Category Archives: Economics

Stuff happens

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groupthink (1) In this NY Times op-ed, Richard Thaler picks up on a theme that Ken Rogoff and James Hamilton raised last week ñ the similarity between the miscalculation of risks relating to the Gulf of Mexico oil spill and the Wall Street financial crisis:

AS the oil spill in the Gulf of Mexico follows on the heels of the financial crisis, we can discern a toxic recipe for catastrophe. The ingredients include risks that are erroneously thought to be vanishingly small, complex technology that isnít fully grasped by either top management or regulators, and tricky relationships among companies that are not sure how much they can count on their partners.

For the financial crisis, it has become clear that many chief executives and corporate directors were not aware of the risks taken by their trading desks and partners. Recent accusations against Goldman Sachs suggest the potential for conflicts of interest among banks, investors, hedge funds and rating agencies. And it is clear that regulators like the Securities and Exchange Commission, an agency staffed primarily with lawyers, are not well positioned to monitor the arcane trading strategies that helped produce the crisis.

The story of the oil crisis is still being written, but it seems clear that BP underestimated the risk of an accident. Tony Hayward, its C.E.O., called this kind of event a ìone-in-a-million chance.î And while there is no way to know for sure, of course, whether BP was just extraordinarily unlucky, there is much evidence that people in general are not good at estimating the true chances of rare events, especially when human error may be involved. [.  .  .]

How can government reduce the frequency and the severity of future catastrophes? Companies that have the potential to create significant harm must be required to pay for the costs they inflict, either before or after the fact. Economists agree on this general approach. The problem is in putting such a policy into effect.

Suppose we try to tax companies in advance for activities that have the potential to harm society. First, we have to have some basis for estimating the costs they may inflict. But before the recent disasters, companies in both the financial and oil drilling sectors would have claimed that the events we are now trying to clean up were, well, one-in-a-million risks, suggesting a very low tax.

Alternatively, an offending party could be made to pay after the fact, by holding it responsible for the costs it imposes. BP has volunteered that it will pay for all damages it considers ìlegitimate,î but we can expect a fight over how to define that word.

.   .    .  Suppose a company worth only $1 billion was responsible for this accident. It would go bankrupt and we would be unable to collect. And if we arenít careful, we will encourage companies that have enough money for collection to leave the drilling to those that donít. [.  .  .]

We are left in a difficult place. Neither the private nor the public sector seems up to handling these kinds of problems. And we canít simply wait for the next disaster, because, as people might say if they had to use G-rated language, stuff happens.

Professor Hamilton zeros in on the group dynamic that leads to the underestimation of risk:

I think part of the answer, for both toxic assets and toxic oil, has to do with a kind of groupthink that can take over among the smart folks who are supposed to be evaluating these risks.

It’s so hard to be the one raising the possibility that real estate prices could decline nationally by 25% when it’s never happened before and all the guys who say it won’t are making money hand over fist.

And this interacts with the forces mentioned above. When the probability of spectacular failure appears remote, and moreover it hasn’t happened yet, it’s hard to set up incentives, whether you’re talking about a corporation or a regulatory body, in which the person who makes sure that the risks stay contained is the person who gets rewarded. When everyone around you starts thinking that nothing can go wrong, it’s hard for you not to do the same. It can become awfully lonely in those environments to try to be the voice of prudence.

Finally, Cato’s Gerald O’Driscoll, Jr. notes the futility of reacting to the oil spill by implementing even more regulation:

What is the missed lesson from all this? When President George W. Bush had his Katrina moment, the federal government’s bumbling response was blamed on him, on the Republicans, and on conservatives. Now it is President Obama’s turn. His administration’s faltering response to the disaster in the Gulf is attributed to his personal failings, staff ineptitude, communication failures, etc. And, of course, the two administrations have shared responsibility for the poor handling of the financial crisis.

A big-government conservative administration failed in crisis, as has a big-government liberal administration. The regulatory state did not prevent excessive risk taking whether in financial services, nor perhaps in offshore oil drilling. Government response to crises once they occur is slow and inept. All this is not because either Republicans or Democrats are in power, but because big government doesn’t work. It can’t deliver on its promises. Big government overpromises and underdelivers. In reaching to do more, big government accomplishes less. That is not an ideological statement, but an empirical observation.

In the case of financial services, virtually all the proposed regulatory reform offers more of the same. Additional regulations will be added to existing ones without addressing why existing ones failed to prevent the crisis. The same process will likely happen with respect to offshore drilling.

The oil spill has triggered an important debate about the value of off-shore drilling, and that debate might conclude that off-shore drilling generates more harm than benefit.

But despite the nightly photos and videos of the oil spill on television, itís important to remember that drilling produces benefits in addition to its costs. Deep-sea drilling has been ongoing for decades with relatively few incidents that even come close to the current spill.

So, while this spill may reveal that deep-sea drilling is too risky, itís also quite possible that this incident was simply the result of poor decision-making combined with bad luck, and that there is a nominal chance that it will reoccur.

And it is very difficult to regulate bad decision-making and bad luck.

Stu
ff happens, indeed.

Obfuscation is government’s secret weapon

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Paulsen Over the past couple of years, Bill King has done a great job (and see generally here) of explaining how Houstonís unfunded public pension obligation represents a horrific burden on the city governmentís financial condition.

Given that such obligations are clearly unsustainable, why does the city government continue to provide them?

Edward L. Glaeser provides the following particularly lucid explanation of the dynamic that leads to such profligacy:

On Friday, The New York Times ran a front-page article about pensions that took note of a 44-year-old retired police officer who receives an annual pension of $101,333 despite never having earned more than $74,000 a year in base pay. The article reported that in Yonkers alone ìmore than 100 retired police officers and firefighters are collecting pensions greater than their pay when they were workingî and that ìabout 3,700 retired public workers in New York are now getting pensions of more than $100,000 a year, exempt from state and local taxes.î

The emotional response of many people is to vilify the retirees, but thatís a mistake. The individual police officers and firefighters were following the rules. They have jobs that require them to risk their lives in service of their communities, and large pensions are one payoff for accepting those risks and accepting relatively lower wages up front. Iím sure many of them are no less impatient than the rest of us and would have preferred to get more money in their 20s and less in their 50s.

The fault lies in the political process that makes their negotiating partners ó state and local governments ó more impatient than their employees. State and local governments donít want to face the short-term consequences of paying higher wages, so they structure compensation in ways that defer the costs of each new deal for years.

Politics doesnít just favor delayed compensation; it also favors forms of compensation that are particularly hard for people to evaluate. Governments almost always love obfuscation. The appeal of Fannie Mae and Freddie Mac was that they could subsidize homeownership without appearing to cost the taxpayers anything. Of course, they ended costing us plenty, just like hard-to-evaluate pension promises.

The rest of Glaeserís post is here.

Sort of reminds one of this, this and this, eh?

Is freedom possible without wealth?

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From the fine HBO John Adams mini-series, Thomas Jefferson and Alexander Hamilton debate the relative importance of the creation of wealth to American society. Amazingly, the debate lives on today.

Our troubling tax system

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Another first rate Cato Institute video on the horrific cost of our overly complicated taxation system.

That health care overhead

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healthcareadmin Following on this post from earlier in the week on the adverse impact that the third party payer system of health care finance has had on controlling health care costs, check out this Catherine Rampell post that passes along the graph on the left and the following startling observation:

ìFor every doctor, there are five people performing health care administrative support.î

And we are about to implement changes in the health care finance system that increases the third party payer element that requires much of this administrative support? While dramatically increasing the number of people covered under such a third party payment scheme with no provision for increased supply of medical services to meet that additonal demand?

What possibly could go wrong?

Milton Friedman on poverty

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De Vany on PED’s, Diet and Exercise

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When you have a free hour, don’t miss Russ Roberts’ fascinating EconTalk interview of Clear Thinkers favorite Art De Vany.

Performance enhancing drugs resulted in new records in baseball?

Pure conjecture. More likely the records are simply the result of outliers.

The more exercise, the better?

Nope. Intensity and randomness is the key to an effective exercise regimen. Forget the jogging.

We’re healthier than our ancestors?

Not really, unless you’re fasting frequently and controlling your insulin levels.

Provocative stuff. Don’t miss it.

Longhorns Inc.

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College Football3 More than a few tongues are wagging around Texas Longhorn athletic circles this week over this blistering Texas Observer op-ed on the UT football program authored by UT professor Tom Palaima, who just happens to serve on the UT Faculty Advisory Committee on Budgets and is UTís representative on the Big 12 steering committee of the Coalition on Intercollegiate Athletics. Hereís a flavor of the article:

The NCAA program at the University of Texas at Austin generated $138 million in revenue last year, $87 million from football. Yet its profit margin is less than $2 million. The programís cumulative debt and debt service are in the high-risk neighborhood.

Longhorns Inc. has wrapped its tentacles around the now-hemorrhaging academic budget. The athletics department gave a $2 million raise to head football coach Mack Brown as colleges across the university are laying off staff. In foreign languages alone, $1.6 million was cut. The head of the student union recently announced the closure of the Cactus CafÈ, a historic music venue, to save just $66,000 over two years.

Worse, the university has ceded trademark and royalty revenues. Longhorns Inc. keeps 90 percent of this income, roughly $10.6 million last year. The yearly debt payment on building bonds for the nearly $300 million in stadium expansions since 1998 is $15 million. The debt run up by the athletics department has risen from $64.4 million in 2004-05 to a staggering $222.5 million in 2008-09.

Unfortunately, Palaima main criticism is how well the UT athletic department and its personnel are doing financially in comparison to the UT academics, whose average salary has increased by ìonlyî 30 percent over the past 20 years or so.

Somehow, however, Palaima utterly misses the most corrupt aspect of big-time intercollegiate athletics. That is, the perverse and discriminatory regulatory scheme that restricts compensation to the players ñ mostly young black men ñ whose talent actually generates most of the wealth for the athletic departments.

As Iíve noted many times, big-time college football and basketball is an entertaining form of corruption. Too bad that someone as bright as Professor Palaima fails to understand the true nature of that corruption.

By the way, below is a video of a lively debate between Professor Palaima and longtime UT Law professor Lino Graglia over college football in which Palaima is actually the defender of the entreprise (a colleague asked Palaima ìDeLoss Dodds must have given you priority seating at [Darrell K. Royal-Memorial Stadium]î. The transcript of the debate is here.

Thoughts on health care finance reform

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stethoscope_3 Inasmuch as Americaís fractured health care finance system has been a common topic on this blog since early 2004, many friends and readers have asked my thoughts about the health care reform legislation that was passed yesterday. So here goes.

The legislation is fundamentally flawed because it imprudently foists a top-down reorganization plan on something as complex and disparate as financing health care. But frankly, I have no idea whether it will result in a worse finance system than the current one, which is pretty bad.

My biggest criticism with both the current system and the one contemplated by Obamacare is that the patient is not the customer, at least as it relates to non-catastrophic illness and injury. Without cost control ñ and customer decision-making is the most efficient one available – neither the current system nor Obamacare will be able to maintain delivery of high-quality care to an increasingly aging population.

However, the reality is that we now have two solid generations of Americans now who enjoy having someone else pay for their health care. So, itís unrealistic to think that such a societal shift is going to change anytime soon. But itís still important to understand how we got to this point.

Employer-based health insurance became popular during World War II because it was initially exempted from gross income as a way to circumvent wartime wage and price controls. After the war, marginal income tax rates were high and individual medical expenses were tax deductible, so at least some rational incentives were returned to the medical marketplace.

But all this changed in 1986 when the Reagan Administration made concessions to achieve bipartisan tax reform. Individual medical expenses were no longer deductible until they reached 7.5% of gross income, which virtually eliminated individual incentives in the medical marketplace. Not surprisingly, everyone was incentivized after tax reform to move all medical expenses to third-party-payor health insurance. As a result, individual out-of-pocket expenses in the health care market dropped from 22% in 1985 to less than than 10% of the market now.

So, in essence, the Reagan Administration horse-traded personal tax deductibility of medical expenses away, but figured that was acceptable because at least employer health insurance remained tax-free benefit. Iím sure if we could ask him now, President Reagan would tell you that he expected a future Congress would fix such perverse incentives after the dust settled on the benefits of tax reform. But alas, that never happened.

What happens now? The only certainly is that special interests will be descending upon Washington in droves to do their bidding over the transfers of wealth that will occur under the new legislation. At least it will be entertaining to watch who wins and loses.

But there are two big points that everyone should remember as we embark on this new world of health care finance.

First, the Obama Administrationís rationalization of future cuts in Medicare spending as a funding source for the health care legislation is utterly disingenuous, as Arnold Kling artfully explains:

Imagine that your crazy uncle Fred had bought a dozen cars on credit. As a result, he faces car payments far in excess of what he can afford. He comes to you and says he has a plan that in a couple of years will reduce his car payments by a few thousand dollars. "Now I have the money for a down payment on a boat!" he exclaims, as he runs off to the boat dealer.

The equivalent is for Congress to treat future cuts in Medicare as if they were a newfound source of wealth to be tapped. Once they adopt this precedent, they can increase spending on whatever they want, in unlimited amounts, while claiming deficit neutrality. Future Medicare spending is so high that you can always come up with cuts, as long as they deferred.

Second, as Greg Mankiw notes, projected Medicare cuts in payment rates for physician services portend the rationing of medical services that the promoters of the current legislation contend wonít occur. Because few consumers actually pay for their health care, most folks donít realize that Medicare and Medicaid payment rates for physician services have already been cut by around 30% since the late 1990ís. That has led many doctors to limit substantially the number of Medicare and Medicaid patients who they are willing to treat in their practices. In my view, that trend is likely to continue under the new legislation. Who will tend to the medical needs of consumers who elect to rely on such insurance in the future?

Supporters of Obamacare generally argue that the legislation offers more equality through expanded insurance and redistribution of benefits. But the wealthy will always find ways to get around the rationing and other restrictions of a government-run health care system. On the other hand, the poor will have no choice but to accept the government health care, which is unlikely to be as high a quality as what the rich folks obtain from their private doctors. Accordingly, although the distribution of health care may be a bit more equal in the short term, I’m not sure that means more equality in health care in the long run.

Which leads me to this question: How long will it be before the federal government requires physicians, as a condition to being allowed to engage in private practice, to accept a certain number of patients under government-sponsored insurance plans that limit payments to the physicians far below what the physicians would otherwise accept?

Roberts on the bailout

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Don’t miss George Mason University economic professor Russ Roberts’ lucid, four minute statement to a House Committee condemning the federal government’s bailout of large financial institutions. The written statement is here. As I’ve been saying all along, it’s not rocket science.