Archive for the ‘Economics’ Category

Thought experiment: Suppose we were to institute a free market in medical finance—that is to say, permit consumers of medical care and producers of financial instruments to enter into whichever kinds of consensual transactions (pertaining to medical finance) they choose, without favoring any particular model(s) by means of public policy. What is there to fear in such a setup?

Concern #1: The poor would not be able to purchase a decent minimum of health care without giving up other essential spending (e.g., shelter). They do not deserve to be in this position—they consciously chose neither their genetic endowments, nor the childhood environments in which they were raised (nor the social circumstances they inherit, for that matter). It is unfair, therefore, to deny them standards of medical care that their more fortunate peers would be able to secure for themselves in the marketplace.

Reply: Indeed. The solution is to transfer wealth from those who have more of it to those who have less of it, up to a point. Such transfers discourage the creation of wealth. We must, therefore, delicately balance our desire for fairness with our desire for prosperity. I do believe, however, that doing so would leave us with ample room to improve the relative plight of the poor.

Concern #2: Cutting poor people checks is only part of the solution. What if, instead of purchasing necessary medical care, for example, a poor person blows her transfer payments on drugs?

Reply: Is she obviously engaging in self-destructive behavior? If she is, then there is a case for encouraging her to spend her money more constructively. A simple subsidy (e.g., a tax break) for buying essential medical care would probably do the trick. If she is obviously harming herself by not having particular financial products (for instance, catastrophic insurance, or a medical savings account), then specifically subsidizing her purchase of these is reasonable enough.

It is worth noting, however, that it is usually not obvious whether someone is engaging in self-destructive behavior. Our everyday decisions force us to make immeasurably complex calculations, which in turn draw upon extensive information about our preferences and the circumstances we inhabit, data concerning which is frequently inaccessible to outside observers.  This is neither to say that humans never engage in self-destructive behavior, nor that outsiders never improve upon the decisions of others. Instead, my claim is simply that it is not often the case that someone is obviously doing harm to themselves. As a consequence, the burden of proof is borne by those who want to encourage people to make different decisions—and it is a heavy burden indeed.

Concern #3: These proposals address the unfairness of some people being less wealthy than others, but they do not address the unfairness of some people being less healthy than others. Why should some have to pay more for medical care than others, simply because their health is in poorer condition (through no fault of their own, needless to say)?

Reply: It is not just sick people who have to pay more than their peers to remedy their God-given deficiencies. Ugly people, too, have to pay more than their peers to look better to others, to feel better about how they look, etc. Stupid people have to pay more than their peers to do better in school, or to do better on the job, etc. These observations do not serve to trivialize poor health. Instead, they underscore the uniqueness of economic inequality as a policy objective.

Usually, a very wealthy sick person is much better off than a very poor healthy person, because a poor person is likely to have many more problems to worry about besides her health, while having few resources to throw at such problems. A wealthy person, by contrast, is likely to have many fewer problems to worry about besides her health, while having a lot of resources to throw at the problem. The problem of poverty is not a problem of having inferior housing, or low-quality education, or inadequate nutrition—it is a problem of not having enough money. To a large (though far from complete) extent, the problem of ill health is a problem of not having enough money, too.

On a more practical note, just as transfers from rich to poor discourage wealth creation, transfers from healthy to sick encourage unhealthy lifestyle choices, which play a large role in shaping longer-term health outcomes (according to some experts, a much larger role than adequacy of medical care). Policies like ‘community rating’ effectively enact such transfers, driving up the cost of medical care in the long run. Consider this one more reason to focus discussions of fairness on economic inequality, rather than on health inequality.

Concern #4: What about spillover effects? Suppose people decide to forgo vaccination for a contagious disease, knowing that they may free ride on others’ vaccinations. Should we not encourage people to get vaccinated? Or consider the fact that our society simply is not going to let poor people with medical emergencies die in the streets. In light of guaranteed emergency care, should we not demand that everyone be able to pay up in the event of a medical emergency?

Reply: In principle, this is unobjectionable. In practice, it is a question of magnitudes. If the social cost of uncompensated emergency care, for example, is very high indeed, then mandating and subsidizing purchase of catastrophic health insurance is sensible enough. Similarly, if a disease is sufficiently dangerous and sufficiently contagious, subsidizing vaccinations is entirely appropriate. Where the social cost is low or negligible, the cure may prove to be worse than the disease, pardon the pun.

Another example relates to our earlier discussion of lifestyle choices. If the reason why uncompensated emergency care is so costly is that people are making unhealthy lifestyle choices (e.g., becoming obese), putting them at risk of various medical emergencies, then it may make more sense, depending on the science, to discourage obesogenic diets than to make insurance mandatory.

Concern #5: Even in the context of a fair distribution of wealth, a free market in health insurance would not work to the benefit of consumers. Since insurance companies would not know as much about a customer’s health as the customer herself, they would have to charge potentially very different customers roughly similar prices. This would cause healthier people to conclude insurance is a bad deal for them, dropping out of the pool, leaving it riskier on average. Responding to this, insurance companies would raise prices, causing still more (relatively) healthy people to drop out of the pool, causing prices to rise further, and so on and so forth. In equilibrium, the market would disappear, failing to serve the medical care financing needs of consumers.

Reply: This problem, known as ‘adverse selection’ in economics, is only a problem to the extent that insurance companies cannot bridge the informational divide. In reality, they work very hard to do this, under the heading of ‘medical underwriting’. Such screening procedures are hardly perfect, but then, consumers’ knowledge of their own health risks is hardly perfect, either. There is little evidence of adverse selection in existing health insurance markets, except in places where public policy actively discourages medical underwriting (e.g., through community rating and ‘guaranteed issue’ policies, which blunt insurer’s incentives to bridge the informational divide). Remember that the goal of such policies (greater equity in the distribution of medical care) is better pursued through explicit transfers, which neither cause adverse selection, nor discourage healthy lifestyle choices.

Concern #6: The case for free markets is premised upon competition. Competition between providers of medical finance ought to, in theory, drive down prices, while increasing quality. Why, then, do premiums keep rising in our medical insurance market? Why do these higher premiums largely support profits rather than better medical care? Is it not because the market for medical insurance is intrinsically non-competitive?

Reply: It is true that the market for medical insurance in the US is hardly competitive, but this is not intrinsic to the provision of medical insurance. Economies of scale in the insurance business do give larger firms a competitive edge over their smaller peers, but there are diminishing returns to scale, and there is little evidence that monopoly, or oligopoly, is the inevitable outcome of a free market in medical insurance. The US medical insurance market is mostly non-competitive due to regrettable public policies.

On the supply side, the US restricts competition between insurers across state lines. Given economies of scale, this encourages the formation of local monopolies. Additionally, a large number of regulations at the state and local levels raise the fixed costs of being in the insurance business, costs which it is easier for larger firms to bear—this, too, encourages insurance companies to scale up beyond what is socially optimal.

On the demand side, employer-provided health insurance is tax-deductible. Consequently, most workers get their insurance plans through their employer. For the majority of workers, the choice of the right job is much more important than the choice of the right health insurance plan. This bit of tax policy thus discourages workers from smart shopping in the insurance market. Employers, in turn, do not really care which insurance plans their employees have, for the cost of these plans is simply deducted from the wages they pay. There is, therefore, little pressure from the demand side for insurers to compete on price and quality.

Concern #7: What, then, should we do about people who, through no fault of their own, would be uninsured because of pre-existing conditions?

Reply: This question reflects a misunderstanding of the concept of insurance. Why do people buy medical insurance? They do so because their health is at risk (e.g., they may get hit by a bus), and they are willing to pay some amount for someone to take the associated medical risk (e.g., expenses for having their injuries treated) off of their hands. Why, then, do people sell medical insurance? They do so because even if the future health status of each of their customers is very unpredictable, the future health status of their entire pool of customers is reasonably predictable. This is a straightforward consequence of the Law of Large Numbers. As a result, insurers take on less medical risk than their customers compensate them for, yielding insurers profit. In short, the value of insurance is that, by pooling the risks of diverse customers, it reduces the aggregate risk borne by the pool as a whole.

What does this have to do with pre-existing conditions? Simple: if you have a pre-existing condition, there is no risk to be insured. For example, if you have cancer, there is no risk that you will demand expensive treatment—this is a certainty. “Insuring” certainties does not add value to anything. What people with pre-existing conditions need is not insurance, it is money. If someone already has plenty of money, public policy need not be concerned with her. If she does not, then the solution, once more, is to give her more money.

Requiring insurance companies to cover pre-existing conditions is to require them to get into a business besides insurance—namely, the business of pre-payment and/or redistribution. We should hardly expect insurance companies to be suited for this. What ever happened to specialization?

Conclusion: I could go on and on, but I think you get the point. There is little to fear in a free market in medical finance that a few, simple, well-designed subsidies cannot fix. Such subsidies warrant caution: I have been writing of the market for medical finance instead of the market for medical insurance, because this is not something we should pre-judge. Insurance was once a novel financial instrument. Innovation in medical finance may one day render it obsolete, which is something public policy should not get in the way of with outdated subsidies. Even today, we likely rely too much upon health insurance, when we should also be relying on medical savings (the tax-deductibility of employer-provided health insurance favors premium-heavy insurance plans over deductible-heavy plans, for example). Insofar as the many purported problems with free market health insurance are really problems, however, the right fix is delicate subsidies, not command-and-control regulation.

With the Supreme Court likely to strike down the PPACA’s individual mandate, comprehensive reform may soon be back on the agenda. Here’s to hoping that future proposals focus on deregulating the health insurance industry, ending the tax-deductibility of health insurance, and converting programs like Medicare and Medicaid into lump-sum subsidies for the poor. If, in such a liberalized, egalitarian environment, many people continue to do obvious damage to themselves by failing to purchase enough medical care, or by failing to purchase the right sorts of financial instruments pertaining to medical care, then we ought to discuss in more detail the merits of subsidizing this or that.

Of course, I have deliberately ignored the elephant in the room—the ballooning cost of medical care itself. For another day, I guess.


The efficient market hypothesis (EMH) was once a widely believed theory in financial economics (see, for example, “Efficient Capital Markets” [Fama 1970]). The EMH states, informally, that financial market prices fully reflect publicly available information concerning the underlying value of the traded security. As expressed, the EMH gives rise to a joint-hypothesis problem: when directly determining whether a given financial market is pricing securities efficiently, one must suppose a particular model of underlying value. Should the EMH, coupled with such a model, fail the test, one is (logically) free to revise the pricing model without rejecting EMH.

Consequently, the EMH itself is usually tested in one of three ways: (1) ‘weak form’ tests explore whether one can consistently outperform the market as a whole by studying patterns in past price movements (i.e., whether technical analysis is a loser’s game in the long run); (2) ‘semi-strong form’ tests explore whether one can consistently outperform the market as a whole by studying publicly available information (i.e., whether fundamental analysis, too, is a loser’s game in the long run); (3) ‘strong form’ tests explore whether one can consistently outperform the market as a whole by having access to information that is only privately available (i.e., whether even insider trading is a loser’s game in the long run). Consistently outperforming the market is a challenge for the EMH, because the EMH implies that, going forward, price movements constitute a random walk, meaning that the limiting probability of consistently earning excess returns is precisely zero.

Why does the EMH imply that future price movements conform to a random walk? If the price of a security fully reflects publicly available information, then the only cause of future price movements is genuine news, which is by its very nature unpredictable. Hence, movements in future prices cannot be predicted, meaning that trading is purely a game of chance. It is certainly possible to win games of chance a large number of times (consider Warren Buffett’s career, for example), but the larger the number of games, the less likely consistent winning becomes.

Most proponents of EMH concede the observation of Grossman & Stiglitz [1980] that, if markets were efficient, it would not make sense for traders to sort through the news, thereby depriving markets of information needed to price securities efficiently. Thus, markets may well be efficient enough to deny traders much in the way of excess returns, but must be inefficient enough to continue to encourage informed trading.

The EMH near-consensus was supported by a large number of empirical studies showing that weak form, and many semi-strong form, tests of EMH conformed to the theory’s predictions (the track record of strong form tests is considerably more mixed). The consensus began to unravel when a number of criticisms from the behavioral finance school emerged, coupled with the increasing conviction of some econometricians that price movements may indeed be predictable. More recently, the EMH has faced a great deal of public criticism pertaining to its purported role in the financial crisis of 2007-2009. Many of these criticisms seem to me to be based upon some key confusions:

First, efficiency is a separate issue from stability. The fact that prices may run up, then suddenly fall off a cliff, does not necessarily condemn efficiency. Suppose, for example, that based upon the best information, housing seems to be a really good investment (perhaps because of a wave of immigration). Later, unexpectedly, compelling evidence to the contrary emerges (immigration seems to be slowing for whatever reason). Prices would rise sharply, then fall sharply, but there is nothing inefficient about this. It is just that, for a time, it was reasonable to believe housing to be a great investment, but this is no longer a reasonable belief. Instability is not necessarily evidence of inefficiency.

Second, efficiency does not imply perfect foresight. The claim of the EMH is that markets efficiently price securities based upon publicly available information, not that it prices securities based upon presently unknown considerations. The future is, to a very large extent, unpredictable. Expecting markets to get it right every time is folly.

Third, efficiency is a separate issue from rationality. Suppose a deeply irrational trader enters the market. His transactions cause a number of securities to become temporarily mispriced (with respect to efficiency). The consequence of this, however, is that rational traders now enjoy opportunities for arbitrage. Their efforts to profit off of this irrational trader will, in very short order, correct the mispricing. Thus, it is possible for many traders to be irrational, but for the market to still be efficient, so long as there are enough rational traders.

As for price trends, I will believe it when I see it. If you stare hard enough at any large data series, you will observe patterns therein. This does not mean, however, that you can reliably predict future price movements on the basis of past movements. If you can, then you can also profit off of those predictions. Where is the evidence of consistent excess returns derived from price trends? Show me the profit!

In my view, the EMH, like any good social scientific model, is a useful approximation for the purposes to which it is put, even if it is not precisely true. Assuming the EMH, we may infer from financial market prices what sorts of (rational) expectations traders have about future developments of interest. We may also explain why sticking with low-cost index funds makes more sense for casual investing purposes than turning one’s money over to expensive, actively managed funds. EMH may have this or that hole, but no alternative theory of financial market pricing gives us a useful interpretation of the relevant prices. Most importantly, no competitor theory can explain the most striking fact in finance: consistent excess returns are extremely, extremely hard to come by, in spite of some of the best and brightest working their very hardest using the most sophisticated tools to find them.

Productivity: a primer

Posted: April 6, 2012 by alephnaughty in Economics, Politics
Tags: , , ,

‘Productivity’ refers to the economic output produced by a unit of labor. Why does productivity matter? Suppose productivity is fixed. In order for the economy to produce more output, it must utilize more labor. More output means more income, which increases the quality of people’s leisure time. More labor, however, decreases the quantity of people’s leisure time. Hence, fixed productivity forces workers to choose between a higher quantity of lower quality leisure time, and a lower quantity of higher quality leisure time.

Greater productivity makes choosing between these two options unnecessary. Workers can increase the quantity, or the quality, of their leisure time without sacrificing the other. It’s a win-win…

…for the more productive workers. Where, though, does the added productivity come from? Productivity growth comes from capital accumulation. Capital, in turn, comes from saving–i.e., not consuming. Even though productivity growth is good for the workers whose productivity has grown, it requires sacrifice to bring it about. Some of that sacrifice may come from others (e.g., someone makes a bunch of money, invests it in equities, the purchased companies buy more powerful computers, making their workers more productive). Some of it may come from the worker himself (e.g, someone turns down opportunities to make money in order to go to school, enriching his human capital, making him more productive). But there is always sacrifice involved in bringing about greater productivity.

Productivity, too, therefore, is a matter of choice. Present-oriented people much prefer consumption today to consumption in the future, so choose to save less. This reduces the capital stock, slowing productivity growth, the consequence of which is a difficult tradeoff between the quantity and quality of future leisure. Future-oriented people have a more balanced perspective, so choose to save more. This increases the capital stock, accelerating productivity growth, the consequence of which is a (comparatively) easy tradeoff between the quantity and quality of future leisure.

Of course, it is more than mere choice that matters for productivity. Institutions and public policies, for one, matter immensely. But given a set of institutions and public policies, variations in productivity is largely reflected in variations in the discount rates people apply towards the future.

Market interest rates in the US have been historically low for quite some time now. Even long-term bonds, such as the 30-year US Treaury bond, are yielding extraordinarily low returns. What does this say about future productivity, and more importantly future living standards? To me, it says that people want to sacrifice now to a historic extent for the sake of a more prosperous future, which tells me people think the future is currently looking very dim indeed. When interest rates begin to rise to more historically normal levels, this will be because people have become more optimistic about the outlook for the US economy.

To be clear, I’m not calling for the Fed to raise interest rates. Interest rates are not extraordinarily low because the Fed wants them to be, but rather because the Fed has to follow the market’s lead in order to do its job of macroeconomic stabilization. The Fed is keeping rates low because people are pessimistic–not the other way around. The solution is to make people more optimistic about the future. In the near term, that’s mostly about stimulating demand/NGDP, but over longer horizons, the US needs to do something about what it appears to be headed for: a prolonged period of productivity stasis.

Two of the central planks of the Patient Protection and Affordable Care Act (PPACA) go by the names of ‘guaranteed issue’ and ‘community rating’. According to guaranteed issue, no health insurance company is permitted to deny someone coverage based upon a pre-existing condition. According to community rating, insurance companies must offer the same policies to everyone for the same price. The idea is that health status is largely something beyond anyone’s control, and so it is unfair for those who, through no fault of their own, suffer ill health to have to pay a price for it. Whatever you think of the merits of these ideas, they’re embedded (in spirit, despite lots of exceptions) in the PPACA.

The worry, in theory, is that many people will wait till they develop a pre-existing condition to get coverage, saving premium expenses in the meantime. The reason is if they do so, they will not have to worry about being denied coverage because of guaranteed issue, and they will pay the same price then whether they buy it now or not. If people in fact do this, insurance companies will only have relatively sick people on their rolls, forcing them to raise premiums to cover the cost of their claims. Higher premiums, in turn, will encourage the relatively healthy among the insured to forgo insurance, rendering the pool still sicker, driving up premiums more. And so on and so forth.

This problem is known as ‘adverse selection’. The ultimate outcome, in principle, is that the price of insurance will spiral upwards until it is no longer a profitable business, causing a disappearance of the market. This has not happened in any of the states that have guaranteed issue and community rating policies, but it has been shown that their premiums rise faster than in states without those policies. What we can expect, then, is that they will quickly and sharply drive up the cost of health insurance.

The purpose of requiring everyone to buy health insurance is to prevent this spiral from getting off the ground. If everyone has insurance, no one can forgo it until they get sick, making adverse selection a non-issue. Arguably, there are other reasons to be wary of such a mandate, but most experts agree it is essential if community rating and guaranteed issue are to work without causing premiums to explode. If the Supreme Court rules the mandate unconstitutional, leaving these other pieces in place, the PPACA is going to cause a lot of problems no one particularly intended.This is why they may choose to eliminate guaranteed issue and community rating, too, in which case the core of the bill will be withdrawn.

I’m not a lawyer, but for what it’s worth, the mandate isn’t that big a deal. Suppose that the government decided to tax every citizen, to pay for a ‘motherhood and apple pie fund’. They then also decide that they’re going to cut a check of the same size to everyone who has health insurance. Nobody would dispute the constitutionality of either of those measures in the slightest, and yet together they amount to a fine for those who do not have health insurance. The only difference is that this is called a ‘tax’, while the mandate’s fee is a ‘penalty’. Note that the penalty is collected by the IRS, and you cannot go to jail for refusing to pay it. Sounds like a distinction without a difference to me.

Legal opponents raise the question of what limits there are on the government if it can require you to buy something. This, to me, is pretty silly. It isn’t requiring you to do anything. It’s just using the word ‘require’ to stigmatize those who choose not to get health insurance, making them feel like outlaws. It also asks them to pay a fine for doing so. The government isn’t coming into anyone’s home, insisting that they buy health insurance at the point of a gun. They’re just making your life a bit more difficult if you don’t get health insurance. Welcome to society. Sometimes the government has to make certain things more of a headache for the sake of promoting the general welfare. PPACA may or may not promote the general welfare, but saying that the government can’t give you a headache for making certain decisions is to say that the government cannot affirmatively try to solve any social problems at all. If you don’t like the PPACA, try to elect some folks who will get rid of it. Don’t try to make it impossible for the government to solve large social problems going forward.

Suppose you’ve imposed a (non-trivial) burden upon someone else without their consent. What is the right course for society to take in response? One option is to force you to fully compensate your victim. Requiring sufficient compensation would completely transfer the cost you’ve imposed upon the rest of society back to you. Knowing this ex ante, your individual cost-benefit calculation becomes identical to society’s cost-benefit calculation, for you expect not only to enjoy every social benefit, but also to suffer every social cost, flowing from your decision.

What ought to happen, then, if you do not have the funds to fully compensate your victim? The government may well seize your physical assets, selling what they can to make up for the shortfall. If even that is not enough to repay your debt to society, the government may have to take ownership of a more intimate asset: you. As with a bankrupt firm, the government may lend you the money you require to fully compensate your victim in a timely manner, but must take temporary ownership of you while you repay your debt in exchange. You would, in effect, be offering to collateralize such a risky loan with the only valuable you have left: your future stream of income.

Here’s my proposal: when a crime is committed (ignoring so-called victimless crimes for the time being), the government produces a transparent, predictable estimate of the crime’s social cost. If the criminal is able to fully pay the price, possibly by liquidating her portfolio, she may do so. If she is not able to pay the price, she goes to prison. Instead of serving a prison term, however, her mandate is to pay down her debt to society in full. In prison, she can produce whatever goods and services it is feasible for her to produce in that setting, which the government will sell to the general public, collecting most of the proceeds. With her small share of the proceeds, she may purchase a better standard of living in prison, or she may contribute extra funds towards paying down her debt, thereby shortening her stay in prison.

The signal such a policy would send is clear: if you commit a crime, be prepared to pay the price. If you’re not so prepared, you will be partially enslaved by the government (i.e., the government will have a controlling equity stake in you) until you have paid the price. Moreover, the higher the quantity and quality of the goods and services you produce for the general public’s consumption, the better your standard of living in prison, the sooner you exit prison, or perhaps both. Your incentive before you commit the crime is to carry out society’s cost-benefit calculation for yourself, and even if you go through with it, your incentive is to be as productive as possible for the benefit of your society, much as it would be outside of prison. Fewer people would be in prison, most would have shorter and less miserable stays, and much less human capital would be wasting away behind bars. All while reducing crime rates. What’s not to love (besides the optics of slavery 2.0…)?

Banking, in a nutshell

Posted: February 23, 2012 by alephnaughty in Economics
Tags: , ,

What do banks do? Two things. First, they maintain their customers’ deposits, paying interest on them for the privilege. Second, they lend some of their customers’ funds to creditworthy borrowers, charging them interest for the privilege. Banks make money, in brief, by taking a bit off of the top when transferring interest payments from their debtors to their depositors.

What is the economic value of what banks do? Banks perform the important tasks of liquidity & maturity transformation. In so doing, they play the role of financial intermediaries–institutions that match savers with borrowers, facilitating investment. Investment, in turn, is a critical driver of economic growth.

A depositor, in general, wants to invest in a short-term, highly liquid vehicle. That is, she wants to be able to, on a moment’s notice (short maturity), convert her investment into cash (high liquidity). A bank deposit offers her just that. As long as her savings reside in the bank they yield her interest. Whenever she wishes, however, she may make a withdrawal, converting her investment into cash without warning.

A borrower, in general, wants to provide a long-term, illiquid vehicle. That is, he wants to be able to spend his borrowed funds over a long period of time (long maturity), without necessarily being able to convert his purchases into cash in the interim (illiquidity). For example, if he borrows from the bank to buy a house, he may not be able to fully pay off his mortgage until it matures (say, thirty years from now), because his stream of income prevents this. A bank loan offer him exactly what he wants. As long as he makes his payments on time, he need not fully pay for his purchases until his loan matures, which may be well into the future.

How do banks manage to match depositors with borrowers, then, given their divergent wants? They manage to do this thanks to the law of large numbers. The withdrawal behavior of each depositor is very unpredictable. Because the behavior of one depositor is independent of the behavior of others, however, the law of large numbers entails that the withdrawal behavior of many depositors is very predictable. A bank that enjoys a large number of customers may confidently predict aggregate withdrawals on a given day, even if it cannot predict how much each customer withdraws. As a consequence, banks keep just enough cash in their vaults (their reserves) to honor these predictable withdrawals, freeing up the remaining funds to be invested with long-term, illiquid borrowers. Banks, therefore, make possible productive investments that would otherwise not be possible, thereby contributing to economic growth.

Sounds too good to be true, doesn’t it? There is, indeed a catch: Exploiting the law of large numbers is only possible because, most of the time, the behavior of one depositor is independent of the behavior of others. If withdrawals become correlated, the business model of banking breaks down. Suppose, for illustration, that a bank invests heavily in one sector of the economy (e.g., housing), believing that this promises the highest risk-adjusted returns for its depositors. Suppose further that many of these investments go belly up, with large numbers of borrowers defaulting on their loans. A depositor, observing this, worries about the ability of her bank to make good on her future withdrawals. Moreover, she knows that if she is worried about this, other depositors must be similarly worried. Even if the bank is in fact solvent, it is never in a position to make good on every deposit simultaneously, for some of the funds have been invested. Knowing that others will make larger-than-usual withdrawals, fearing that the bank is insolvent, it is in her best interest to beat them to it. If she isn’t one of the first to get her money out of the bank, the bank may not be able to honor her deposits, even if it was solvent in the first place.

A banking panic (or bank run) is a self-fulfilling prophecy. Fears concerning a bank’s solvency trigger correlated withdrawals, rendering the bank insolvent regardless of its prior condition. Systemic banking panics occur for similar reasons. If many banks turn out to have exposure to lots of bad loans, uninformed depositors may play it safe, running on their bank regardless of its individual exposure. This pushes the entire banking system into insolvency, causing a complete breakdown of financial intermediation in the economy, severely undermining economic growth.

Most economists, therefore, believe it is part of the role of government to stem banking panics, but not to make every failing financial institution whole. It is also important to regulate banking, because if banks can count on the government to bail them out in a panic, that limits their downside, encouraging them to take excessive risks with their depositors’ funds. The best way to do these things, however, is a matter of considerable debate. With the introduction of deposit insurance, depositors no longer monitor commercial bank’s investments, which is why the government tightly regulates them (for better or for worse). In the recent financial crisis, there were runs on so-called ‘shadow banks’, which work similarly to commercial banks, but operate outside of ordinary bank regulations.

The most important lessons, going forward: (1) preserve the banking system, not individual banks; (2) preserve institutions–preserve neither the management, nor the shareholders; (3) the purpose of regulation is to force bankers to put their own money on the line, not just the taxpayer’s–otherwise, keep it simple. The US definitely erred too much on the side of caution in ’08-’09, for which it may be rightly criticized, but it is safe to say swinging too far in the other direction may have done even more damage to the economy. Pick your poison.

Fixing the corporate income tax

Posted: February 22, 2012 by alephnaughty in Economics

First, businesses only ought to report their revenue from sales. Second, they should deduct purchases from other businesses. Third, they must also deduct labor expenses (wages & benefits). On the difference, they ought to be taxed at a flat rate. No further deductions, credits, etc. Simple.

‘Closing loopholes’ sounds good, but the devil is in the details. If it is code for taxing purchases from other businesses, for example, then these may not be loopholes worth closing. Also remember that means-testing raises marginal tax rates. If you want to close loopholes, close them for everyone, not just big businesses.

Finally, note that corporate income tax reform has little or nothing to do with stimulating the economy in the short run. By contrast, it has everything to do with long-run economic growth, the state of the government’s finances, and the distribution of wealth in society. So judge proposals on those terms.