Russell Roberts's Blog, page 1457

Rodrik and externalities

In this week's EconTalk, Dani Rodrik discusses how labor markets in some countries work better than others. It's an interesting conversation about the next best alternative. When workers in America lost their jobs the next best alternative can be fairly close to the lost job and may pay nearly as well. And of course some workers who lose their jobs are fortunate to find a job that even pays more. But in poorer countries, if the agriculture sector is destroyed by cheaper imports, for example, the next best alternative may not even be there or if it is, it may pay very poorly. One way to think of this is that creative destruction may not be equally creative everywhere.

Along the way, Rodrik argued, to my surprise, that starting a new venture in a poor country has a positive externality that leads to market failure. He gave the example of a call center–suppose a country has a work force that would be good at working in call centers. An entrepreneur who starts a call center will thereby provide information to other entrepreneurs about the quality of the work force. The original entrepreneur can't capture this gain so the government should correct this market failure by subsidizing it. Rodrik and I discussed the issue for a while and he raised what he considered other examples of market failure including the possibility that any rents generated from starting the call center might quickly be eroded by other entrants who start their own centers and bid up the price of your labor.

After the podcast was over, I realized I had neglected to raise an important objection to Rodrik's claim. We ended up emailing back and forth and he kindly gave me permission to print our exchange. I offered him the last word but he didn't respond. I'm sure he was had simply had enough or had other things to do. I mention it only because I don't want you to think that I didn't give him the chance or that he conceded my point. Again, I'm sure he has something more to say.

ROBERTS: If entrepreneurs are uncertain about whether a countries labor force is productive or not, how would a government policy maker assess that more accurately?

RODRIK: It's actually very simple.  The first-best intervention here is an entry subsidy to any entrepreneur who invests in a product or technology that is new to the country.  And there is a host of second-best policies that could also do the trick.

You don't need to assume the government knows more than the private sector, any more than in the case of externalities from R&D in the advanced economies.  Even though the government has no idea which research projects will produce genuine advances, there is an argument for subsidizing R&D across the board.

Or think of patents, which are aimed to achieve in a second-best fashion, the same kind of knowledge spillovers that new products and processes generate in rich countries.

In fact, when entrepreneurs in developing countries engage in cost discovery, they are the source of exactly the same kind of positive externalities that entrepreneurs in Silicon Valley produce.  Except that the latter get patent protection, while the first normally don't get any subsidies at all (unless we implement the kind of policies I am advocating).

ROBERTS: Let's say creating a cardboard box factory, a new venture for the country, has a negative rate of return so no one is willing to start one. The government offers a subsidy to all new products. Now, when the subsidy is included, the factory has a positive return so it gets built. How is that a good idea?

RODRIK: It's a good idea in the same sense that financing a R&D project with a potential externality is a good idea EX ANTE, even if the project ends up failing.  Other R&D projects that are successful (and are similarly subsidized) will more than pay for the failures.

This is all worked out in the following paper: http://www.hks.harvard.edu/fs/drodrik...

But here is the gist.  If there is an externality in investing in new activities, there will be underinvestment by the private sector.  A (small enough) subsidy to investors is efficiency-enhancing, because it brings investment closer to the first-best level, even if not all of the new projects succeed.

ROBERTS: I guess I'm skeptical about subsidizing R& D as well. If the subsidy is set too high (and there will be a political incentive to so) the subsidy will make the nation poorer. The same seems true of a blanket subsidy to new ventures.

If you're interested in the idea, check out his paper and the podcast. The only other point I would add is that political pressure will make it very hard to define "new" as in subsidies to "new" ventures.

The housing boom and bust, part 2

In this post, I suggested that the spike in housing prices starting in 1997

[image error]

was due more to government housing policy and less to animal spirits or a self-fulfilling bubble that somehow got started out of the blue.

The picture is from Barry Ritholtz's blog, The Big Picture.

Barry responds in the comments:

Be wary of squishy thinking.

While its easy to blame Uncle Sam, you need to show the data that supports that argument — so far, no one has successfully done that. NO ONE.

The much more persuasive case has been made that the combination of ultra low rates, shadow banking system, corrupt rating agencies, foolish lenders, irresponsible borrowers and dumb bond fund managers were the primary causes.

The DATA provides an overwhelming viewpoint of where the Housing boom and bust came from

Barry, I think you're confusing the subprime crisis with the housing boom. They are related but they're not the same thing. The Fed's low interest rates between 2002 and 2004, for example, did have something to do with the subprime crisis. And artificially low interest rates did inflate the housing market generally. I don't think they had much anything to do with housing prices in 1997. And yes, the shadow banking system had a lot to do with the run-up in prices after 2003 or s0. And yes, there were a lot of dumb, myopic lenders, borrowers and bond-fund managers. But why did they start getting dumb in 1997.

My other thought is that we don't have particularly good models of bubbles, by definition. So when you say there no one has produced the data, I'm not sure what standard to use to evaluate it. What I think you really meant when you wrote that was that Fannie and Freddie and the CRA can't explain why Bear Stearns and Lehman and a bunch of other cowboy waa-hoos went crazy on MBS. And you're right. But that's not all that I meant by government housing policy.

Here's the outline of my narrative. Sure, it's squishy in parts. All narratives are. Yours, too, I suspect, but I'll let you make the call on that one.

The role of government in the housing market goes back decades to the deductibility of mortgage interest, FDIC insurance, and the creation of Fannie Mae. But those interventions were done a long time ago and they stayed in place with minor variations. They weren't the cause of the crisis. You have to find a change in government policy. My narrative starts in the early 1990′s. Check out this article from 1992. (And don't worry, even though I'm going to use the letters "CRA" in consecutive order in what follows, I don't think the CRA is the main cause of the subprime crisis. I, like you, blame most of that on shadow banking. But the CRA has something to do with it…)

It's about how ACORN and others used provisions of the CRA to get urban banks to make loans in neighborhoods that hadn't been receiving loans:

The Philadelphia banks in the program, Mellon, Continental and Fidelity,, say their experience shows that a well-structured program can break even in the short run and promises intangible and financial gains over the long haul. The banks charge sufficient fees to cover costs and work hard to keep delinquencies and foreclosures low.

"These are not conventional loans and we make sure that we don't lose money," Mr. Desiderio said. "But they are totally beneficial to us because they improve our trade area. In the long run this will drop to the bottom line."

Bankers believe that as poor neighborhoods stabilize, the entire region benefits, which affects a bank's future profitability.

What is more, these mortgages help banks fulfill somewhat vague obligations of the Community Reinvestment Act of 1977, which requires banks to invest in communities that provide them with deposits.

It also talks about the role of Fannie and Freddie. Remember, this is 1992, right around the time HUD starts pushing Fannie and Freddie to buy more loans than they had bought before in poor neighborhoods.

But the mergers that have helped create the lending programs are also a cause of concern for some. LaVerne Butts, a Philadelphia Acorn official, fears that mega-mergers may leave the poor in the dust. "Where's the accountability?" she asked. "We're doing wonderful things, but we're still swimming against the tide. Many of these banks still don't view low- and moderate-income people as people. When they get so big, who do you lean on?" Aiming at Secondary Market

Yet at present, the three Philadelphia banks seem responsive. They have lobbied with Acorn in Washington to find ways to make it easier to package these mortgages and sell them in the secondary market. This would reduce the banks' risk and free up more money to lend.

The biggest buyer of mortgages is the Federal National Mortgage Association, known as Fannie Mae, which resells them to investors. But Fannie Mae has been reluctant to buy such unconventional mortgages. Acorn hopes that large commitments like that of Nationsbank will help bring pressure on Fannie Mae. Already, Nationsbank is talking about joining with Acorn's Washington lobby.

Fannie was reluctant, but they got over it. They made an enormous amount of money when they were "forced" to lower their standards. They weren't really forced. They liked being thrown into the briar patch.

Remember, this is 1992. In 1995, the CRA got revised and was made tougher. Fannie and Freddie's were required to buy more mortgages made to low-income buyers. In 1995, President Clinton announced the 1996 Home Ownership Strategy. Read about it here. Go to the end of the document. It details all the activities that would increase home ownership.

And it worked. Or something did. Correlation is not causation. The fact that home ownership rates started to rise in 1995 doesn't mean the policy worked. But that was the goal of the policy and the stated activities related to that goal (Making Financing More Available, Affordable, and Flexible) would increase home ownership. Of course, you have to look at the data. You have to show that financing did become more available, affordable, and flexible. This 2001 paper by Josh Rosner makes the case pretty convincingly. But maybe I'm biased. You tell me where Rosner goes wrong. He does have a lot of data. Remember, this is 2001. Long before the important part of the subprime crisis.

I summarize the role of Fannie and Freddie's increased willigness to buy mortgages they wouldn't have bought before, here. I'm agnostic about their direct role in subprime. I don't think they bought very much of it. They bought a lot of subprime MBS. But maybe someone else would have bought that anyway. It was awfully profitable for a while.

So my claim is that between 1995 (and maybe a little earlier) and 2001, there was a lot of government policy that pushed up the demand for housing. Increases in demand usually increase prices. There are exceptions. If supply is sufficiently elastic, the price increase can be minimal. But I think it's pretty clear that in some cities, supply was quite inelastic, for both geographic reasons and zoning restrictions. So the push in demand helped create the rise in prices you see in the graph.

It probably didn't create the subprime crisis directly. But it doesn't have to in my story. In my story, the increase in demand (driven by housing policy, somewhat well-intended (getting people into homes who couldn't afford them before), somewhat very nasty self-interested cronyism (NAR, NAHB, Fannie and Freddie) pushed up the price of housing between 1995 and 2001.

Once the price of housing started rising dramatically, it became profitable to bet on the rise continuing. So a lot of people, smart and stupid, tried to ride that meteor as it shot upward. And that's where the shadow banking system and the low interest rates come in. The shadow bankers pumped trillions into that market via all those innovative new assets (CDO's, CDO squared etc). They use borrowed money because they could. The lenders lent the money because the government had signaled that lenders would get made whole even when the bets their loans financed were worthless. I learned part of that story from a fine book called Bailout Nation. I think you've heard of it. So moral hazard had something and maybe a lot to do with the last part of the housing bubble and especially the subprime part. But why did the moral hazard spend itself in the housing market rather than somewhere else? That was because that market was rising nicely. But why was it rising nicely. Animal spirits or government policy that kicked off the madness? I think the government had a lot to do with it.

Here's where my story is squishy. It's not enough to say that demand went up, so prices went up. You have to show that the magnitudes are reasonable. You have to show the areas where Fannie and Freddie were most active between 1995 and 2001 were the areas where price rose. I've seen one paper that argues that Fannie and Freddie's affordable housing goals had a limited impact on providing liquidity. Could be. But it is hard to tease out independent effects. I suspect this debate and empirical evidence will keep going for a while. But it's a reasonable debate. It's not silly.

And yes, I know other countries had housing bubbles but didn't have a CRA or Fannie or Freddie. You can increase subsidies to home ownership without having the same named entities. Again, it's an empirical question. And I certainly agree that monetary policy and the coddling of cronies in the shadow banking system made the whole thing many times worse than it otherwise would have been.

I responded to Brad DeLong's claims that Fannie and Freddie had nothing to do with the crisis, here.

I responded to Erik Hurst's claims about animal spirits, interest rates and foreign capital flows, here.

 

 

 

Aren't We Fortunate?

Cafe patron Dave Bieler sends this link to a U.S. government site bearing the headline "Financial Literacy: The Federal Government's Role in Empowering Americans to Make Sound Financial Choices"

In his e-mail, Dave comments "It's nice to know that the most financially irresponsible people in the country are so concerned about our financial literacy…."

A lifetime spent spending other people's money does not instill any knowledge of financial responsibility.

The housing boom and bust

Here is an updated version of Case-Shiller's housing index for the country. (The source for the updating and the image is The Big Picture and TBP reader Steve Barry.) It is of course somewhat misleading because there is not a national housing market. But it does capture factors that affect all housing markets.

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Some people explain the recent 15 years as being caused by "animal spirits" arguing that if you think prices of an asset will go up, then that belief can be sufficient to cause a bubble. True, no doubt. But what causes that belief to take hold. Some people say it's just random. A fad. The madness of crowds. Could be. I suspect that the systematic attempt by federal government policy that began in earnest in 1995 and ran through the Clinton and Bush II administrations had a lot to do with it.

Daniels

I've thought for a while that Mitch Daniels would make a good Presidential candidate. The best candidates for the GOP will be the anti-Obamas. That rules out Romney (too good-looking and too unwilling to attack his own health care reform in Massachusetts). That elevates Daniels and Christie. Both are dramatically less elegant and Ivy-League than the President and both have a track record for fiscal responsibility. It looks like Daniels will run. i think Christie will run if no one jumps out early. He will be "talked into" running.

UPDATE: Bret asks in the comments:

Would he make a good president? Or just a good presidential candidate? Obama was a great presidential candidate, but maybe not such a great president.

I deliberately wrote "candidate" in the post. Whoever is the next President is going to run on fiscal responsibility. If that is a winning platform, that candidate will find a willing Congress. So the best candidate for the GOP will be the candidate who can sell that theme most effectively. I suspect Obama will be selling the same theme. He will find it harder to sell.

There's no their there

Joseph Stiglitz writes about the top 1% in Vanity Fair. I will try to comment on more of the article at some point, but it starts off like this:

It's no use pretending that what has obviously happened has not in fact happened. The upper 1 percent of Americans are now taking in nearly a quarter of the nation's income every year. In terms of wealth rather than income, the top 1 percent control 40 percent. Their lot in life has improved considerably. Twenty-five years ago, the corresponding figures were 12 percent and 33 percent.

So compared to 25 years ago, the share of income going to the top 1% has doubled, from 12% to almost 25%. But the conclusion that Stiglitz draws, does not follow. It does not follow that their lot in life has improved considerably. There's no "their" there. The people who were in the top 1% 25 years ago are not the same people in the top 25% today. The numbers that are quoted are two snapshots at two different times. The correct statement is that the people who are in the top 1% today earn a larger share of the income pie than the people who were in the top 1% 25 years ago.

How would Stiglitz answer this? Perhaps he would say it's mostly the same people and that I am nit-picking. Or that the people who are in the top 1% today may not have been in the top 1% 25 years ago but they were close. They were maybe in the top 5%. So his statement is close enough for an article in Vanity Fair. Yes, his statement is imprecise, but it captures what is going on.

My counter would be that many of the people in the top 1% today were not even in the work force 25 years ago. LeBron James. Sergey Brin. Mark Zuckerberg. The imprecision allows Stiglitz to imply that the 1% are a coherent group that does stuff to maintain or grow their economic power. But it's not true. Yes, some of the top 1% are politically adept. They work in the financial sector. Or in law firms that work in and around New York City and Washington DC doing stuff related to government power. But some and maybe much of that growth in the economic power of the top 1% is due to productivity.

Finally, I would point out that when you actually follow the same people over time, the gains at the top (and the bottom) do not mirror the changes in the two snapshots:

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This picture is from a study of the Pew Economic Mobility Project. This study follows the same people over time over roughly a 30 year period:

Family incomes in the PSID sample were measured in 1967–1971, when parents had an average age of 41years, and again in 1995–2002, when their adult children had anaverage age of 39 years.

The gray bars are from the period 1967-1971. They represent the parents. The scarlet bars are the kids.

And notice that the overall change between generations is an increase in real terms (corrected for inflation) from $55,600 to $71,900. That's an increase of 29%. And the inflation correction probably overstates inflation. Not exactly the Great Stagnation. There is ZERO gain in the top quintile. I know. The top quintile is not the top 1%. But my point is that if you look at the share going to the top quintile between 1969 and 1999 as two snapshots, you'd find big gains for the top quintile that is misleading in the same way the Stiglitz inference from the data is misleading.

This is from InfoPlease that gets the data from the Census Bureau. I assume it's right–it mirrors what we hear over and over again. The top of the income distribution appears to get all of the the gains or at least the biggest gains:

Table 11.4  Share of Income Received by Each Quintile and the Top 5 Percent


Year
Lowest
Second
Third
Fourth
Fifth
Top 5%


2000
3.6
8.9
14.9
23.0
49.6
21.9


1990
3.9
9.6
15.9
24.0
46.6
18.6


1980
4.3
10.3
16.9
24.9
43.7
15.8


1970
4.1
10.8
17.4
24.5
43.3
16.6

Source: U.S. Census Bureau

Notice that all of the quintiles, except the top quintile get smaller shares between 1970 and 2000, roughly the time covered by the Pew study. But the Pew Study comes to the exact opposite conclusion. The lowest quintiles got the biggest gains WHEN YOU FOLLOW THE SAME PEOPLE. Using the Census data over time tells you NOTHING about what "they" (the top whatever percent) had happen to "them" over time.

It is also worth pointing out that the pie is not constant. So you're well-being can grow even when your share of the pie falls if the pie is getting sufficiently larger.

Here is an earlier post on the same topic reacting to a similar claim by Justin Wolfers.

It's a great time to be alive

This wouldn't have been imaginable fifteen years ago as something creative people could do. We are just beginning to tap the extraordinary potential for human creativity and how we can use the internet to harness that creativity. This is stunning both in concept and execution. Beautiful.

And the Straw Individual(ism) Is Down for the Count!

Mr. Ross Lampert

Dear Mr. Lampert:

Writing at Daily Kos, you charge individualism with being destructive and morally degenerate ("Deflating Conservative Arguments: The Myth of Individualism," April 10).  A key sentence in your brief against individualism is this one: "In order to believe in individualism, you must be willing to believe that what we do has no effect on the outside world, that there is no causal relationship between anything that we do and the things we see around us."

Nothing – truly nothing – can be further from the truth.

No academic discipline boasts as many champions of individualism as does economics.  From Adam Smith in the 18th century to Vernon Smith today, the ranks of economists have been full of learned and powerful voices for individualism.  Chief of among the reasons is that economists  focus on explaining the material manifestations of the great and often global interconnectedness of human choices and actions.

Consider that the most iconic of economic models, supply and demand, is a means of explaining how the decisions of countless individual buyers and sellers are coordinated by prices and how changes in these decisions cause changes in prices and, through these changes in prices, changes in the actions of distant strangers – how, for example, increased demand for peanuts in Peoria will cause farmers in Alabama to plant less alfalfa and more peanuts.

Or consider what Adam Smith wrote in The Wealth of Nations: "In civilized society he [man] stands at all times in need of the cooperation and assistance of great multitudes, while his whole life is scarce sufficient to gain the friendship of a few persons.  In almost every other race of animals each individual, when it is grown up to maturity, is entirely independent, and in its natural state has occasion for the assistance of no other living creature.  But man has almost constant occasion for the help of his brethren."  Smith then explained how markets coordinate the demands of consumers with the actions of suppliers.

Does Smith – a champion of individualism if ever there was one – here sound as though he believed that "there is no causal relationship between anything that we do and the things we see around us"?

You've slain a straw man, sir.

Sincerely,

Donald J. Boudreaux

Some Links

Dan Griswold's latest, data-rich study on the U.S. trade deficit is a must-read.  Here's the abstract:

A nearly universal consensus prevails that the goal of U.S. trade policy should be to promote exports over imports, and that rising imports and trade deficits are bad for economic growth and employment.

The consensus creed is based on a misunderstanding of how U.S. gross domestic product is calculated. Imports are not a "subtraction" from GDP. They are merely removed from the final calculation of GDP because they are not a part of domestic production.

Contrary to the prevailing view, imports are not a "leakage" of demand abroad. In the annual U.S. balance of payments, all transactions balance. The net outflow of dollars to purchase imports over exports are offset each year by a net inflow of foreign capital to purchase U.S. assets. This capital surplus stimulates the U.S. economy while boosting our productive capacity.

An examination of the past 30 years of U.S. economic performance offers no evidence that a rising level of imports or growing trade deficits have negatively affected the U.S. economy. In fact, since 1980, the U.S. economy has grown more than three times faster during periods when the trade deficit was expanding as a share of GDP compared to periods when it was contracting. Stock market appreciation, manufacturing output, and job growth were all significantly more robust during periods of expanding imports and trade deficits.

The goal of U.S. trade policy should not be to promote exports at the expense of imports, but to maximize the freedom of Americans to trade goods, services, and assets in the global marketplace.

Speaking of trade deficits, in this video, Dan Mitchell exposes an IRS proposal that, if implemented, would certainly reduced America's trade deficit – and, in doing so, make Americans poorer.

Writing in today's Wall Street Journal, Carrie Lukas offers evidence against the proposition that women are paid less in the U.S. economy than are comparably productive men.  Here's a key passage:

Recent studies have shown that the wage gap shrinks—or even reverses—when relevant factors are taken into account and comparisons are made between men and women in similar circumstances. In a 2010 study of single, childless urban workers between the ages of 22 and 30, the research firm Reach Advisors found that women earned an average of 8% more than their male counterparts. Given that women are outpacing men in educational attainment, and that our economy is increasingly geared toward knowledge-based jobs, it makes sense that women's earnings are going up compared to men's.

And more speaking of: speaking of comparing men's to women's pay, consider these data offered by Carpe Diem's Mark Perry.

All Marylanders should toast this policy change! (HT Daniel Kuehn)

Atlas Shrugged hits theaters on Friday!  Here's the New York Post's Kyle Smith's take on this movie.  I saw it a few weeks ago and thoroughly enjoyed it.

Terryfied

Here's a letter to the Chronicle of Higher Education:

Terry Eagleton writes that "There is a sense in which the whole of Marx's writing boils down to several embarrassing questions: Why is it that the capitalist West has accumulated more resources than human history has ever witnessed, yet appears powerless to overcome poverty, starvation, exploitation, and inequality?" ("In Praise of Marx," April 11).

Where is this "capitalist West" of which Prof. Eagleton speaks?  In the U.S. – surely one of history's premier capitalist western nations – poverty, starvation, exploitation, and inequality as these were suffered for millennia upon millennia until the 18th century, are today nearly totally eliminated.  The poverty that does exist in the U.S. in 2011 is relative – in the sense that I, on my college-professor's salary, am poverty-stricken relative, say, to Alec Baldwin or Barbra Streisand.

Only the tiniest fraction of Americans today lives without solid roofs over their heads and solid floors beneath their feet, and even they don't starve to death. The poorest Americans have life expectancies at least double those of crested and landed nobles before the industrial revolution.  These same poor Americans are immensely better fed, clothed, housed, entertained, medicated, educated, and hygienated than were the vast majority of their (or anyone's) ancestors.  These facts – along with the additional one that capitalists must continually innovate (typically for mass markets!) in order to continue earning their riches – make claims of widespread "exploitation" in capitalist countries ludicrous.

Prof. Eagleton is like the lawyer who, upon seeing a gifted physician restore to complete health a patient who had been machine gunned, beaten, burned, and thrown from the roof of a skyscraper, accuses the physician of malpractice because the patient has a mild case of acne.

Sincerely,

Donald J. Boudreaux

After I post this letter, I'm going to the supermarket to be exploited, and to be served by the supermarket's exploited workers.