Simon Johnson's Blog, page 4

Economism and Arbitration Clauses

By James Kwak

As banking scandals go, Wells Fargo opening millions of new accounts for existing customers so that it could pump up its cross-selling metrics for investors is about as clear-cut as it gets. It’s up there with HSBC telling its employees how to get around U.S. regulations in order to launder money for drug cartels, or traders and treasury officials at several banks conspiring to fix LIBOR.

Holding Wells responsible, however, was a bit trickier. The bank agreed to restitution (i.e, refunding the fees it had collected from its customers for the phony accounts) and a paltry $185 million in fines. When customers sued for damages, however, Wells hid behind its mandatory arbitration clauses, which were so broadly written that they even applied to accounts that the customer never intended to exist and that the bank had fraudulently created. Wells eventually reached a settlement with the class of plaintiff customers, but the settlement amount was no doubt influenced by the bank’s ability to compel arbitration.

The Consumer Financial Protection Bureau has proposed to eliminate the Wells Fargo defense by prohibiting class action waivers—clauses that take away customers’ right to participate in class action lawsuits—in arbitration clauses of financial contracts. (Class actions are crucial to deterring and punishing systematic fraud against consumers, because the harm to any single person will not be worth the expense of pursuing a lawsuit; without a class action, no one will sue, and the company will escape unharmed.)

Republicans, not surprisingly, are opposed to the proposed CFPB rule because … markets! The argument against regulations such as a ban on class action waivers is simple and elegant. A class action waiver is just a contract term open to negotiation. The waiver clause is bad for the consumer; therefore, its existence in the contract implies that the consumer must have gotten something else in exchange for that clause—lower fees, free checking, a lower interest rates, whatever. In a free market, customers have a choice: those who want the right to pursue a class action can pay a higher price for it, while those who don’t care about that right can trade it in exchange for a lower price. When a big, bad regulator like the CFPB comes along, and bans waivers altogether, it harms the latter group, who now must pay a higher price for a right they don’t want in the first place.

As law professor Jeff Sovern points out in a new paper, this is just a classic example of economism. Courts love making deductions from first principles of introductory economics; see, for example, Frank Easterbrook in IFC Credit Corp. v. United Bus. & Indus. Fed. Credit Union: “As long as the market is competitive, sellers must adopt terms that buyers find acceptable; onerous terms just lead to lower prices.” The problem is that the conclusions they arrive at are often simply not true in the real world. Sovern, who has done empirical research on arbitration clauses, points out what should be no surprise to any actual human being: few people understand them, which makes it difficult to see how they could be getting anything in exchange for agreeing to them. In one study, Sovern and his co-authors showed hundreds of people a contract that included a class action waiver in ALLCAPS; afterward, four times as many people thought they could still participate in class actions as realized that they could not.

A variant on the argument above is that, in a free market, banks will treat their customers well because it’s good for business. That is, when customers complain, banks will correct any errors they have made, because otherwise the customer will close her bank account or credit card. This argument is so preposterous that it doesn’t even warrant the ten-point rebuttal that Sovern gives in his paper. As anyone who has ever been a customer of any large company could point out, this still gives banks the incentive to rip off their customers unless they know that 100% of those customers will notice and take the effort to complain.

It’s unlikely that anyone actually believes that consumers understand arbitration clauses and take them into account when making buying choices. These arguments aren’t meant to be taken seriously. They are air cover for banking executives who like taking advantage of customers and politicians who want to do favors for the financial lobby. That’s the purpose of economism, and why it continues to be so influential.

How Markets Work

By James Kwak

The Congressional Budget Office’s assessment of the Republican health care plan, as passed in the House, is out. The bottom line is that many more people will lack health coverage than under current law—23 million by 2026—even though the bill allows states to relax the essential health benefits package, which should in theory attract younger, healthier people. This is not a surprise.

I just want to comment on the role of markets in all of this, which I think is not fully understood. For example, the Times article by the very up-to-speed Margot Sanger-Katz explains that the American Health Care Act of 2017 will make markets “dysfunctional.”

[image error]

This is consistent with the rosy view that many people, particularly centrist Democrats, have of health care: if we could only get markets to behave properly (correct for market failures, to use the jargon), everything would be great.

But that’s not how markets work.

The CBO report specifically discusses the “stability of the health insurance market,” which they define in these terms: the market is unstable “if, for example, the people who wanted to buy coverage at any offered price would have average health care expenditures so high that offering the insurance would be unprofitable.” In their analysis, instability will result in some states that waive both the essential health benefits package and the prohibition on medical underwriting (charging premiums based on applicants’ health status). In that case, healthy people will choose cheaper policies with less comprehensive benefits. Only sick people will buy more generous policies, which will soon become apparent to insurers, who will raise premiums (to account for sick people’s higher expected health care costs), which will make insurance unaffordable for the people who need it most.

This is all true. But that’s not a dysfunctional market. That’s just a market.

It’s a common characteristic of markets that suppliers offer different products, each designed to meet the needs of a different segment of buyers. In fact, this is generally considered a positive feature of markets. Market completeness—meaning, roughly speaking, that all possible goods and services can be traded—is an assumption of some of the most important theorems in economics.

In the example above, health insurers are offering one low-frills, low-priced product and another gold-plated, high-priced product. In most contexts, we would consider this a good thing. Can you imagine if everyone had to buy the same Toyota Camry? Isn’t it good that people with low incomes can buy a Honda Fit, while those with high incomes can buy a BMW M6? And we don’t worry about the fact that most people can’t afford an M6.

Say you have treatable cancer. Your expected medical costs are $50,000 for the next year. In a functioning market, your health insurance policy should cost about $60,000. (The extra $10,000 covers administrative costs and the cost of capital.) It’s still insurance, because you’re protected against the risk that your medical costs will unexpectedly be $100,000. That’s the right product for you: it’s the one you need, and it’s priced appropriately. That’s what markets are supposed to provide. The world where you can buy an individual policy for $3,000 because the insurer doesn’t know you have cancer, or because Obamacare prohibits the insurer from using that information—you may get treatment in that world, but only because we prevent the market from functioning the way it’s supposed to.

The core problem, of course, is that cancer treatment isn’t like a BMW that can go 150 miles per hour; we’re not willing to call it a luxury that most people can’t afford. Most people can’t afford to pay $60,000 for a health insurance policy. A world in which sick people are priced out of health care is not a world we want to live in. And that’s why markets are the wrong way to distribute essential health care (something I discuss at much greater length in Economism.)

We think all people should get decent care regardless of their income. That means we have to have a basic minimum available to everyone, and people shouldn’t have to pay more for it than they can afford. There’s a name for this system: single payer. We may need a long time to get there. But in the meantime, let’s stop pretending that markets can solve our problems, if only we could somehow make them function properly.

 

Fees Add Up

By James Kwak

Public pension funds are having a tough time. On the one hand, the average funding ratio (assets as a percentage of the present value of future obligations) is below 80% because of inadequate contributions by sponsors (states and municipalities) and poor investment returns since the collapse of the technology bubble in 2000. On the other hand, because pensions responded to low returns by shifting more of their money into hedge funds and private equity funds, a larger proportion of their assets is siphoned off as investment fees each year.

Unlike some people, I am not against hedge funds and private equity funds in principle. I think it’s highly likely that there are people who can beat the market on a sustained basis—particularly if they are people who are especially good with computers—both for theoretical reasons (someone has to be the first person to discover each relevant piece of information or actionable pattern) and empirical reasons (see Fama and French 2010, for example). Hedge funds have lagged the stock market in recent years, but what critics sometimes overlook is that they are supposed to trail the market in boom periods, because many target a beta of around 0.5. But I am mystified by the fact that, in what is supposed to be a highly competitive and innovative industry, the price of investing in a hedge fund has stayed virtually fixed at 2-and-20 (2% of assets, plus 20% of investment returns) for decades.

The consequences of these high prices are added up in The Big Squeeze, a new report sponsored by the American Federation of Teachers. Because true investment fees are usually not disclosed—fund managers insist that they are confidential and require investors not to divulge them—the report simply quantifies the potential savings from reducing fees from 1.8-and-18 to 0.9-and-9. This may seem arbitrary, but I know anecdotally that some funds, even big ones, are charging something like 1-and-10 even to ordinary investors. Since state pension funds are some of the biggest investors that exist, you would think they would be able to negotiate even lower fees.

Not surprisingly, the numbers involved add up quickly. Lower fees over the past five years would have saved the average pension fund included in the study $1.6 billion; to put things in perspective, it would have improved the aggregate funding ratio for these funds by more than two percentage points, which is nothing to sneeze at.

The important question is why high fees persist despite the potential market power of big pension funds. There are probably multiple explanations. One is a culture of secrecy, which makes it difficult for any fund to find out what other funds are paying. Another is the marketing prowess of fund managers, who are adept at explaining whey their fund is unlike any other in the world and therefore merits its high fees. A third is that pension fund managers are playing with other people’s money (in this case, the other people are the fund’s beneficiaries—teachers, firefighters, and other government employees)—and may be more interested in ingratiating themselves with the asset management industry than with getting the best deal they can. (This is even more likely the case for the investment consultants who match pension funds with asset managers.) But in a political climate that makes tax increases on rich fund managers unlikely, state governments could achieve the same results by taking a harder line on investment management fees: requiring public disclosure of all fees or even imposing hard fee caps for pension fund investments. With the amount of money involved, it’s hard to imagine that major pension funds couldn’t find anyone competent to take their money for 0.9-and-9.

Soak the Poor, Feed the Rich

By James Kwak

After the dangerous clown show that has been the Trump White House, it’s comforting to return to some good, old-fashioned conservative policymaking: bashing the poor to cut taxes on the rich. I’m talking, of course, about the Republican plan to repeal and replace Obamacare.

Health care financing can sometimes seem like a complicated topic. Adverse selection, risk adjustment, blah blah blah. But it’s easy to understand the American Health Care Act or, as it is sure to be known, Trumpcare. In the medium term, financing policies have little effect on the price of health care. At most we can hope to “bend the [long-term] cost curve.” So health care policy essentially comes down to a single question: Who pays?

Let’s start with the most fundamental element of the Republican plan, the one most near and dear to Paul Ryan’s heart, the principle that has kept the conservative coalition unified since 1994: cutting taxes on the rich. Trumpcare will eliminate virtually all of the taxes that Obamacare introduced to expand health care coverage, including the Medicare surcharges that only apply to high earners: 0.9% on earned income and 3.9% on investment income. That in itself is a 16% cut in taxes on investments for a class of people who make lots of money from investments. Health savings accounts will increase the tax breaks available to high-income families. The “Cadillac tax,” which would have affected people with generous health plans, will be pushed back until 2025 (in a transparent bid to improve the bill’s scoring for reconciliation purposes), with the expectation that it will be repealed at some point in the future.

With less revenue coming in to pay for health care, the federal government will pay for less health care. Trumpcare reduces government spending in two main ways. First, people who buy insurance in the exchanges will have to pay more, both in premiums and out of pocket. Obamacare’s income-based subsidies will be replaced by age-based tax credits. The net effect will be to increase the price of coverage for lower-income people and decrease it for higher-income people:

[image error]

(The chart is from the Kaiser Family Foundation and is based on slightly different numbers from the proposed bill, but the basic principles remain the same. The final bill does phase out tax credits beginning at $150,000 in family income.)

Because Trumpcare eliminates the individual mandate, more healthy people are likely to opt out of coverage. This will increase the average actuarial cost of people buying individual plans, which will push up premiums—a transfer from sick people to healthy people. Trumpcare also repeals the Obamacare limits on cost sharing (deductibles, copayments, etc.) for low-income families. So in addition to paying more to buy health insurance in the first place, poor people will have to pay more when they actually try to use their health insurance.

The second major way that Trumpcare pays for its tax cuts is by reducing federal spending on Medicaid. The plan reduces the amount the federal government pays for Medicaid expansion (a central component of Obamacare), which at best will simply shift costs to the state level, and at worst (and more likely) will cause more states to opt out of Medicaid expansion altogether. In addition, Trumpcare achieves the long-held conservative dream of converting Medicaid into a block grant program, which means that Republican state governments will be able to use the money in ways that are only tangentially related to providing health care for poor people. (Temporary Assistance for Needy Families block grant money, for example, is routinely used to support abstinence programs or premarital counseling services aimed at getting couples to marry.)

There are more details, but the basic outlines of the plan are simple: Cut taxes on the rich, cut spending on the poor, and expose more families to rising health care costs. The thing is, we’re talking about health care here. People will need the same amount of health care no matter what Congress does. If the government pays less for health care, poor people will have to pay more. If they can afford it, Trumpcare is effectively the same as a tax on the poor. If they can’t afford it, it’s even worse. This is as naked an example of class warfare as you’ll see today.

Review Copies of Economism

By James Kwak

If you teach introductory economics or introductory micro, at either the high school or university level, and you’re interested in possibly using Economism in your class, let me know and I’ll send you a (free) review copy. Just email me at james.kwak@uconn.edu from your school account and let me know your shipping address, and I’ll order a copy for you.*

Quick summary: The central theme of Economism is that some of the basic models taught in “Economics 101” have acquired disproportionate influence in contemporary society and are routinely and systematically misapplied to important policy questions. The problem is not that introductory models are wrong, but that too many people forget their limitations and believe that their simple conclusions can be reflexively applied to the real world. As Paul Samuelson said in the first edition of his textbook, the idea that “any interference with free competition by government was almost certain to be injurious … is all that some of our leading citizens remember, 30 years later, of their college course in economics.” In chapters on labor markets, taxes, trade, and other topics, Economism first walks through the implications of introductory models before explaining how a richer understanding of economic reality, including empirical research, teaches different and more interesting lessons.

If you worry that the typical first-year curriculum produces too many students who think unregulated markets are the answer to every problem, Economism may be the antidote you need. In the Financial Times, Martin Sandbu wrote, “Economics lecturers, take note: include [Economism] on your syllabus and set aside ample time to discuss its arguments in class.” The book has also received praise from many economists including Ian Ayres (Yale Law School), Jared Bernstein (former chief economic adviser to Vice President Joe Biden), Heather Boushey (chief economist, Washington Center for Equitable Growth), Simon Johnson (MIT Sloan; former chief economist, IMF; and my frequent co-author), Dani Rodrik (Harvard), and Noah Smith (Bloomberg View).

For more about the book, you can visit economism.net. The Atlantic also published an excerpt. (It’s basically the first half of the labor market chapter, on the minimum wage; the second half of that chapter deals with the compensation of very high earners.) And again, email me if you want a review copy.

Note: I’m not doing this for the money. I have donated all of my royalties from 13 Bankers, White House Burning, and Economism to charitable organizations. I can’t anticipate my financial situation for the rest of my life, but I will donate all royalties from Economism for at least the next five years.

* U.S. addresses only, please. I’m using the black magic of Amazon Prime to ship books, and that only works within the United States (and Puerto Rico).

Why Is Connecticut Giving Its Employees’ Money to the Asset Management Industry?

By James Kwak

In general, the State of Connecticut offers pretty good defined contribution retirement plans to its employees. Most importantly, it offers several low-cost index funds in institutional share classes. For example, you can invest in the Vanguard Institutional Index Fund Institutional Plus Shares, which tracks the S&P 500 for just 2 basis points, or the TIAA-CREF Small-Cap Blend Index Institutional Class, which tracks the Russell 2000 for just 7 basis points. Administrative fees are unbundled, and are only 5 basis points. For no good reason I can discern, however, you can also invest in actively managed stock funds like the JPMorgan Mid Cap Value Fund, which costs 80 basis points.

As I’ve previously said, I have mixed feelings about target date funds. In principle, they do the reallocation and rebalancing for you, so they could be appropriate for people who want to make one choice and then forget about their investments (which, in many ways, is a good strategy). The hitch is that a target date fund is only as good as the funds inside it. Fidelity, for example, puts twenty-five different funds inside one of its target date funds, including thirteen U.S. stock funds, eleven of which appear to be actively managed. This is just a clever way to sneak expensive active management back in through the back door.

The Connecticut retirement plans do have target date funds, but luckily they use Vanguard’s versions, which are made up of index funds and only charge 14–16 bp (as opposed to 77 bp for the Fidelity Freedom 2040 fund) … until now. As of February, the Connecticut defined contribution plans are switching away from Vanguard to something called “GoalMaker,” which takes your money and spreads it out among the various funds offered by the plan—including those expensive, actively managed funds. For example, if you say you have a moderate risk tolerance and want to retire in 2034, it puts your money in fourteen different funds—including six U.S. stock funds, three of which are actively managed.

This is just fake diversification. On one level, it may seem more prudent to have money in both the Vanguard S&P index fund and the Fidelity VIP Contrafund Portfolio (wow, “VIP,” that must be special!). But mutual funds are already diversified—particularly index funds. If you have some reason for thinking that the VIP Contrafund Portfolio will beat the index, then you might choose to invest in it—but, in fact, it’s trailed the S&P 500 over 1, 3, 5, and 10 years.

Most likely, the people who are currently invested in Vanguard target date funds will get shifted into GoalMaker portfolios. They will pay several times as much in fees for basically the same thing, except with a little additional risk due to managers’ attempts to beat the market. It’s hard to see how this makes anyone better off—except the asset managers themselves.

The Right to Have Rights

By James Kwak

There’s a story you hear often these days. The story is that America has too many lawsuits: too many lawyers, too many people filing frivolous suits, too many excessive damages awards by juries, and so on. This story is the reason for all the “litigation reform” in recent decades: the Private Securities Litigation Reform Act of 1995, Prison Litigation Reform Act of 1996, the state-level tort reform movement, Bell Atlantic v. Twombly, Ashcroft v. Iqbal, and so on.

There are two problems with this story. The first is that it isn’t true. Take medical malpractice, for example—a frequent target of tort reform advocates. Only a tiny fraction—probably under 2%—of people harmed by negligent medical care actually file suit. Of suits that are filed, according to an after-the-fact review by unaffiliated doctors, 63% involved errors by doctors, and another 17% showed some evidence of error. According to the most basic economic theory of torts, we want people harmed by negligence to sue, because otherwise potential defendants (doctors, companies, etc.) will not have sufficient incentive to make the efficient level of investments in preventing injuries. In short, it is highly likely that we suffer from not enough lawsuits, not from too many lawsuits.

The second problem is more important, however. That problem is that while the costs of litigation are real—not just money but also defensive medicine, intimidation of startups by patent trolls, intimidation of the media by billionaires—the exclusive focus on costs overlooks the crucial role of litigation in our democracy. That is the focus of the new book In Praise of Litigation by Alexandra Lahav, a colleague of mine at the University of Connecticut School of Law. (The book is also where I got the statistics in the previous paragraph.)

Most people probably think it’s good that we have laws. As Lahav points out, there are three ways those laws actually get enforced: administrative agency regulation (e.g., the Office of the Comptroller of the Currency telling Wells Fargo not to foreclose on homeowners without proper documentation); lawsuits by administrative agencies (e.g., the OCC or the Department of Justice suing Wells for foreclosing on homeowners without proper documentation); and, when authorized, lawsuits by private parties (e.g., a class action by homeowners against Wells for foreclosing on them without proper documentation). Now, I didn’t choose those examples at random. We know that the federal regulatory agencies didn’t stop illegal foreclosures; then, after belatedly threatened to sue, they settled with the big banks for with largely illusory penalties; and the settlements insulated the banks from private liability for fraudulent foreclosures. (For the definitive word on that whole topic, see Chain of Title by David Dayen.) If you are skeptical about the ability or inclination of the federal government to enforce the law, you should be particularly protective of the ability to file a lawsuit on your own.

This is even more true if you care about individual rights. If you think that your rights have been violated, you can sue to enforce them. This is particularly important if your rights have been violated by a state or by the federal government, because in that case it’s unlikely that a government agency is going to take your side. The right to sue is arguably the most fundamental right that exists, because it is the right to have rights in the first place. For example, the Sixth Amendment (as interpreted in Gideon v. Wainwright) says that you have the right to an attorney if you are charged with a felony. But many states and localities refuse to pay for lawyers for the poor; see Dylan Walsh in The Atlantic, or the story of Jack Bailey on This American Life, for example. So you have to sue. A series of lawsuits by the Southern Center for Human Rights led to the creation of the Georgia public defender system, and the Southern Center continues to challenge judicial circuits that fail to provide sufficient representation for poor defendants.

But the right to sue is slowly being limited, not just by “litigation reform” acts but particularly by Supreme Court decisions that made it harder for plaintiffs to challenge secret wrongdoing by companies (Bell Atlantic), enhanced government officials’ immunity from private lawsuits (Iqbal), enforced mandatory arbitration clauses in standard form contracts (AT&T Mobility v. Concepcion, American Express v. Italian Colors Restaurant), limited the jurisdictional reach of federal courts (J. McIntyre Mach. v. Nicastro), and prevented plaintiffs from obtaining injunctions against illegal government actions unless they could prove that they were likely to be harmed by those actions again in the future (City of Los Angeles v. Lyon). The common theme is increasing restrictions on the ability of ordinary people (or small businesses in some cases) to challenge illegal actions by large companies and governments. But no one ever said, “Your rights are being limited.” Instead, changes in legal procedure effectively increased the cost of enforcing those rights—in some cases to infinity.

The importance of lawsuits is something that conservatives have long understood. While conservatives are all in favor of restricting lawsuits against their investors (corporations, rich professionals other than lawyers)—which has the side benefit of taking money away from the trial lawyers, who tend to lean Democratic—litigation has been a central part of their strategy for decades. Think, for example, of the rewriting of the Second Amendment in District of Columbia v. Heller or the D.C. Circuit’s campaign against federal financial regulation (Business Roundtable v. SEC, MetLife v. FSOC).

In Praise of Litigation is only 149 pages (not including the copious notes that demonstrate Lahav’s command of the underlying material), and it’s simply written, because at the end of the day none of this is rocket science. We have three branches of government for a reason. The transformation of the judicial branch into a tool that is primarily accessible to the rich and the powerful is a serious problem in our democratic system of government. Sure, there are lawsuits that are only intended to harass people or extort settlements from companies that can’t afford millions of dollars in legal fees. But closing the door to the courthouse makes it harder both to enforce the law and to protect people’s rights.

Economism and Economics

By James Kwak

One point I try to be clear about in my new book is that economism—the assumption that simple Economics 101 models accurately describe the real world—is not the same as economics. There are people who think that all of economics, or at least all of modern, mathematically inclined, “neoclassical” economics, is at fault for the growth of neoliberal capitalism and the increase in inequality in rich countries. I am not one of them.

In my mind, the problem is knowing just a little bit of economics—the proverbial little bit of knowledge. (My favorite form of that proverb, despite its religious origins, is the following: “A little knowledge is apt to puff up, and make men giddy, but a greater share of it will set them right, and bring them to low and humble thoughts of themselves.”) When you learn more economics, you learn that the world has more than just supply, demand, price, and quantity.

Matt Yglesias has even tried to argue that “on a whole lot of issues the basic econ 101 view supports the liberal position.” I think he’s exaggerating his point—on a whole lot of issues, Economics 101 tells you that market failures are possible, but that doesn’t necessarily dictate a liberal policy outcome. But whatever is actually in an introductory textbook, the problem is that what people think they remember—or what people who never took economics think the subject teaches—is that competitive markets produce optimal outcomes. As Paul Samuelson wrote in the first edition of his textbook (and I never tire of quoting), the idea that “any interference with free competition by government was almost certain to be injurious … is all that some of our leading citizens remember, 30 years later, of their college course in economics.”

The historical development of economism, and its divergence from economics, is the subject of chapter 3 of my book, and also of my new article in the Chronicle Review. The article also includes some of my thoughts on how the teaching of economics might be modified to give students a richer and more balanced understanding of the discipline. For more, head on over there.

Economism and the Law

By James Kwak

Economism—the simplistic, unreflecting application of Economics 101 models to complex, real-world issues—is particularly influential in the law, including both legal academia and actual court opinions that decide important questions.

The "economism" that @jamesykwak talks about is at its worst in the legal profession: https://t.co/84oUoNl49r

— Noah Smith (@Noahpinion) January 17, 2017

Noah Smith, for example, points to a paper by a law professor arguing that forced prison labor deters crime because it effectively raises the price of crime in a supply-and-demand model. The problem with this model is that it doesn’t accurately describe criminal behavior. Smith quotes economist Alex Tabarrok on what happened when the United States dramatically increased the harshness of punishments:

In theory, this should have reduced crime, reduced the costs of crime control and led to fewer people in prison. In practice … the experiment with greater punishment led to more spending on crime control and many more people in prison.

I discuss economism and the law briefly in the historical chapter of my book, but the basic story is simple. Beginning in the 1960s, the law and economics movement, most closely associated with Richard Posner, re-conceptualized various areas of the law in economic terms. To simplify greatly, the central idea was that the law should be designed to promote economically efficient outcomes; for example, a product manufacturer should only be liable for failing to include some safety feature if the cost of that feature was exceeded by its expected benefits in the form of reduced injuries. Law and economics was and remains a valuable way to think about the law. At the time, however, few law professors knew very much about economics, and so there was an explosion of theoretical papers that assumed the accuracy of basic rational-actor models more or less swallowed whole from Economics 101. (The law and economics movement was also enthusiastically backed by conservative foundations, most notably the Olin Foundation, who saw in it a way to reorient the judiciary toward business-friendly, free-market principles.)

My go-to example of economism in the law is Frank Easterbrook’s opinion in Jones v. Harris Associates, 527 F.3d 627 (7th Cir. 2008). One of the issues was whether it is possible for mutual fund fees to be excessive. Easterbrook thought not, because those fees are set by a competitive market. Among other things, he wrote:

It won’t do to reply that most investors are unsophisticated and don’t compare prices. The sophisticated investors who do shop create a competitive pressure that protects the rest. See Alan Schwartz [and] Louis Wilde, Imperfect Information in Markets for Contract Terms, 69 Va. L.Rev. 1387 (1983).

Now, I’ve looked at the article by Schwartz and Wilde: It’s about contract terms in general, its primary examples are warranties and security interests (not mutual funds), and it is entirely theoretical. By 2008, of course, the world had learned a lot more about how consumers make decisions—and it isn’t the way you would expect based on Economics 101. But Easterbrook had no need for reality, since the model sufficed to make his point.

I just read Richard Posner’s book Divergent Paths (the one in which he cites one of my anti- Bluebook rants), and he has another good example (beginning on page 192). It’s Edwards v. District of Columbia 755 F.3d 996 (D.C. Cir. 2014), a case in which a company that gives tours of Washington, DC challenged a city regulation requiring tour guides to pass a test of their knowledge of the city. The court overturned the regulation because the city did not provide evidence that “market forces are an inadequate defense to seedy, slothful tour guides”; in Posner’s words, “The opinion rejects the legitimacy of government regulation in any situation in which the market can in principle do an adequate job of regulation, whatever the reality” (emphasis added).

Posner fills in several reasons why markets will not protect tourists from being ripped off by tour guides, which really anyone could think of: tourists will not necessarily know they are being misled, Internet rating websites (on which the court relied) do not adequately police services aimed at tourists, and so on. And as an aside, can you guess what constitutional protection this regulation violated? That’s right: the First Amendment right to freedom of speech. As Posner points out, a person who fails the tour guide test is in the same situation as “an applicant for a teaching job who having flunked her licensing test cannot exercise her right of free speech at the front of a Washington schoolroom.”

In short, the D.C. Circuit invokes the magic tool of free markets without pausing to consider whether it can actually do the job it needs to do in this context. This is not economics; this is ideology. (Posner: “There is no plausible nonideological explanation for the decision.”) That’s what economism looks like in action.

 

 

Economism and Health Care

By James Kwak

A core feature of competitive markets, according to the basic model, is that they allocate goods to the people or companies that are willing to pay the most for them. In theory, and in many situations, this is a good thing: If I am willing to pay $1,000 for a custom portrait of my (daughter’s) dog, and you are only willing to pay $1 for it, then aggregate satisfaction is likely to be higher if I get the portrait. But not always: If I am willing to pay $10 for a turkey sandwich, but you are only willing to pay $1 because you only have $1, and have no borrowing capacity, then society may very well be better off if you get the sandwich. Yet in an ordinary, healthy market, I get the sandwich.

This problem is acutely apparent when it comes to health care. People place a high value on not dying, but when it comes to the allocation of medical treatment, they can’t bid more than their income allows. The obvious result is that markets deliver unnecessary procedures to rich people while denying essential care to poor people—because that’s what markets do. Obamacare attempted (with mixed success) to mitigate this problem. The Trump administration is rhetorically committed to deregulating health insurance; the question is whether they are willing to accept the political consequences of pricing millions of people out of not dying.

This is the topic of my new guest post, “Health Care and John D. Rockefeller’s Dog,” on Econbrowser (a fabulous economics blog, by the way, written by Menzie Chinn and James Hamilton). For more, head on over there.