Simon Johnson's Blog, page 49

Are They Really That Good?

By James Kwak

The instinctive defense from Wall Street bankers is that they deserve the money they make: they're just that good. By that logic, Jon Corzine was the best of the best: he was the head of Goldman, after all (although in his days, if I recall correctly, Goldman and Morgan Stanley were roughly tied in prestige). The failure of MF Global may have had many causes, but it does make one wonder: Are the people at Goldman really that good individually, or is it the firm (and its reputation, and its information flow) that makes them so good?

Andrew Ross Sorkin speculates that MF Global got Goldman-style risk-taking without Goldman-style compliance and risk management. I would just add: they also got it without a Goldman-style too-big-to-fail government guarantee.

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What's Wrong with Groupon?

By James Kwak

Groupon plans to go public later this week. According to the latest leaks, things are going well: the IPO valuation, scaled back from $30 billion to about $12 billion, may be raised because of a successful road show. Apparently even after the company conceded that the amount they pay to a merchant does not count as revenue, investors have decided they like what they see.

But there is still something fishy about Groupon's business model.

The company's basic story goes like this: We have been losing money (more than $300 million so far this year) because we are investing in building our customer base. In essence, we are paying for customers. But once we have a customer, we can harvest a long-term revenue stream from her, and the value of that revenue stream is greater than the amount we pay to acquire her in the first place. In an effort to show that this model eventually results in profitability, the company severely cut back on marketing expenses in the third quarter. That's how its operating loss fell by $101 million while revenues only increased by $38 million. (See the quarterly results, p. 60.)

This is the most compelling evidence that their business model will work (p. 81):

"The Q2 2010 cohort is illustrative of trends we have seen among our North American subscriber base. The Q2 2010 cohort included 3.7 million subscribers that we initially spent $18.0 million in online marketing to acquire in the second quarter of 2010. In that quarter, we generated $12.8 million in revenue from the sale of approximately 1.2 million Groupons to these subscribers. Through September 30, 2011, we generated an aggregate of $92.8 million in revenue from the sale of approximately 9.4 million Groupons to the Q2 2010 cohort. In summary, we spent $18.0 million in online marketing expense to acquire subscribers in the Q2 2010 cohort and generated $92.8 million in revenue from this group of subscribers over six quarters."

In other words, they spent $5 to get each subscriber, and have since earned $25 in revenue from that subscriber. Sounds good.

But there are still a couple of problems with this story. First, out of every dollar in revenue, Groupon incurs 64 cents in non-marketing costs (cost of revenue and SGA). So from that $25 in revenue you have to subtract not only $5 in marketing costs, but another $16 in other costs, leaving only $4 in profit (plus 36 percent of any future sales to those subscribers).

Second, Groupon's long-term profitability depends on its ability to harvest revenue from existing customers. The problem is that, on average, sales to a given customer will follow a decay function. In the quarter in which you become a customer, by definition, you will buy at least one Groupon and quite possibly more. For example, Groupon entered Boston in Q2 2009 and sold 26,032 Groupons to 8,545 customers, or 3 per customer. On average, that number will fall over time as people lose interest, unsubscribe, switch to competitors, etc. The big question is how fast and how far it will fall.

I don't have enough data points (and Groupon hasn't been around long enough) to estimate that function. But I can do a quick-and-dirty estimate of sales to old customers by making an assumption about how many Groupons the typical new customer buys. This chart shows how many Groupons were bought by the average old customer in Boston, with different assumptions about how many were bought by the average new customer.

What you end up with is a number that is below 0.8 and falling. This means that when Groupon has saturated Boston (and it's pretty close, with more than a million subscribers and almost 400,000 people who have bought at some point in the past) it can expect to bring in about 0.8 sales per quarter from its customer base. That's not bad: with the current customer base, that would mean 360,000 Groupons per quarter. But what's worrying is that that number has been falling for more than a year, meaning that the productivity of the existing customer base is decreasing. How far that will fall is anyone's guess. That fall could be part of the decay function, in which case it will level off as the business matures. Or it could be something else, which might not level off.

Another big question mark is that Groupon's business model depends on its ability to make money off existing customers without spending a lot on marketing. In theory, this makes sense, since email is cheap. But is it true?

We know that Groupon slashed its marketing expenses in Q3 in order to pretty up its financials. That should have had no impact on its existing customers, if you believe the company's line. ("Once acquired, subscribers have been relatively inexpensive to maintain because our interaction is largely limited to daily emails and our mobile applications," p. 80.) But in both Chicago and Boston (the two North American cities that Groupon breaks out numbers for), the total number of Groupon sales fell—by 11 percent and 5 percent, respectively. Since Groupon added new subscribers and customers in both cities (though not as many as in previous quarters), that means that sales to the existing customer base did particularly badly. This implies that sales to the current customer base are affected by marketing spending. So we really don't know how Groupon will do without a continuing blizzard of marketing spending. The only data point we have to go by is Q3—when the company was getting plenty of free publicity because of the run-up to the IPO—and that isn't encouraging.

Then there's the fact that revenues as a share of billings (that is, the share of what customers pay that they keep) have been falling steadily, which could be an indication of increasing price competition.

Now I can't prove that Groupon won't be profitable in the long run. It's quite possible that as they saturate markets, they can find a level of marketing that generates enough sales to old customers (since there won't be many new ones) to cover their expenses, and that they'll be able to keep prices high enough despite competition. In fact, my guess is that they probably can. But there's nothing in the S-1 that proves that that is likely, either, because we can't see the numbers that matter.

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Mr. Hoenig Goes to Washington

By Simon Johnson

To fix a broken financial system – and to oversee its proper functioning in the future – you need experts.  Finance is complex and the people in charge need to know what they are doing.  One common problem, which is also manifest in the United States today, is that many of the leading experts still believe in some version of business-as-usual.

At the height of the Great Depression, Marriner S. Eccles was summoned to Washington from Utah – where he was a regional banker.  He helped remodel the Federal Reserve through the Banking Act of 1935 and then became its first independent chairman – the Fed board had previously been chaired by the Treasury Secretary.  Eccles was not a fan of big Wall Street firms and their speculative stock market operations; rather he understood and identified with smaller banks that lent to real businesses.  Eccles was the right kind of expert for the moment.  Who has the expertise to play this kind of role in our immediate future?

Tom Hoenig, formerly president of the Kansas City Fed, has long been a strong voice for financial sector reform along sensible lines.  Within the official sector, he has spoken loudest and clearest on the most important defining issue: Too Big To Fail is simply too big.  And last week he took a major step towards a more prominent role, when he was announced as the administration's nominee to become vice-chair at the Federal Deposit Insurance Corporation (FDIC).

The FDIC is not as powerful as the Fed.  But in our current financial arrangements, it does have a critical role to play.  The Dodd-Frank legislation has its weaknesses, but it gives the FDIC two important powers.  First, with regard to big banks, the FDIC can help force the creation of credible "living wills" – explaining how the bank can be wound-down if necessary.  If such wills are not plausible then, in principle, the FDIC could force simplification or divestiture of some activities.  Second, the FDIC is now in charge of "resolution" for megabanks, i.e., actually closing them down and apportioning losses in the event of failure.

One important concern is whether the FDIC has enough clarity of thought and – most critically – enough political support in order to take the preemptive actions needed to make our biggest banks smaller and safer.  (For more specific suggestions – and some disagreement – on what exactly is required to strengthen financial stability, you can watch two speeches from Friday at a George Washington law school symposium; Sheila Bair, the former FDIC chair, spoke first and I spoke immediately after; my remarks start around the 49 minute mark).

The FDIC senior team is already strong, with a great deal of experience handling the problems of small and mid-size banks.  The current acting chairman, Martin J. Gruenberg, was vice chair under Sheila Bair.  These are not people who are easily intimidated by big banks.  And Mr. Gruenberg is highly regarded on Capitol Hill, where he worked on the Senate Banking Committee for nearly two decades. (Disclosure, I'm on the FDIC's Systemic Resolution Advisory Committee, which meets in public; I'm not involved in any personnel or policy decisions.)

I have been a strong supporter of Mr. Hoenig in recent years, endorsing his views and arguing in the past that he should become Treasury Secretary.

In the current mix of Washington-based policymakers, Mr. Hoenig would be a great addition.  He spoke out early and often against Too Big To Fail banks.  In early 2009 His paper "Too Big Has Failed" became an instant classic.  It is worth reading again because it contains a number of forward-looking statements that remain important today.  Perhaps the most relevant for his FDIC role,

"[S]ome are now claiming that public authorities do not have the expertise and capacity to take over and run a "too big to fail" institution. They contend that such takeovers would destroy a firm's inherent value, give talented employees a reason to leave, cause further financial panic and require many years for the restructuring process. We should ask, though, why would anyone assume we are better off leaving an institution under the control of failing managers, dealing with the large volume of "toxic" assets they created and coping with a raft of politically imposed controls that would be placed on their operations?"

This sounds very much like the basis for a sensible strategy of thinking about Bank of America, which is in serious trouble – and where the FDIC should consider a more pro-active intervention.

The European debt situation is also threatening to spiral out of control, with potentially serious consequences for our financial sector.  If you have not yet reviewed the details of Bill Marsh's graphic from Sunday's New York Times, I strongly recommend that you do so – but you'll need a big computer screen or the ability to print out on a very large piece of paper (The picture is literally big, 18×21 inches; there is also a nice interactive version, which lets you look at various scenarios).

We do not know how these or other shocks will hit our financial system.  Nor do we know exactly who will fall into what kind of trouble.

We need experts at the helm with sensible judgment and the right priorities – and with a good understanding of what kind of financial system we really need.  We also need policymakers who have strong support from across the political spectrum, including on Capitol Hill.

Tom Hoenig is exactly the right person for the moment.

An edited version of this post appeared this morning on the NYT's Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

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European Debt: The Big Picture

By Simon Johnson

For everyone struggling to get their arms around the debt crisis in Europe, Bill Marsh in today's New York Times offers literally a compelling picture, with graphic illustration for the key issues.

The picture is big, 18×21 inches. Either you need a very large computer screen or a hard copy of the paper (pp. 6-7 in the SundayReview section, "It's All Connected: A Spectator's Guide to the Euro Crisis).

The main debt linkages across borders for which we have data are all here – and the graphic pulls your eye appropriately to the centrality of Italy in whatever happens next.  (On why eurozone policy towards Italy now matters so much – and what are the options – see my recent paper with Peter Boone, "Europe on the Brink".)

But you might think also about what is not in the NYT graphic because we lack reliable information.  For example, what is the exposure of US financial institutions to European debt, directly or indirectly, through derivatives transactions of any kind?

The opaqueness of derivative markets means that most investors can only guess at what could happen.  Most of the relevant regulators and supervisors with whom I have talked seem also to be largely in the dark – remember the experience of AIG in 2008.

Cross-border bank exposures through loans and other holdings are publicly disclosed – data from the Bank for International Settlements are represented by the arrows in the NYT graphic.  These data are surely not perfect, but they do convey the main points and they tell you where to focus attention.

Why do we not require publication of similar data, preferably by financial institution, for all derivative transactions – including both gross and supposedly net exposures across borders?

The Bush Tax Cuts and the 99 Percent

By James Kwak

I forgot to alert you to my latest Atlantic column, which went up on Monday. To my mind, Occupy Wall Street is a protest movement, and a valuable one, and the often-stated criticism that they should have concrete demands is kind of silly. (See Frank Pasquale's response, point 5.) I have spent a fair amount of time reading the 99 Percent tumblr, however, and I think the kind of policies that would help the people who describe themselves there are pretty obvious. This is Mike Konczal's summary:

"Upon reflection, it is very obvious where the problems are.  There's no universal health care to handle the randomness of poor health.  There's no free higher education to allow people to develop their skills outside the logic and relations of indentured servitude. Our bankruptcy code has been rewritten by the top 1% when instead, it needs to be a defense against their need to shove inequality-driven debt at populations. And finally, there's no basic income guaranteed to each citizen to keep poverty and poor circumstances at bay."

But in my opinion, the preliminary step to getting rich (and reasonably comfortable) people to pay for a better social safety net is to let the Bush tax cuts expire, as I argue in the column. Most importantly, it's the only inequality-reducing policy I can think of that has any chance of happening in the next year—simply because it only requires doing nothing. How much would it reduce inequality? That's just the reverse of what the tax cuts did in the first place. (If you can't read the table, click on it for a larger version.)

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Jon Huntsman: Too Big To Fail Is Too Big

By Simon Johnson

The idea that big banks damage the broader economy has considerable resonance on the intellectual right.  Tom Hoenig, recently retired president of the Kansas City Fed, has been our clearest official voice on this topic.  And Gene Fama, father of the efficient markets view of finance, said on CNBC last year, that having banks that are too big to fail is "perverting activities and incentives" in financial markets – giving big financial firms, "a license to increase risk; where the taxpayers will bear the downside and firms will bear the upside."

The mainstream political right, however, has been reluctant to take on the issue. This changed on Wednesday, with a very clear statement by Jon Huntsman in the Wall Street Journal on regulatory capture and its consequences.  Before the 2008 financial crisis: "The largest banks were pushing hard to take more risk at taxpayers' expense."  And now,

"More than three years after the crisis and the accompanying bailouts, the six largest American financial institutions are significantly bigger than they were before the crisis, having been encouraged to snap up Bear Stearns and other competitors at bargain prices. These banks now have assets worth over 66% of gross domestic product—at least $9.4 trillion, up from 20% of GDP in the 1990s. There is no evidence that institutions of this size add sufficient value to offset the systemic risk they pose."

This message could work politically, for five reasons.

First, for anyone on the right of the political spectrum who thinks at all about the issues, this is a coherent and appealing position.  Fama had it exactly right when he said, in the same interview:  "[Too Big To Fail] is not capitalism. Capitalism says – you perform poorly, you fail."

"Too big to fail" is not a market; it's a government subsidy scheme – of the most inefficient and dangerous kind.

This is exactly Huntsman's theme: "Hedge funds and private equity funds go out of business all the time when they make big mistakes, to the notice of few, because they are not too big to fail. There is no reason why banks cannot live with the same reality."

Second, senior serious figures within the Republican Party have long been pointing in this direction.  In 2009, for example, Nicholas Brady said: "First we should just come out and say it: the financial system that led us to the brink of disaster is broken."  George P. Schultz has emphasized that we should "Make Failure Tolerable", for example, "an escalating schedule could be required of necessary capital ratios geared to size and matched with escalating limits on leverage."

Republicans like to discuss who is and is not a true Republican.  How can any "true" Republican really condone the subsidies that underpin our biggest financial firms today?

Third, mainstream financial thinking is in exactly the same place, in terms of arguing that capital requirements for big banks should be much higher.  On this issue I refer you, as always, to the work of Anat Admati and her colleagues at Stanford University.

Huntsman's position is in alignment with the strongest possible technical thinking, but he has also found a direct and easy to communicate the right political message.  Higher capital requirements for big banks are a great idea – this should help prevent financial disaster.  But when such disaster occurs, we need financial institutions that can actually fail – with losses to creditors – without bringing down the entire system.  Anything that is Too Big to Fail is simply just too big.

Fourth, political Republicans who favor the status quo with regard to megabanks are going to have hard time justifying that position – including in a confrontational debate format.  In particular, Mitt Romney is very vulnerable on this issue – particularly as he has already lined up so much support from among biggest banks.

Presumably the prospect of Wall Street donations is enough to deter some Republicans (and many Democrats) from really confronting the issue of Too Big To Fail.  But if Romney is already far ahead is this fund raising category, there is much less to lose.  And his donations must make it harder for him to explain exactly how he would ensure that even one mega-bank could fail.

It's not enough to just wish that big banks could fail – or to promise not to support them "next time."  This is not a credible commitment – and the "resolution authority" created under the Dodd-Frank reform legislation is a complete paper tiger with regard to winding down the biggest banks.  If the choice is global economic calamity or unsavory bailout, which would you choose – let alone any Republican president?

Huntsman has joined the dots.  There are various ways to directly address and remove the implicit subsidies that the largest banks receive – bloated size and excessive leverage can be effectively taxed.

"Eliminating subsidies would encourage the affected institutions to downsize by selling off certain operations or face having to pay the real costs of bailouts. We need banks that are small and simple enough to fail, not financial public utilities".

Fifth, the eurozone is on the verge of calamity in large part because they built very large banks with huge implicit subsidies – and this facilitated an irresponsible accumulation of public sector debt.

During the Dodd-Frank financial reform debate last year, we heard repeatedly from people – including senators on both sides of the aisle – who believed that reducing the size of our largest banks would somehow put the rest of our private sector at a disadvantage.

Who now would like to emulate in any way the disaster that the Europeans have brought upon themselves?  Seriously, Mr. Romney, please explain how you would prevent our largest banks from becoming ever larger and taking on more risk – and supporting the reckless build-up of debt throughout the global economy?

An edited version of this post appeared this morning on the NYT.com's Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

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More Bathtubs

By James Kwak

Last week I criticized David Brooks for not understanding the difference between stocks and flows (that is, between your paycheck and your bank balance). (Paul Krugman instead criticized the Tax Foundation, the source for Brooks's error—I wonder why?)

It turns out that a lot of people make this kind of mistake. Difficulty understanding stocks and flows may be a fundamental cognitive error such as anchoring or availability bias. In one experiment by Matthew Cronin, Cleotilde Gonzalez, and John Sterman, more than half of a group of students at MIT Sloan—one of the top business schools in the country—could not figure out, from a chart of entrances to and exits from a department store, when the most and fewest people were in the store. These errors turn out to be robust to different framing stories, different ways of presenting the data, and even when getting the questions wrong meant you had to stay in the room for an hour.

The underlying issue seems what they call the correlation heuristic: people think that the behavior of a stock (the amount of water in the tub) should be similar to the behavior of its inputs (the rate at which water pours from the faucet). This is especially a problem when it comes to understanding climate change. In another experiment, most people thought that stabilizing emissions was sufficient to stabilize the level of carbon dioxide in the atmosphere; if you think about it, though, you should realize that if you want the level to be stable, inflows have to equal outflows (and right now inflows are about double outflows).

This fallacy may be one thing that leads people to adopt a wait-and-see approach to climate change. On a correlation heuristic-influenced view, we should wait until bad things start happening in year X and then reduce emissions (because reducing emissions will reduce the level of greenhouse gases in the atmosphere). But if we want to stabilize greenhouse gas concentrations at the year X level, we would have to immediately reduce emissions to the rate at which they are absorbed by plants and oceans—which right now would require a 50 percent reduction in emissions. (And this leaves aside the fact that climate change itself lags behind greenhouse gas concentrations, so keeping concentrations stable will not prevent climate change from continuing.)

The national debt situation is complicated (and helped) by the fact that (according to most people) what matters is debt as a percentage of GDP, not in nominal terms. So spending is the inflow, but there are two outflows: tax revenues and economic growth. (Or, to put it another way, the bathtub is constantly getting bigger.)

Still, I don't think this gets David Brooks off the hook. Thinking that the impact of a tax increase on the national debt will equal one year's incremental tax revenues goes well beyond the correlation heuristic. That's more like thinking that a salary increase and a bonus are the same thing, or confusing the speed and the range of a car.

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The More You Pay, the Less You Get

By James Kwak

Schumpeter at The Economist pointed me to a paper by Richard Cazier and John McInnis on one of my favorite topics: CEO hiring. Cazier and McInnis first confirm, not surprisingly, that pay for new, externally-hired CEOs is positively related to the past performance of their previous firms. In particular, they measure EXCESS_COMP as the difference between actual first-year compensation and the compensation that you would predict just based on the characteristics of the hiring firm; EXCESS_COMP turns out to be positively associated with the CEOs' prior firms' stock returns. That makes sense, since you would think that people from successful companies would be able to command a higher price than people from less successful companies, and it isn't obviously controversial, since you would think they would deserve it.

But what do the new firms get for this pay premium? It turns out that their future performance, measured in terms of return on assets and operating return on assets, is negatively associated with excess compensation based on prior performance.* In other words, people from successful companies don't deserve the pay premium because the higher the premium they are able to command, the less well they are likely to do.

This should not be too surprising. The more of a superstar someone is at Company A, the more likely the board of Company B is to overlook all the things that make her a bad fit for Company B—like not having experience in the industry, or with the new company's customer base, or having led Company A through a different phase of its lifecycle than Company B, or not having the skills that Company B needs at that point in time, or any number of other things. The more reasons for concern that Board B overlooks, the more likely the new hire is to do badly. In the end, you get something vaguely like the Peter Principle: the more successful Company A is, the more market power its CEO has, and the more likely she is to be overpaid to be CEO of a company she is not qualified to lead.

Last month I used Steve Jobs's resignation as an opportunity to talk about the difference between founder and non-founder CEOs. Since then, Jobs's death has led to reverential eulogies throughout the media and widespread celebration of Jobs as the greatest CEO of our time. Yet I would be surprised if Jobs ever thought of himself as a master of generic "management," whose greatest skills were identifying and nurturing talent, bringing out the best in people, motivating employees, delegating wisely, and all the other blather associated with management-speak. He may have been good at some of those things (and famously bad at some others), but that's not what made him great.

According to Cazier and McInnis, the argument in favor of external CEO hiring is that "society has accumulated an expansive body of knowledge regarding management disciplines which, if mastered by a CEO, enable him to effectively manage nearly any modern corporation." Jobs did lead three different companies, but the idea that his success was due to abstract management ability—as opposed to, say, his vision for the iPod—seems ludicrous. Yet companies look less for people like Jobs than for people like, well, John Sculley. Or Meg Whitman, who turned a successful run managing a consumer-to-consumer Internet startup and a catastrophic campaign for California governor into a job as CEO of Hewlett-Packard.

* Cazier and McInnis use fitted excess compensation—the amount predicted by the CEOs' prior firms' past performance—rather than actual excess compensation as their explanatory variable. This troubles me slightly, but I can't figure out which is more appropriate theoretically. At the very least, their specification does capture the extent to which hiring boards are swayed by the impressiveness of prior performance.

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A Dangerous Idea In The Deficit-Reduction Supercommittee

By Simon Johnson

Can tax cuts "pay for themselves" – inducing so much additional economic growth that government revenue actually increases, rather than decreases? The evidence clearly says no.

Nevertheless, a version of this idea, under the guise of "dynamic scoring," has apparently surfaced in the supercommittee charged with deficit reduction – the joint congressional committee with 12 members. Dynamic scoring sounds technical or perhaps even scientific, but here the argument means simply that any pro-growth effect of tax cuts should be stressed when assessing potential policy changes (e.g., reforming the tax code). For anyone seriously concerned with fiscal responsibility, this is a dangerous notion.

Economists disagree about almost everything, of course, and the effect of tax cuts is no exception. One reasonable way to assess the evidence is to begin with the highest plausible effects, then see what happens if some of the more extreme assumptions are relaxed (this is a nice way of saying that we don't believe everything the authors are trying to tell us).

I would start with a study by Gregory Mankiw, former chair of George W. Bush's Council of Economic Advisers – and therefore presumably on the tax-cutting side of American politics – and Matthew Weinzierl that shows the economic growth caused by a tax cut can at best offset a portion of the revenues lost by that tax cut.  (Unfortunately, you need a subscription to the journal to read the study.)

Specifically, Profs. Mankiw and Weinzierl calculated that 32.4 percent of the "static" or direct revenue loss of a capital gains tax cut and 14.7 percent of the static revenue loss of a labor tax cut could be offset in present-value terms by additional growth, ignoring short-term Keynesian effects (i.e., any immediate stimulus provided to the economy).

Now 32.4 percent is a lot, but it is far less than 100 percent. And a critical assumption for Profs. Mankiw and Weinzierl is that government spending falls to keep the budget in balance.  In their framework that's a good thing – as they are effectively assuming away any productive effects of government spending (e.g., what if less spending on schools means less education and this hurts "human capital" and therefore productivity down the road?)

Sticking for a moment with just with their view of the world, if instead the tax cuts are financed by additional debt – as was our collective experience during the 2000s – the ultimate effect of those cuts can be to lower economic growth in the long term, depending on whether the larger debt eventually leads to lower government transfers, lower government consumption, higher taxes on capital or higher taxes on labor. (See Eric M. Leeper and Shu-Chun Susan Yang, "Dynamic Scoring: Alternative Financing Schemes," Journal of Public Economics 92 (2008): 159-82, pp. 166-69.  Again, a subscription is needed to read the article.)

More broadly, in 2005 the Congressional Budget Office – then headed by a Republican appointee, Douglas Holtz-Eakin – estimated that the economic effects of a 10 percent cut in income taxes would offset between 1 and 22 percent of the revenue loss in the first five years; in the following five years, the economic effects might offset up to 32 percent of the revenue loss — but might also add 5 percent to the revenue loss.

This is an entirely reasonable assessment – the C.B.O. exists in order to provide balanced analysis for the budget process. The bottom line is that betting that tax cuts will pay for themselves is a high-risk strategy – and not a good idea at our current levels of government debt relative to gross domestic product. We do not have a large margin for error.  (Disclosure: I'm on the Panel of Economic Advisers for the C.B.O, but I didn't have anything to do with that study).

Of course, economic studies do not necessarily have a direct effect on political discourse. For example, President George W. Bush asserted in 2007, "It is also a fact that our tax cuts have fueled robust economic growth and record revenues." But this is nothing more than an assertion. Growth during the 2001-7 expansion was only 2.7 percent compared, for example, with 3.7 percent during the 1990s expansion (when tax rates were higher).

And much of the growth during the Bush period turned out to be illusory; it was based on our corporate and national accounting system, which measures profits (an important part of G.D.P.) but not on a risk-adjusted basis. When the risks materialized in the financial crisis of 2008-9, we lost so much output that G.D.P. per capita in real terms today is only at about the level of 2005.

To assess growth properly, you should look "over the cycle," meaning roughly 10 years for the modern American economy. It is hard to argue that the last decade was any kind of growth success. Of course, other things happened during the 2000s – including further financial sector deregulation not directly related to the tax cuts.

That's why we have the economic analysis, particularly by the C.B.O. – to disentangle what tax cuts can really do. If the supercommittee buys into dynamic scoring for tax cuts, at best this would be wishful thinking. At worst, it would represent yet another round of fiscal irresponsibility at the top of American politics.

And if anyone is seriously considering altering the rules under which the CBO operates, they should stop and think again.  Changing the scorekeeping guidelines at this stage would amount to undermining the credibility of the Congressional Budget Office – one of the few remaining impartial and well-informed observers.  Perhaps this strategy might yield some short-term political gains but the damage to our creditworthiness would be immense, and the consequences would be felt sooner rather than later.

The nightmare downward spiral and fiscal implosion in the eurozone began with a few countries cheating on their numbers – first to get into the currency union and then to avoid various forms of official criticism.  Do not start down the same path.

An edited version of this post appeared on the NYT.com's Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

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The Smugness of Unintended Consequences

By James Kwak

After my post on Corey Robin's new book, a friend recommended Albert O. Hirschman's Rhetoric of Reaction. As the title suggests, the book is about the rhetorical style of conservative thought dating back to Burke. Hirschman identifies three common tropes: perversity (that great-sounding progressive idea you have will have the opposite of its intended effect), futility (that great-sounding progressive idea won't change anything, because you don't understand the fundamental laws of the world), and jeopardy (that great-sounding progressive idea will destroy some other thing that we all agree is valuable, making everyone worse off in the end). Hirschman doesn't dwell on this specific point, but it's obvious that, similar to the argument Robin makes, these rhetorical devices can only exist in opposition to some progressive reform movement.

I thought the description of the contemporary form of the perversity thesis (e.g., welfare programs create poverty) was especially good. "Here the failure of foresight of ordinary human actors is well-nigh total as their actions are shown to produce precisely the opposite of what was intended; the social scientists analyzing the perverse effect, on the other hand, experience a great feeling of superiority—and revel in it" (Belknap Press, 1991, p. 36). This seems to me an accurate description of why the Economics 101 ideology is so powerful. People get a sense of superiority from owning counter-intuitive theoretical insights—even if those insights are wrong.

For example, Economics 101 was all over the health care reform debate, arguing that if we make people pay more for their marginal health care, they will consume less and our cost problem will be solved. But it doesn't work that way in real life. Atul Gawande wrote an article describing how higher co-pays reduced spending for most employees, but increased it significantly for the most expensive employees. The solution, according to the people profiled in his article, is to give the highest-consuming people more primary health care, which reduces the amount of catastrophic care they need.

Then there's Frank Easterbrook, the king of Economics 101, asserting in Jones v. Harris Associates that there's no way that people can be paying excessive mutual fund fees because market prices are set by sophisticated investors (and citing a purely theoretical law review article).

But as a cocktail party debating point, nothing beats "If you make people pay more to see the doctor, they'll see the doctor less"—which is even better when backed up by a pair of supply and demand curves on a napkin.

This isn't a criticism of economics in general. As I've noted before, people with Ph.D.'s in economics tend to be less doctrinaire about Economics 101 principles than undergraduate economics majors. It's a criticism of how facile economic logic gets used in public debate.

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