Category: Economics & Business

On the role of regulation in a free-market economy

Andrew Lo, professor MIT Sloan School of Management, in congressional testimony last week:

Why are fire codes necessary? In particular, given the costs associated with compliance, why not let markets determine the appropriate level of fire protection demanded by the public? Those seeking safer buildings should be willing to pay more to occupy them, and those willing to take the risk need not pay for what they deem to be unnecessary fire protection. A perfectly satisfactory outcome of this free-market approach should be a world with two types of buildings, one with fire protection and another without, leaving the public free to choose between the two according to their risk preferences.

But this is not the outcome that society has chosen. Instead, we require all new buildings to have extensive fire protection, and the simplest explanation for this state of affairs is the recognition—after years of experience and many lost lives—that we systematically under-estimate the likelihood of a fire. In fact, assuming that improbable events are impossible is a universal human trait …, hence the typical builder will not voluntarily spend significant sums to prepare for an event that most individuals will not value because they judge the likelihood of such an event to be nil. Of course, experience has shown that fires do occur, and when they do, it is too late to add fire protection. What free-market economists interpret as interference with Adam Smith’s invisible hand may, instead, be a mechanism for protecting ourselves from our own behavioral blind spots.

Via The Baseline Scenario.

Consumer spending

Just for you edification, consumer spending (aka consumption) accounts for just less than two-thirds of the American economy. Drops in consumer spending like we are seeing are a very big deal.

Normally investment is about 15% of the economy, government spending 20%. Exports and imports net to about zero.

Saving Motown

I never thought I’d say this, but I think I might agree with David Brooks.

Granting immortality to Detroit’s Big Three does not enhance creative destruction. It retards it. It crosses a line, a bright line. It is not about saving a system; there will still be cars made and sold in America. It is about saving politically powerful corporations. A Detroit bailout would set a precedent for every single politically connected corporation in America. There already is a long line of lobbyists bidding for federal money. If Detroit gets money, then everyone would have a case. After all, are the employees of Circuit City or the newspaper industry inferior to the employees of Chrysler?

The End of Wall Street’s Boom

The wonderful writer, author among other things of Liar’s Poker, Michael Lewis revisits Wall Street. A short excerpt from this fascinating piece:

In the two decades since then, I had been waiting for the end of Wall Street. The outrageous bonuses, the slender returns to shareholders, the never-ending scandals, the bursting of the internet bubble, the crisis following the collapse of Long-Term Capital Management: Over and over again, the big Wall Street investment banks would be, in some narrow way, discredited. Yet they just kept on growing, along with the sums of money that they doled out to 26-year-olds to perform tasks of no obvious social utility. The rebellion by American youth against the money culture never happened. Why bother to overturn your parents’ world when you can buy it, slice it up into tranches, and sell off the pieces?

At some point, I gave up waiting for the end. There was no scandal or reversal, I assumed, that could sink the system.

As Pink Floyd says

“Money, it’s a gas. Grab that cash with both hands and make a stash.”

In the early 1990s NewMexiKen traveled extensively overseas. Along the way I saved numerous small denomination bills and coins and put them away.

Little did I know that these foreign savings might be my retirement nest egg.

Here is my particular favorite — from Yugoslavia, 500 billion dinara.

500 Billion Dinara

Click image for larger version.

“Money, so they say, is the root of all evil today.”

Double take line of the day

[F]ormer Bear Stearns chief risk officer Michael Alix has landed a job in the office of the Federal Reserve charged with assessing the safety and soundness of domestic banking institutions.

We suppose that Alix at least has plenty of experience with unsound banking institutions. He was the chief risk officer of Bear Stearns from 2006 until 2008. So, basically, he was the guy on the mast charged with yelling “iceberg” just before the titantic introduced its bow to a floating hunk of ice. …

Clusterstock

Thanks to Bob Ormond for the pointer.

It’s the Housing Bubble, Not the ***** Credit Crunch!

The bursting of the housing bubble damaged both consumer confidence and the card house of the credit markets. These in turn led to the bursting of the stock bubble, which has led to even more loss of consumer confidence.

This excerpted from a posting by Dean Baker — Beat the Press:

The news media almost completely missed the housing bubble. They relied almost entirely on sources who either had an interest in not calling or attention to an $8 trillion housing bubble or somehow were unable to see it. As a result they did not warn the public that their house prices were likely to plunge in future years.

Having dismally failed in their jobs to inform the public, reporters are still relying almost exclusively on sources that completely missed the housing bubble. As a result, they are still badly misinforming the public, first and foremost by attributing the economic downturn to a credit crunch.

This is truly incredible. Homeowners have lost more than $5 trillion in housing wealth. There is a very well established wealth effect whereby $1 of housing wealth is estimated as leading to 5 to 6 cents of annual consumption. This implies that the loss of wealth to date would cause consumption to fall by $250 billion to $300 billion annually (1.7 percent to 2.0 percent of GDP). If you add in the loss of around $6 trillion in stock wealth, with an estimated wealth effect of 3-4 cents on the dollar, then you get an additional decline of $180 billion to $240 billion in annual consumption (1.2 percent to 1.6 percent of GDP).

These are huge falls in consumption that would lead to a very serious recession, like the one we are seeing. This would be predicted even if all our banks were fully solvent and in top flight financial shape.

Automakers Report Grim October Sales

General Motors on Monday reported an incredible 45 percent decline in its sales from the month a year ago, and Chrysler said its sales were down 35 percent. The Ford Motor Company said it sold 30.2 percent fewer cars and trucks.

Toyota Motor said its sales were 23 percent lower, despite offering no-interest financing and large discounts on many models. Sales were down 33 percent at Nissan and 25.2 percent at Honda.

“If you adjust for population growth, this is probably the worst industry sales month in the post-World War II era…”

The New York Times

GDP

GDP, Thursday’s term du jour, stands for Gross Domestic Product. It’s the total value of the goods and services produced in a country for a specified period of time.

The GDP for the U.S. for the third quarter (July, August and September) was down 3/10ths of a percent in real dollars from the previous quarter. Less GDP is not good, and is one serious indicator of the R-word, “RECESSION.” (The actual current dollar value for the quarter was $14.429 trillion.)

The GDP consists of four components (and many sub-divisions, etc.). The four are (1) consumption (what you and I buy), (2) investment (what businesses spend to increase their capacity or inventory), (3) government spending and (4) net exports (exports minus imports, because imports are part of some other country’s GDP).

In this past quarter it was consumption that changed most markedly, dropping at an annual rate of 3.1%. And durable goods — refrigerators and cars — dropped at an annual rate of 14%.

You need to go out and buy some American-made stuff.

A Big Banker Speaks Out

A 35-year veteran of the banking industry speaks out. An excerpt:

So far, despite doling out more than $125 billion in new capital to banks, the government has been unwilling to do anything more than politely ask the banks to make more loans. That approach is never going to work. Since 1999, the government has issued several guidelines to the banks, warning them of the potentially disastrous consequences of diving into the risky subprime mortgage market. It has urged them to curtail this behavior. The banks refused to listen and went head-long into that market, driven solely by greed. For the government to now believe that the big banks are somehow going to have an epiphany and change their behavior is delusional.

Emerging Markets

The financial crisis this week is the implosion of the “emerging markets.”

What’s an emerging market?

They’re the rich poor countries — China, India, Russia, Turkey, Eastern Europe, Mexico, Brazil, Venezuela. (As opposed to the rich countries like the U.S., Western Europe, Japan.)

What’s the problem?

Think of the emerging markets as people buying more house than they can afford. These countries showed some economic progress, borrowed big, now can’t pay back the loans in the global slowdown because their products or commodities are depressed — and/or because they spent the money on luxuries rather than infrastructure that would increase production.

More risky loans by banks in other words. (And no, Fannie and Freddie didn’t cause this problem either.)

Information gleaned from yesterday’s Planet Money podcast.