and what we can learn from them.

Not surprisingly, Kenworthy has a lot more than one good idea. National Economic Success has a boatload. Ditto his latest, Egalitarian Capitalism: Jobs, Income and Growth in Affluent Countries (2007). This post is already altogether too long, so I’ll leave it to other posts—and other posters—to delve into those ideas.

Austan Goolsbee, are you listening?

* Streeck’s key 1997 article, “Beneficial Constraints: On the Economic Limits of Rational Voluntarism,” doesn’t seem to be available online.

 

Consumption Inequality Revisited: Uh...Hello??

Coming back to the Cox and Alm Cox article in the NYT, whose basic argument was that poor people spend 50% as much as rich people in America. Everyone's good. Don't worry. Be happy.

I don't know why it took me so long to realize this, and I'm utterly at a loss as to why better-equipped souls like Paul Krugman didn't realize it instantly. (He questions the quality of the underlying data when there's an elephant in the room?) Cox and Alm do, after all, point out the fundamental failing of their whole analysis:

While some of these families are mired in poverty, many (the exact proportion is unclear) are headed by retirees and those temporarily between jobs, and thus their low income total doesn’t accurately reflect their long-term financial status.

Tens of millions of retirees—and the presumably gigantic gap between their collective (non)earnings and spendings—have to be a huge factor.  And, uh...students? Who are being supported by well- or at least better-off parents who are nevertheless not part of the "household"?

The sticky issue of "life stages" (my children earn nothing, but the little hoodlums sure seem to consume a lot) is basic to the most freshman-level macro-equity analysis. Why aren't people who know better pointing this out?

Absent this "unclear" information, the whole Cox and Alm thing seems to tell us exactly...nothing.

Wealth and Innovation: The Freedom to Do Cool Shit

If there's (only) one thing that macroeconomists agree on, it's probably that innovation and entrepreneurship are the driving forces behind the vast improvements in well-being that we have seen over the decades, and over the centuries. (It’s also what's allowed for some of the most heinous acts imaginable. But still.)

I pointed out in a previous post that 1) wealth inequality is extreme in America, dwarfing both income and consumption inequality;  2) it varies greatly between OECD countries; and  3) in comparing those countries, over the long term wealth equality seems to correlate very strongly with growth in GDP per capita.

Why the correlation? In particular, does widespread wealth distribution promote innovation and entrepreneurship?

I'm going to punt on answering that question empirically because the paucity of data—and even more so, the difficulty of proving causation—is pretty insurmountable.

But I do have a personal tale to tell, one that some might find representative of a general rule, and hence somewhat convincing.

When I was 32—back when I still had the fire and drive for startups—my father died and I received a low-six-figure inheritance. It was nothing like retirement money, but it was a very comfortable cushion for someone earning in the mid-to-high five figures.

Within a year, I invested a nontrivial portion of that inheritance (along with a partner) into launching a new business. I also invested an insane amount of work that I could have devoted to guaranteed income. (Read: large opportunity cost.) It worked out very well for all involved.

Without that inherited wealth, I would not have had the financial or emotional freedom to start that business. (I had a new baby at the time, and a second one turned up within two years.) Having a solid nest egg in the bank gave me the confidence I needed to take a chance—not only risking some of the nest egg, but putting aside the reliable income I was generating (and reducing the likelihood of future reliable income), in return for a large possible upside.

To say it another way that puts across what it actually felt like at the time: that nest egg gave me the psychological space to go off and do some really cool shit, without worrying that failure would hurt my family significantly.

So why does wealth equality correlate with growth? I think it's because many more people have that space to take risks and innovate. In this case the “incentive” is actually a removal of limitations—the limitation being a widespread lack of wealth that is arguably encouraged by a free-wheeling, cut-throat, competitive economy. It's hard to overestimate the power of millions of people who have that kind of space and freedom to innovate.

This data-free surmise is supported to some extent by the previous post on wealth inequality. In the short term, concentration of wealth seems to correlate with faster growth. That’s in keeping with traditional economic models. But in the long term—where even fairly modest generational wealth like my father’s can have its sway—widespread distribution of that wealth removes limitations on millions of eager young strivers, resulting in the kind of risk, innovation, and success that I am so lucky to have experienced.

I'm making no statements (here) as to what we might do to promote that kind of wealth distribution. But I am saying that it should be a goal, one that we should seek to effectuate when we can do so without significant short-term damage to our economy. Not only is it more fair; it makes us all better off in so many, many ways.

Wacky Objections to an Obama Senate Bill

Greg Mankiw links, apparently approvingly, to a VoxEU post by Willem Buiter and Anne Sibert savaging an Obama-sponsored bill in the Senate. (Cloyingly titled the Patriot Employer Act.)

Felix Salmon has replied quite effectively, pointing out that the bill would not have the kind of disastrous effects the authors suggest, and that their objections are flawed, overblown, and largely trivial.

Mankiw pulls the money quote for his post title: the authors describe the bill as "reactionary, populist, xenophobic and just plain silly." They forgot "distortionary," which is their post's main basis for fear-mongering.

I just want to point out a couple of blatantly disingenuous parts of Buiter and Sibert's argument, which to me exemplify how frantic and reactionary the whole post is.

The bill provides a one-percent-of-revenues kickback to employers who fulfill a list requirements. One of those requirements (in Buiter and Sibert's words, my emphasis) is that:

"[employers] must provide a defined benefit retirement plan or a defined contribution retirement plan that fully matches at least five percent of each worker’s contribution."

Putting aside the question about "fully" matching five percent, or the incredibly low bar that five percent represents: The authors attack this by attacking defined benefit retirement plans (a.k.a. company pension plans)—with some good basis for their objections. But they conspicuously ignore the "or"—the option for defined contribution plans. Presumably they can't muster any objection to those.

Next, to receive the kickback under the bill, employers must:

pay at least sixty percent of each worker’s health care premiums

The authors' objection:

tax incentives...that link health insurance with being employed rather than with being alive, are distortionary and unfair.

So...because the bill does not promote universal, single-payer health care, it's a bad bill.

Is Mankiw really endorsing this argument?

The main point, though, is that employers aren't required to opt in to this program. If they think they can fulfill its requirements for less than 1% of revenues, they can do so—with the manifest benefits (primarily to Americans) that would result for individuals, the companies, the government, and the general public.

Isn't this exactly the kind of win/win incentive that government at its best (and only government) can provide?