Category Archive for: Market Failure [Return to Main]

Tuesday, March 19, 2013

The Freedom to Exert Economic and Political Power

I agree with some of this, and I definitely agree with the last sentence of the following "explanation" of inequality from John Taylor -- a "poor diagnosis of the [inequality] problem will lead us in the wrong direction":

Economic Freedom For All, by John Taylor: In talks..., I argue that shifts toward and away from the principles of economic freedom have had profound effects on economic performance. From the mid-1960s through the 1970s, deviations away from economic freedom were large, economic policy was bad, and economic performance was poor with rising unemployment and inflation and falling economic growth. During the 1980s, 1990s, and until recently, deviations were smaller, policy was better, and economic performance improved; unemployment and inflation declined and growth picked up. In recent years policy has been poor and so has economic performance with high unemployment and low economic growth.
Many ask about how changes in the distribution of income fit into this story...
A large body of research documents that returns to education started increasing in the 1980s as evidenced by the growing college and high school wage premium. ... The source of the income distribution problem is thus related to a poor education system. We are restricting educational opportunities, especially for those who are disadvantaged.
In other words the explanation for the widening inequality is the restriction of economic freedom rather than the promotion of economic freedom. Economic freedom did not mean economic freedom for all. ...
Not extending economic freedom to all in the area of education is only one example of how deviations from economic freedom can adversely affect the distribution of income. ...

Ironically some argue that moving further away from the principles of economic freedom—with higher marginal tax rates or more regulations on firms or more discretion for regulators or more interventionist macro policy—is the way to improve the economy and the distribution of income. That would be a great tragedy since history shows that over the long haul it has been more economic freedom that has pulled people out of poverty. The point is not that income distribution isn’t a problem; it is that a poor diagnosis of the problem will lead us in the wrong direction.

The increase in inequality occurred during an era of deregulation, so I can't agree with his basic premise. In any case, I am all for increasing opportunity, and for improving access to education. But the story that inequality is a result of education (and the freedom thing) doesn't hold up to closer scrutiny. It's a "poor diagnosis of the problem":

OK, I see that some people are doubling down on the claim that rising inequality is all about education — when what the CBO report drives home is that this is all wrong, the big increase has come from gains at the very top. ...
Yes, college grads have done better than non; but inequality in America is mainly a story about a small elite pulling away from everyone else, including ordinary college grads. And we’ve know this for a long time! There is no excuse for getting it wrong.

The "Regulatory capture by large firms, crony capitalism, deviations from the rule of law, [and] bailouts of the creditors of large financial firms" certainly contributed to inequality (though his comments about the Fed seem more like sour grapes than analysis). But the problems he describes such as regulatory capture, crony capitalism, etc. are largely about the economic and political power enjoyed by the wealthy. It's hard to see how having government step even further out of the way than it has since the 1970s -- less oversight, less regulation, lower taxes at the top, etc., etc. -- will solve these problems.

[Taylor also has an op-ed in the WSJ. Noah Smith responds.]

Wednesday, February 20, 2013

China Says It May Implement a Carbon Tax

China may implement a (modest) carbon tax:

Taxing Carbon, by Vikas Bajaj, NY Times: Long considered the biggest holdout in climate change negotiations, China said this week that the country would implement new taxes designed to curb greenhouse gas emissions. Officials in Beijing provided few details, but a report by the state-owned Xinhua news service suggested that the government is working on a relatively modest plan. ...
The Xinhua report ... did not say how big a tax the country would impose, but it pointed to a three-year-old proposal by government experts that would have levied a 10-yuan ($1.60) per ton tax on carbon in 2012 and raised it to 50-yuan ($8) a ton by 2020. Those prices are far below the $80 (500-yuan) a ton that some experts have suggested would be needed to achieve “climate stability,” and which would raise the cost of gasoline by about 70 American cents a gallon.
China’s plan will not make a serious dent in global warming, though the tax may still have some beneficial impact within the country, where air pollution is a serious problem. ...
Meanwhile, in the U.S., many members of Congress find the idea of carbon taxes totally anathema and think such taxes would wreck the economy. They might, however, want to consider a proposal promoted by Mr. Hansen that would take the money collected from carbon taxes — or carbon fees as he prefers to call them — and rebate it in full to individuals. That would help consumers pay for more expensive electricity and gasoline, while giving them an incentive to cut their use of energy and fossil fuels. It’s an elegant way to limit damage to the economy while giving people incentives to do what is right for the planet.

Contrary to what "many members of Congress" (i.e. many Republicans) claim, eliminating a market failure through a carbon tax moves the economy closer to the optimal growth path rather than further from it.

Tuesday, February 12, 2013

What Do Republicans Really Want?

My latest column begins with Eric Cantor's call for Republicans to talk about "helping folks":

For Obama, State of the Union Means State of the People, by Mark Thoma: House Majority Leader Eric Cantor believes that Republicans must show their concern for those struggling in this economy if they want to regain their political footing. “We’ve got to be talking about helping folks,” he said Sunday on Meet the Press, “You’ve got so many millions of Americans who feel that they have become an afterthought.”
There’s a reason people feel that way. Republicans have refused to support any of the jobs proposals president Obama has put forward...

What do Republicans really want?:

Pretending to be on the side of the middle class while enacting policies that help businesses and the wealthy has worked well in the past, so it shouldn’t be surprising to see Republicans try this again. Remember the failed promises of trickle-down economics?

But if Republicans -- and Obama -- want to steer the conversation away from the debt, I'm all for that:

President Obama also wants to change the conversation toward the needs of the millions of Americans who feel abandoned by politicians, and he intends to emphasize jobs and the economy in his State of the Union address. This is a welcome change. Instead of focusing on the debt, we should be discussing what we want the government to do. What are our priorities, what will they cost, and what can we, as a nation, afford? In the short-run, is there room for us to do more to help the unemployed? In the longer run, should government be bigger or smaller...? Can the composition of spending and taxes be improved? How fast does the debt need to be reduced, and should it be reduced through tax increase or spending cuts? As we get richer as a society – income doubles every thirty years or so – should the share of GDP devoted to helping people increase, or should government’s share of output be limited to historical averages as many conservatives argue?

As we discuss these important questions about the size and role of government, we need to remember something that has been forgotten too often amid Republican attempts limit government intervention into the economy. The government has an important role to play in overcoming market failures... The private sector, on its own, will not provide the correct amounts of infrastructure, retirement security, health care spending, protection against monopoly and corruption, unemployment insurance, national defense, environmental regulation, education, food and drug safety, bank regulation, innovation, anti-trust action, safe working conditions, support of basic research, stabilization policy, and so on. Fixing these market failures through government action does not distort private sector economic activity away from the optimal outcome as many on the right would have us believe, it moves us closer to the ideal textbook economy. ...

Full column here.

Wednesday, February 06, 2013

Jagdish Bhagwati Does Not Seem to Like Al Gore

Not sure where to start with this one other than to note that Jagdish Bhagwati does not seem to like Al Gore:

Futurama, by Jagdish Bhagwati: ...Al Gore ... surely succeeded beyond his wildest expectations as the author of An Inconvenient Truth. But his phenomenal success had little to do with science (which has remained somewhat controversial: many of us remember for instance the not-too-distant scare about global cooling, also from climate scientists) and much to do with the photographs of polar bears caught on drifting ice as glaciers melted. An image like that is what we all need when we push our pet agendas. Alas, none of us is so fortunate. Nor is Gore as he turns now to writing about our future. ...
The problem Gore faces in the bulk of this book therefore is that his identification of problems, and his proposed solutions, are not compelling. His erudition is considerable but is necessarily limited since he casts his net wide, and he is both unfamiliar with important issues pertinent to his analysis and also shallow in his prescriptions for remedial policies. ...
Given Gore’s justified reputation on climate change, a disappointing feature of Gore’s book is in the chapter titled “The Edge.” I agree with him that the evidence on climate change, and the contribution to it by man-made carbon emissions, is about as good as science can provide; and he is persuasive in his sketch of the scenario of the dangers that global warming, unchecked, hold for mankind. Where he fails is in the remedies that he discusses. To focus on just one issue: there is now agreement from the last meeting at Cancún on the attempted renewal of Kyoto Protocol that $100 billion be found annually to create new technologies of mitigation and adaptation to climate change. It is expected that a significant share of this will be public funds. We have the precedent that public monies should largely be used to create public good: thus the new seeds under the green revolution were publicly financed and they were available to everyone virtually for free. Should we then not expect the green technologies developed with public funds to be available for free to Mars, China, and India?
But, to my knowledge, Gore has not embraced this proposal, which would make, say, India accept more ambitious targets of carbon reduction because it would reduce the cost of doing so. I would not make the ferocious charges that Gore levels at the opponents of climate change (see page 283). But may I wonder whether the reason for Gore’s omission is that he is heavily invested in green-energy stocks and would like to see public funds to be used only for private payoffs by these firms?
The good in the book is therefore offset by the bad. But even the bad will produce good if it irritates us into thinking harder about the many issues that Gore correctly insists we must confront.

Gore's sin is not embracing a particular proposal, and it must be because "he is heavily invested in green-energy stocks?" Pretty thin charge, and pretty speculative -- I expected a more compelling complaint. (Bhagwati agress with Gore on the science, says he's persuasive, etc., and acts like the know-it-all judge of all things related to climate change, yet he tosses out the global cooling thing? There's a reason this is called the "global cooling myth.")

In another part, I was surprised to hear a call for unions:

...The problem in this world of competition among similar products is that comparative advantage is now fragile: it has a “knife-edge” quality. One day you have it; the next day you do not. Almost every entrepreneur has a rival breathing down his neck; and this need not be from China or India, with their “low wages”—what Gore frets about—but may be Poland or France or Sweden. There are three implications.
First, firms need flexibility in firing if they are to hire.
Second, we can no longer assure economic security for workers by giving them lifetime employment. The security has to be for the worker herself, unrelated to specific occupation and employment.
Third, the volatility also means that we can no longer expect firms to provide training and hence “human capital” to blue-collar workers who can be expected to leave at the next sign of trouble at their plant or firm. We therefore have to provide this human capital through efforts by unions, employers, community colleges, etc.
Gore also accepts uncritically the notion that we are doomed to greater inequality in a globalized world of trade and multinational investment. The evidence is more mixed than he reports...

I think it would only be fair to note the incentives work the other way as well. With firms willing to fire workers at the drop of a hat -- older social obligations to retain workers through tough times are largely gone -- there's no incentive for workers to invest in themselves if the human capital is unique to the particular firm. Why bother if you are unlikely to be there for very long? (That is, I don't think the problem is workers who "leave at the next sign of trouble." f course they'll leave for another opportunity if they fear they'll be fired in the near future due to the "trouble.")

Wednesday, January 30, 2013

'The Real, and Simple, Equation That Killed Wall Street'

I'm sympathetic to the argument that excess leverage was a problem in the financial crisis, but I don't see it the primal cause of the recession. Instead, leverage iss a magnifier that makes things much, much worse when problems occur:

The Real, and Simple, Equation That Killed Wall Street, by Chris Arnade, Scientific American: ...It ... is the overly simple narrative that many in the media have spun about the last financial crisis. Smart meddling kids armed with math hoodwinked us all.
One article, from the March 2009 Wired magazine, even pinpointed an equation and a mathematician. The article “Recipe for Disaster: The Formula That Killed Wall Street,” accused the Gaussian Copula Function.
It was not the first piece that made this type of argument, but it was the most aggressive. ...
This theme plays on the fallacy that danger always comes from complexity. ...
The reality is much simpler and less sexy. Wall Street killed itself in a time-honored fashion: Cheap money, excessive borrowing, and greed. And yes, there is an equation one can point to and blame. This equation, however, requires nothing more than middle school algebra to understand and is taught to every new Wall Street employee. It is leveraged return. ...
The Gaussian Copula Function, opaque to most, is convenient to blame. It allows us to shake off our collective sense of guilt. It obscures the real crime...

I'm willing to blame leverage for contributing to the magnitude of the crisis, and I've long-called for limits on leverage to mute the negative effects of the next financial recession, which will come no matter how hard we try to avoid it. But I don't think it's correct to blame leverage itself for our problems, i.e. that "there is an equation one can point to and blame."

[The article actually notes many other factors, e.g. bad incentives for ratings agencies, failures of regulation, easy moneary policy by the Fed, and so on, but still ends up focusing on the leverage component as the key factor. In any case, the article is directed squarely at Felix Salmon, and I'm posting this in the hope that it will help prod him into responding.]

Sunday, January 27, 2013

Climate Policy in Obama's Second Term

I think of Robert Stavins as being on the optimistic side when it comes to action on climate change, but even he seems discouraged despite Obama's mention of this issue in his inaugural address:

The Second Term of the Obama Administration, by Robert Stavins: In his inaugural address on January 21st, President Obama surprised many people – including me – by the intensity and the length of his comments on global climate change.  Since then, there has been a great deal of discussion in the press and in the blogosphere about what climate policy initiatives will be forthcoming from the administration in its second term. ...
Although I was certainly surprised by the strength and length of what the President said in his address, I confess that it did not change my thinking about what we should expect from the second term.  Indeed, I will stand by an interview that was published by the Harvard Kennedy School on its website five days before the inauguration (plus something I wrote in a previous essay at this blog in December, 2012).  Here it is, with a bit of editing to clarify things, and some hyperlinks inserted to help readers. ...
Q: In the Obama administration’s second term, are there openings/possibilities for compromises...?
A: It is conceivable – but in my view, unlikely – that there may be an opening for implicit (not explicit) “climate policy” through a carbon tax. At a minimum, we should ask whether the defeat of cap-and-trade in the U.S. Congress, the virtual unwillingness over the past 18 months of the Obama White House to utter the phrase “cap-and-trade” in public, and the defeat of Republican Presidential candidate Mitt Romney indicate that there is a new opening for serious consideration of a carbon-tax approach to meaningful CO2 emissions reductions in the United States.
First of all, there surely is such an opening in the policy wonk world. Economists and others in academia, including important Republican economists such as Harvard’s Greg Mankiw and Columbia’s Glenn Hubbard, remain enthusiastic supporters of a national carbon tax. And a much-publicized meeting in July, 2012, at the American Enterprise Institute in Washington, D.C. brought together a broad spectrum of Washington groups – ranging from Public Citizen to the R Street Institute – to talk about alternative paths forward for national climate policy. Reportedly, much of the discussion focused on carbon taxes.
Clearly, this “opening” is being embraced with enthusiasm in the policy wonk world. But what about in the real political world? The good news is that a carbon tax is not “cap-and-trade.” That presumably helps with the political messaging! But if conservatives were able to tarnish cap-and-trade as “cap-and-tax,” it surely will be considerably easier to label a tax – as a tax! Also, note that President Obama’s silence extends beyond disdain for cap-and-trade per se. Rather, it covers all carbon-pricing regimes.
So as a possible new front in the climate policy wars, I remain very skeptical that an explicit carbon tax proposal will gain favor in Washington. ...
A more promising possibility – though still unlikely – is that if Republicans and Democrats join to cooperate with the Obama White House to work constructively to address the short-term and long-term budgetary deficits the U.S. government faces,... then there could be a political opening for new energy taxes, even a carbon tax. ...
Those who recall the 1993 failure of the Clinton administration’s BTU-tax proposal – with a less polarized and more cooperative Congress than today’s – will not be optimistic. ... The key group to bring on board will presumably be conservative Republicans, and it is difficult to picture them being more willing to break their Grover Norquist pledges because it’s for a carbon tax.

Here's the surprising part (to me anyway), some optimism after all:

What remains most likely to happen is what I’ve been saying for several years, namely that despite the apparent inaction by the Federal government, the official U.S. international commitment — a 17 percent reduction of CO2 emissions below 2005 levels by the year 2020 – is nevertheless likely to be achieved!  The reason is the combination of CO2 regulations which are now in place because of the Supreme Court decision [freeing the EPA to treat CO2 like other pollutants under the Clean Air Act], together with five other regulations or rules on SOX [sulfur compounds], NOX [nitrogen compounds], coal fly ash, particulates, and cooling water withdrawals. All of these will have profound effects on retirement of existing coal-fired electrical generation capacity, investment in new coal, and dispatch of such electricity.
Combined with that is Assembly Bill 32 (AB 32) in the state of California, which includes a CO2 cap-and-trade system that is more ambitious in percentage terms than Waxman-Markey was in the U.S. Congress, and which became binding on January 1, 2013. ...  In other words, there will be actions having significant implications for climate, but most will not be called “climate policy,” and all will be within the regulatory and executive order domain, not new legislation. ...

Thursday, January 24, 2013

'Robots and All That'

Fred Moseley responds to my comments on his comments (I suggested that if he wants a theory of exploitation that is consistent, he should consider dropping Marx's Labor Theory of Value, which does not actually explain value, and instead explain exploitation in more modern terms, i.e. with reference to why workers have not received their marginal products in recent decades):

Thanks to Mark for posting my critical comment on Krugman’s explanation of stagnant real wages and declining wage share of income, and for his introductory comment, which raises fundamental issues.
A question for Mark: how do you know what the “MP benchmark” is that workers should have received. The MP benchmark is presumably the “marginal product of labor”, but how do you know what this is? I know of no time series estimates of the aggregate MPL (independent of income shares) for recent decades. If you know of such estimates, please send me the reference(s).
What you have in mind may be estimates like Mishel’s estimates of the “productivity of labor” and the “real wage of production workers”, which shows a widening gap in recent years (see Figure A in “The wedges between productivity and median compensation growth”; ). But these estimates of the “productivity of labor” are not of the MPL of marginal productivity theory, but are instead the total product divided by total labor. These estimates are more consistent with Marxian theory than with marginal productivity theory. And I agree that explaining this divergence is an important key to understanding the increasing inequality in recent decades. I think the explanation has to do with a number of factors that have put downward pressure on wages: higher unemployment, outsourcing and threat of more, declining real minimum wage, attacks on unions, etc. This is very different from Krugman’s “capital-biased technological change”.
A word on the labor theory of value: the LTV is not mainly a micro theory of prices, but is instead primarily a macro theory of profit. And I think that it is the best theory of profit by far in the history of economics (there is not much competition). It explains a wide range of important phenomena in capitalist economies: conflicts over wages, and conflicts over the length of the working day and the intensity of labor in the workplace, endogenous technological change, trends and fluctuations in the rate of profit over time, endogenous causes of economic crises, etc. (For further discussion of the explanatory power of Marx’s theory see my “Marx Economic Theory: True or False? A Marxian Response to Blaug’s Appraisal”, in Moseley (ed.) Heterodox Economic Theories: True or False?; available here:
Marginal productivity, in very unfavorable contrast, can explain none of these important phenomena.
Thanks again.
Fred

Just one comment. If the LTV cannot explain input or output prices, and it doesn't, how can it explain profit?

(Okay, two -- In defense of Krugman, his book Conscience of a Liberal was anything but a “capital-biased technological change” explanation of rising inequality, and he stated the “capital-biased technological change” explanation as something to look into rather than a conclusion he has drawn. For example, he says:

More on robots and all that ... there’s another possible resolution: monopoly power. Barry Lynn and Philip Longman have argued that we’re seeing a rapid rise in market concentration and market power. The thing about market power is that it could simultaneously raise the average rents to capital and reduce the return on investment as perceived by corporations, which would now take into account the negative effects of capacity growth on their markups. So a rising-monopoly-power story would be one way to resolve the seeming paradox of rapidly rising profits and low real interest rates. As they say, this calls for more research; but the starting point is to realize that there’s something happening here, what it is ain’t exactly clear, but it’s potentially really important.

So I don't think it's completyely fair to say that Krugman's explanation for rising inequality is "capital-biased technological change.")

Saturday, January 19, 2013

Financial Collapse: A 10-Step Prevention Plan

Alan Blinder lists "10 financial commandments, all of which were brazenly violated in the years leading up to the crisis":

Financial Collapse: A 10-Step Recovery Plan, by Alan S. Blinder: ...let me try to encapsulate what we must remember about the financial crisis...:
1. Remember That People Forget ...
2. Do Not Rely on Self-Regulation ...
3. Honor Thy Shareholders ...
4. Elevate Risk Management ...
5. Use Less Leverage ...
6. Keep It Simple, Stupid ...
7. Standardize Derivatives and Trade Them on Exchanges ...
8. Keep Things on the Balance Sheet ...
9. Fix Perverse Compensation ...
10. Watch Out for Consumers ...
Mark Twain is said to have quipped that while history doesn’t repeat itself, it does rhyme. There will be financial crises in the future, and the next one won’t be a carbon copy of the last. Neither, however, will it be so different that these commandments won’t apply. ...

Wednesday, January 09, 2013

The FTC and Google

Shane Greenstein:

The FTC and Google: What did Larry Learn?, by Shane Greenstein: The FTC and Google settled their differences last week, putting the final touches on an agreement. Commentators began carping from all sides as soon as the announcement came. The most biting criticisms have accused the FTC of going too easy on Google. Frankly, I think the commentators are only half right. Yes, it appears as if Google got off easy, but, IMHO, the FTC settled at about the right place.
More to the point, it is too soon to throw a harsh judgment at Google. This settlement might work just fine, and if it does, then society is better off than it would have been had some grandstanding prosecutor decided to go to trial.
Why? First, public confrontation is often a BIG expense for society. Second, as an organization Google is young and it occupies a market that also is young. The first big antitrust case for such a company in such a situation should substitute education for severe judgment.
Ah, this will take an explanation. ...

Monday, January 07, 2013

The Reason We Lose at Games: Implications for Financial Markets

Something to think about:

The reason we lose at games, EurekAlert: Writing in PNAS, a University of Manchester physicist has discovered that some games are simply impossible to fully learn, or too complex for the human mind to understand.
Dr Tobias Galla from The University of Manchester and Professor Doyne Farmer from Oxford University and the Santa Fe Institute, ran thousands of simulations of two-player games to see how human behavior affects their decision-making.
In simple games with a small number of moves, such as Noughts and Crosses the optimal strategy is easy to guess, and the game quickly becomes uninteresting.
However, when games became more complex and when there are a lot of moves, such as in chess, the board game Go or complex card games, the academics argue that players' actions become less rational and that it is hard to find optimal strategies.
This research could also have implications for the financial markets. Many economists base financial predictions of the stock market on equilibrium theory – assuming that traders are infinitely intelligent and rational.
This, the academics argue, is rarely the case and could lead to predictions of how markets react being wildly inaccurate.
Much of traditional game theory, the basis for strategic decision-making, is based on the equilibrium point – players or workers having a deep and perfect knowledge of what they are doing and of what their opponents are doing.
Dr Galla, from the School of Physics and Astronomy, said: "Equilibrium is not always the right thing you should look for in a game."
"In many situations, people do not play equilibrium strategies, instead what they do can look like random or chaotic for a variety of reasons, so it is not always appropriate to base predictions on the equilibrium model."
"With trading on the stock market, for example, you can have thousands of different stock to choose from, and people do not always behave rationally in these situations or they do not have sufficient information to act rationally. This can have a profound effect on how the markets react."
"It could be that we need to drop these conventional game theories and instead use new approaches to predict how people might behave."
Together with a Manchester-based PhD student the pair are looking to expand their study to multi-player games and to cases in which the game itself changes with time, which would be a closer analogy of how financial markets operate.
Preliminary results suggest that as the number of players increases, the chances that equilibrium is reached decrease. Thus for complicated games with many players, such as financial markets, equilibrium is even less likely to be the full story.

Thursday, January 03, 2013

Health Exchanges: Competition versus Standardization

Jonathan Gruber describes a "central tension" in online health exchanges: more choices and more competition versus standardization that makes choices between plans abundantly clear:

The health-insurance markets of the (very near) future, MIT News: An online health-insurance exchange is coming to your state. How effective will it be?

That is an increasingly important question in the United States. In June 2012, the Supreme Court upheld the legality of the country’s Affordable Care Act, passed by Congress and signed into law by President Barack Obama in 2010. The program mandates private-sector health insurance for all citizens, and provides subsidies for those who otherwise could not afford it. Insurance-plan choices will be available through exchanges, or marketplaces; most people will be able to study plans and sign up for one online. As of December, nearly 20 states have elected to run exchanges themselves; the federal government will run the exchanges in other states.

And therein lies a key issue: Creating a consumer-friendly exchange is no easy task. It is hard enough to know what kinds of foods we should eat, which cars to drive, or which apps to use. Selecting an insurance plan is a far more complex decision.

“Health insurance is a confusing and difficult choice,” says Jonathan Gruber, a professor of economics at MIT who specializes in health-care issues. “It’s important that people make decisions in an organized and effective market. In that way they can make the best choices, and we can ensure the best level of competition among insurers.” ...

Moreover, as Gruber readily acknowledges, state-run insurance exchanges must pull off a difficult balancing act. The point of markets is to provide competition, but academic research shows that when people are given too many choices, they struggle to select logical options for themselves.

“The tension that exchanges face,” Gruber says, “is [having] enough standardization to make choice and competition work effectively, but not so much standardization that people can’t find the plans that best fit their tastes. That’s absolutely a central tension.” To handle this challenge, policymakers and academic researchers will almost certainly have to collaborate in productive ways.

Indeed, plenty of research suggests that America’s existing health-care offerings are already too complex. ...[more]...

Wednesday, December 26, 2012

'A Conservative Case for the Welfare State'

Bruce Bartlett argues conservatives should support the welfare state:

A Conservative Case for the Welfare State, by Bruce Bartlett, Commentary, NY Times: At the root of much of the dispute between Democrats and Republicans over the so-called fiscal cliff is a deep disagreement over the welfare state. Republicans continue to fight a long-running war against Social Security, Medicare, Medicaid and many other social-welfare programs that most Americans support overwhelmingly and oppose cutting. ...
This is foolish and reactionary. Moreover, there are sound reasons why a conservative would support a welfare state. Historically, it has been conservatives like the 19th century chancellor of Germany, Otto von Bismarck, who established the welfare state in Europe. They did so because masses of poor people create social instability and become breeding grounds for radical movements.
In postwar Europe, conservative parties were the principal supporters of welfare-state policies in order to counter efforts by socialists and communists to abolish capitalism altogether. The welfare state was devised to shave off the rough edges of capitalism and make it sustainable. Indeed, the conservative icon Winston Churchill was among the founders of the British welfare state.
American conservatives, being far more libertarian than their continental counterparts, reject the welfare state for both moral and efficiency reasons. It creates unhappiness, they believe, and inevitably becomes bloated, undermining incentives and economic growth.
One problem with this conservative view is its lack of an empirical foundation. Research by Peter H. Lindert of the University of California, Davis, shows clearly that the welfare state is not incompatible with growth while providing a superior quality of life to many of those left to sink or swim in America. ...
There are many ... ways ... in which what the conservatives call bloated European welfare states are actually very efficient. ...
American conservatives routinely assert that the people of Europe live in virtual destitution because of their swollen welfare states. But according to a commonly accepted index of life satisfaction, many heavily taxed European countries rank well above the United States...

If conservatives want to support the welfare state out of the desire to defend capitalism from "socialists and communists" -- to defend it against the instability that high degrees of inequality cause -- no problem, though it's interesting that they would acknowledge that the system itself can lead to societal inequities that are so dangerous the government needs to intervene to fix them. I prefer the efficiency argument (which is not to say that the other argument has no merit, it does). When there are substantial market failures -- the type that exist in retirement and health markets for example -- the government can make these markets work better through rules, mandates, and other regulatory interventions, or it can provide the services itself. Whether a heavily regulated private market will work better than the government providing services itself in the presence of substantial market failures is something that can be debated, and in general the lines aren't always clear. But for health and retirement markets it does appear that direct government provision works better than heavily regulated markets (i.e. "privatization"). In any case, the broader point is that the government provision of social insurance either directly or indirectly can be justified on an efficiency argument, i.e. as a means of overcoming market failures that prevent the private sector from providing these important goods and services in sufficient quantities at the lowest possible price.

Friday, December 21, 2012

What Do Economists Know (about Guns)?

Stephen Williamson:

Guns, by Stephen Williamson: Like most of you, I've been thinking about guns for the last few days. As economists, what do we have to say about gun control? ...

What's the problem here? ... The people who buy the guns and use them seem to enjoy having them. But there are third parties who suffer. ...
There are also information problems. It may be difficult to determine who is a hunter, who is temporarily not in their right mind, and who wants to put a loaded weapon in the bedside table.

What do economists know? We know something about information problems, and we know something about mitigating externalities. Let's think first about the information problems. Here, we know that we can make some headway by regulating the market so that it becomes segmented, with these different types of people self-selecting. This one is pretty obvious, and is a standard part of the conversation. Guns for hunting do not need to be automatic or semi-automatic, they do not need to have large magazines, and they do not have to be small. If hunting weapons do not have these properties, who would want to buy them for other purposes?

On the externality problem, we can be more inventive. A standard tool for dealing with externalities is the Pigouvian tax..., the Pigouvian tax we would need to correct the externality should be a large one, and it could generate a lot of revenue. If there are 300 million guns in the United States, and we impose a tax of $3600 per gun on the current stock, we would eliminate the federal government deficit. But $3600 is coming nowhere close to the potential damage that a single weapon could cause. A potential solution would be to have a gun-purchaser post collateral - several million dollars in assets - that could be confiscated in the event that the gun resulted in injury or loss of life. This has the added benefit of mitigating the moral hazard problem - the collateral is lost whether the damage is "accidental" or caused by, for example, someone who steals the gun.

Of course, once we start thinking about the size of the tax (or collateral) needed to correct the inefficiency that exists here, we'll probably come to the conclusion that it is more efficient just to ban particular weapons and ammunition at the point of manufacture. I think our legislators should take that as far as it goes.

Wednesday, December 19, 2012

Inflation is Caused by Monopoly Power?

Why would a reputable economist endorse nonsense like this from Mickey Kaus (you know who you are):

If increased concentration lets ”corporations use their growing monopoly power to raise prices” couldn’t that be, you know, inflationary? But Krugman’s spent another trillion pixels lecturing us about how inflation is not a threat. Discuss.

One possible answer, Krugman Derangement Syndrome. [There's more nonsense where that came from, and not just in this article, but I just can't link the Daily Caller in good conscience.]

Wednesday, December 12, 2012

Just Sayin': It May Already Be Too Late

Tim Haab:

Just sayin': I was thinking of writing a lengthy post about climate change denial being completely unscientific nonsense, but then geochemist and National Science Board member James Lawrence Powell wrote a post that is basically a slam-dunk of debunking. His premise was simple: If global warming isn’t real and there’s an actual scientific debate about it, that should be reflected in the scientific journals.
He looked up how many peer-reviewed scientific papers were published in professional journals about global warming, and compared the ones supporting the idea that we’re heating up compared to those that don’t. What did he find? This:

Powell-Science-Pie-Chart[1]The thin red wedge.   Image credit: James Lawrence Powell

Maximillian Auffhammer at the Berkeley blog:

Doha schmoha: On Saturday (Dec. 8) another wildly unsuccessful round of climate negotiations, in Doha, Qatar, concluded with applying a band aid to solve the rapidly accelerating climate problem. The 1997 Kyoto accord was extended to 2020. If you think this is a good thing, you are severely mistaken. China, the US and the other usual suspects made no significant concessions. Further,  the climate leader — the EU — is internally in disagreement over what reductions should be agreed to. ...
While academics have proposed a number of interesting avenues for further studies of so called architectures for future agreements, time is slowly running out. It is simply too difficult to get 200+ countries to agree and then stick to a binding agreement. So what to do?
I think a simple handshake between the U.S. and China would be a good start. Each agrees to a carbon tax which is collected fairly far upstream. Any country wanting to sell its goods into the U.S. or Chinese markets could either pay a carbon tariff at the border or start charging its own equivalent carbon tax and be exempt from the tariff.
Is this going to happen? Maybe not...
But one thing is for sure: We are becoming richer as a species and we will want to consume more energy services. Unless we start pricing carbon, that energy will largely come from coal. And if that happens, limiting warming to 2 degrees is a pipe dream. In fact, it may already be too late.

Tuesday, December 11, 2012

'Jobs, Productivity, and the Great Decoupling'

This is not starting off as the greatest day ever. Grrr. A quick one on inequality while I sort things out:

Jobs, Productivity and the Great Decoupling, by Erik Btynjolfsson and Andrew McAffee, Commentary, NY Times: ...For several decades after World War II ... G.D.P. grew, and so did productivity... At the same time, we created millions of jobs, and many of these were the kinds of jobs that allowed the average American worker, who didn’t (and still doesn’t) have a college degree, to enjoy a high and rising standard of living. ...

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But as shown by the accompanying graph, which was first drawn by the economist Jared Bernstein, productivity growth and employment growth started to become decoupled from each other at the end of that decade. Bernstein calls the gap that’s opened up “the jaws of the snake.” They show no signs of closing. ... Wages as a share of G.D.P. are now at an all-time low, even as corporate profits are at an all-time high. The implicit bargain that gave workers a steady share of the productivity gains has unraveled.
What’s going on? ... There are several explanations, including tax and policy changes and the effects of globalization and off-shoring. We agree that these matter but want to stress another driver of the “Great Decoupling” — the changing nature of technological progress. ...
The Great Decoupling is not going to reverse course... And this should be great news for society. Digital progress lowers prices, improves quality, and brings us into a world where abundance becomes the norm.
But there is no economic law that says digital progress will benefit everyone evenly. ... Designing a healthy society to go along with such an economy will be the great challenge, and the great opportunity, of the next generation. ...

As I've stressed in the past many, many times, I believe the growth in economic power and the political power that comes with it is also a factor, and this has distorted the distribution of income away from working class households (the market power and technological progress explanations aren't mutually exclusive, and may be complementary -- I should also mention political factors as well, e.g. the politics behind the demise in unions, as another cause even though I think of this as part of the economic/political power explanation).

'The Political Economy of Inequality'

In light of the recent attention on the importance of capital ownership as source of inequality, Arin Dube reminds me of this piece in the Economists' Voice from March 2012 that he published along with Ethan Kaplan ("Occupy Wall Street and the Political Economy of Inequality"). They argue that upper tail income inequality is best understood through the lens of increasing power of those owning capital. Here is an excerpt provided by Arin: 

... During the 1990s and 2000s, most economists viewed the growth in the upper-tail inequality as largely representing the same phenomenon as the growth in wage inequality elsewhere—primarily a change in the demand for skills through technological change, with some role for policy ...  Missing from all this was a discussion about how upper-tail earnings inequality could be better understood as an increase in the power of those with control over financial and physical capital. The exceptions were mostly outside of mainstream economics (e.g., Duménil and Lévy 2004). 
Consider three pieces of evidence. First, there has been a broad decline in the labor share of income from around 66 percent in 1970 to 60 percent in 2007. Moreover, as measured, labor income includes compensation going to top executives—the modern day equivalent of the nineteenth century capitalist. The exclusion of their compensation would show a substantially greater drop in labor’s share. Additionally, most of the growth in executive compensation has been capital-based, i.e., through stock options but appears in national accounts as labor income (Frydman and Molloy 2011).
Second, based on tax data, the majority of income at the top comes from capital-based earnings (capital gains, dividends, entrepreneurial income and rent). In 2007, this proportion was 62 percent and 74 percent for the top 1 percent and 0.1 percent, respectively (Figure 1).
Third, the biggest driver of upper-tail inequality—both in terms of capital and wage based income—was finance, the sector which governs the allocation of capital. Between 2002 and 2007, 34 percent of all private sector profits came from the financial sector. Meanwhile, studies of financial sector pay setting suggest that the exorbitant finance premium in earnings was driven by financial sector profits (Philippon and Resheff 2009, Crotty 2011).
Overall, a focus on the 1 percent concentrates attention on the aspect of inequality most clearly tied to the distribution of income between labor and capital. This type of inequality is seen as being the least fair, as economic rents and returns to wealth are often perceived as unearned income (Atkinson 2009). ...

Monday, December 10, 2012

Paul Krugman: Robots and Robber Barons

I have been arguing for some time now "that we have paid too little attention to the growing economic and political power of our largest firms," and that this is a factor in the "maldistribution" of income, so it's nice to see this issue get more attention:

Robots and Robber Barons, by Paul Krugman, Commentary, NY Times: The American economy is still, by most measures, deeply depressed. But corporate profits are at a record high. How is that possible? It’s simple:... profits have been rising at the expense of workers in general, including workers with the skills that were supposed to lead to success in today’s economy.
Why is this happening? As best as I can tell, there are two plausible explanations, both of which could be true to some extent. One is that technology has taken a turn that places labor at a disadvantage; the other is that we’re looking at the effects of a sharp increase in monopoly power. Think of these two stories as emphasizing robots on one side, robber barons on the other.
About the robots: there’s no question that in some high-profile industries, technology is displacing workers of all, or almost all, kinds. ... What’s striking ... is that many of the jobs being displaced are high-skill and high-wage; the downside of technology isn’t limited to menial workers. ...
What about robber barons? We don’t talk much about monopoly power these days; antitrust enforcement largely collapsed during the Reagan years and has never really recovered. Yet Barry Lynn and Phillip Longman of the New America Foundation argue, persuasively in my view, that increasing business concentration could be an important factor in stagnating demand for labor, as corporations use their growing monopoly power to raise prices without passing the gains on to their employees.
I don’t know how much of the devaluation of labor either technology or monopoly explains, in part because there has been so little discussion of what’s going on. I think it’s fair to say that the shift of income from labor to capital has not yet made it into our national discourse.
Yet that shift is happening — and it has major implications. For example, there is a big, lavishly financed push to reduce corporate tax rates; is this really what we want to be doing at a time when profits are surging at workers’ expense? Or what about the push to reduce or eliminate inheritance taxes; if we’re moving back to a world in which financial capital, not skill or education, determines income, do we really want to make it even easier to inherit wealth?
As I said, this is a discussion that has barely begun — but it’s time to get started, before the robots and the robber barons turn our society into something unrecognizable.

Sunday, December 09, 2012

'GOP Fires Author of Copyright Reform Paper'

This is pretty Mickey Mouse. Republicans have fired a staffer for daring to put market reform -- making markets work better like Republicans say they favor -- ahead of special interests.:

GOP fires author of copyright reform paper, by Cory Doctorow: Derek Khanna, the Republican House staffer who wrote an eminently sensible paper on copyright reform that was retracted less than a day later has been fired. So much for the GOP's drive to attract savvy, net-centric young voters. After all, this is the party that put SOPA's daddy in charge of the House Tech and Science Committee.
But it's pretty terrible for Khanna -- what a shabby way of dealing with dissent within your ranks.

From the linked article:

it's now been confirmed that, due to significant lobbying pressure by the entertainment industry and (even more so) the US Chamber of Commerce, Derek Khanna ... has been let go from his job.

Where's the outrage from sensible Republicans (I checked Mankiw, but he's whining about taxes on the wealthy again today -- big surprise there)? Saying Republicans support free markets is almost as funny as saying they want lower taxes on the wealthy because of the wondrous economic growth miracle lower taxes would bring us. (Can you feel that miracle all around us from the vastly lower taxes we already have? No? You must be in the wrong income class.) Republicans want what's good for the people who pay for their campaigns, nothing more, nothing less, and they'll use whatever arguments get them there.

Thursday, December 06, 2012

'Climate Science Predictions Prove Too Conservative'

Don't say you weren't warned about the risks of climate change, though you might be able to say you weren't adequately warned:

Climate Science Predictions Prove Too Conservative, by Glenn Scherer and DailyClimate.org: Across two decades and thousands of pages of reports, the world's most authoritative voice on climate science has consistently understated the rate and intensity of climate change and the danger those impacts represent, say a growing number of studies on the topic. 
This conservative bias, say some scientists, could have significant political implications, as reports from the group – the U.N. Intergovernmental Panel on Climate Change – influence policy and planning decisions worldwide, from national governments down to local town councils.
As the latest round of United Nations climate talks in Doha wrap up this week, climate experts warn that the IPCC's failure to adequately project the threats that rising global carbon emissions represent has serious consequences: The IPCC’s overly conservative reading of the science, they say, means governments and the public could be blindsided by the rapid onset of the flooding, extreme storms, drought, and other impacts associated with catastrophic global warming. ...

Wednesday, December 05, 2012

A Counter Example to the 'Tragedy of the Commons'

Running late -- have a dissertation proposal defense to get to, then a final to give to my Ph.D. students -- so a quick one:

A Counter Example to the "Tragedy of the Commons", by Matthew Kahn: ...This OP-ED by Andrew Kahrl is actually quite interesting. ... For at least 20 years, I have lectured on the "tragedy of the commons" that takes place both in cities and in the oceans. Consider a smoker in a city...[numerical example]. This is a simple example of the tragedy of the commons --- this smoker unintentionally degraded the commons as he pursued his privately optimal action. The same logic applies to over-fishing in common oceans. One "solution" to this property rights issue is to privatize the commons and the owner would charge a price to allow the smoker to smoke and the smoker would only smoke if he is willing to pay this fee.

We can now evaluate Professor Kahrl's claims. He argues that the privatization of beaches in the Northeast is the reason that Hurricane Sandy caused so much damage.

He writes; "By increasing the value of shoreline property and encouraging rampant development, the trend toward privatizing formerly public space has contributed in no small measure to the damage storms like Hurricane Sandy inflict. Tidal lands that soaked up floodwaters were drained and developed. Jetties, bulkheads and sea walls were erected, hastening erosion. And sand dunes — which block rising waters but also profitable ocean views — were bulldozed." ...
Kahrl is saying that capitalism and the pursuit of aesthetic beauty nudged us to drop our guard and destroy Mother Nature's coastal defense system. .... For this claim to be true, he must assume that the tragedy of the commons would not have degraded such natural capital. This may be true.

Mother Nature is now engaging in a takings as she tries to seize coastal property from incumbent owners. I say let her win. These place based stakeholders want to use your tax dollars as funds to build a wall around them. A compromise would be for the state government to buy these properties and knock them down and revitalize the natural capital adaptation strategies that the author lists. ...

Tuesday, November 20, 2012

The Bigger They Are, the Harder They Fall on the Rest of Us

We are live:

The Bigger They Are, The Harder They Fall on the Rest of Us

The title at the link is about breaking up big banks, but one of the points is that the growing problems associated with size/interconnectedness, including those associated with too big to fail, occur in more than just the financial sector. These problems are getting worse, and the question is, what are we going to do about it?

Saturday, November 17, 2012

'House Republicans Release Watershed Copyright Reform Paper'

Via Boing Boing:

House Republicans release watershed copyright reform paper, by Cory Doctorow Three Myths about Copyright Law and Where to Start to Fix it (PDF) is a position paper just released by House Republicans, advocating for a raft of eminently sensible reforms to copyright law, including expanding and clarifying fair use; reaffirming that copyright's purpose is to serve the public interest (not to enrich investors); to limit statutory damages for copyright infringement; to punish false copyright claims; and to limit copyright terms.
This is pretty close to the full raft of reforms that progressive types on both sides of the US political spectrum have been pushing for. It'll be interesting to see whether the Dems (who have a much closer relationship to Hollywood and rely on it for funding) are able to muster any support for this. ...

[Update: See also Radicals for Capitalism at Crooked Timber.]

[Update: Rajiv Sethi tweets: Amazing. The RSC policy brief on copyright law has been disavowed and taken down. I've posted a copy here.]

'The Role of Firms in Aggregate Fluctuations'

Firms that are large, highly interconnected with other firms, and in concentrated industries -- large financial firms fit this description, but there are firms like this in other industries too -- have a surprisingly large effect on aggregate fluctuations (note also that average firm size is growing, and notably for the discussion below, "at the very top end of the scale, the world’s biggest firms keep on getting bigger"). There are lots of reasons to worry about the presence of large, dominant firms in an industry, excessive economic and political power for one (in my view there is too little attention to this issue outside of the financial sector), and this extends the list:

The role of firms in aggregate fluctuations, by Julian di Giovanni, Andrei Levchenko, Isabelle Méjean, Vox EU: Practical discussions of macroeconomic fluctuations are often couched in terms of the impact of individual firms on aggregate GDP. For instance, according to JPMorgan, sales of Apple’s iPhone 5 could add as much as half a percentage point to US 4th quarter GDP growth this year (CNBC 2012). In France, the recent poor performance of Renault and Peugeot is expected to induce a domino effect across the production chain. Since it is believed that each job lost in Renault leads to the disappearance of two or three suppliers of automobile parts, an adverse shock to this car manufacturer could drag down aggregate growth in the French economy (Le Point 2012). These two examples pertain to very large economies, but in smaller countries the contribution of individual large firms to aggregate fluctuations is likely to be even more noticeable (di Giovanni and Levchenko 2012).

The role of firms in the business cycle

By contrast, the role of firms in the business cycle has received comparatively less attention in the literature; the majority of research in macroeconomics relies on aggregate (economy-wide) shocks as a driver of aggregate fluctuations. A prominent exception is a recent contribution by Gabaix (2011), which argues that because the firm size distribution is extremely fat-tailed – the economy is ‘granular’. This means that idiosyncratic shocks to individual (and large) firms will not average out and instead lead to aggregate fluctuations. Acemoglu et al. (2012) have developed a network model in which idiosyncratic shocks to a single firm or sector can have sizeable aggregate effects if it is strongly interconnected with other firms/sectors in the economy, regardless of the size distribution. However, there is currently little empirical evidence to complement these theoretical studies1.

Empirical approach

In our research, we provide a forensic account of the contribution of individual firms to aggregate fluctuations using a novel database covering the universe of French firms’ domestic sales and destination-specific exports for the period 1990–2007 (di Giovanni, Levchenko, and Méjean 2012). We develop an empirical strategy that decomposes the growth of a firm’s rate of sales of to a single destination market into

  • A macroeconomic shock, defined as the component common to all firms
  • A sectoral shock, defined as the component common to all firms in a particular sector
  • A firm-level shock

The procedure yields estimates of the time series of the macroeconomic, sectoral, and firm-specific shocks for each destination served by each firm. We then decompose aggregate volatility in the economy into the contributions of macroeconomic/sectoral and firm-specific shocks, and use our estimates to assess whether microeconomic shocks have an impact on aggregate volatility.

Firm-specific contributions

Our main finding is that firm-specific components do contribute substantially to aggregate fluctuations. Their contribution is roughly similar in magnitude to the combined effect of all sectoral and macroeconomic shocks. We then evaluate two explanations for the positive overall contribution of firm-specific shocks. The first – from Gabaix (2011) – is that firm-specific idiosyncratic volatility does not average out because of the presence of very large firms. We refer to this as the ‘granularity’ hypothesis. The second – from Acemoglu et al. (2012) – is that idiosyncratic shocks contribute to aggregate fluctuations because input-output linkages generate comvement between firms. We refer to this as the “linkages” hypothesis. The overall contribution of firm-specific shocks to aggregate volatility can be decomposed additively into two terms that capture these two mechanisms. Though both channels matter quantitatively, about two-thirds of the contribution of firm-specific shocks to the aggregate variance is accounted for by the 'linkages' effect – the covariances of the firm-specific components of the growth rate of sales.

Explaining ‘granularity’ and ‘linkages’

We then exploit cross-sectoral heterogeneity to provide further evidence on the ‘granularity’ and ‘linkages’ mechanisms. We compare the covariances of the firm-specific shocks aggregated at the sector level to a measure of sectoral linkages taken from the Input-Output Tables. As shown in Figure 1, sectors with stronger input-output linkages tend to exhibit significantly greater correlation of firm-specific shocks. This is direct evidence for the linkages hypothesis. We also relate each sector’s contribution to aggregate volatility to the ‘granularity’ of the sector.

Figure 1. Sectoral input-output linkages and covariance of firm-specific shocks

Gabaix (2011) shows that granular fluctuations in the economy will be more pronounced the larger is the Herfindahl index of firm sales – a common measure of concentration. Confirming this result, Figure 2 shows that industries that are more concentrated than the average sector contribute more significantly to aggregate volatility, whereas the contribution of less concentrated sectors is comparatively smaller. In summary, we find direct corroboration in the data for the mechanisms behind both the ‘granularity’ and the ‘linkages’ hypotheses. Sectors that are populated by firms that are more interconnected with the rest of the economy; and more concentrated contribute a disproportionate share of aggregate volatility relative to what we would expect in a ‘symmetric’ economy.

Figure 2. Sector’s concentration (Herfindahl Index) and sector’s contribution to aggregate volatility

The rising importance of large firms
Looking forward, both the recent theoretical contributions and our findings are informative given the significant and rising importance of large firms in overall economic activity. Trade integration has the potential to make the largest firms even larger (di Giovanni and Levchenko, 2012). Likewise, consolidation across industries -- for instance via mergers and acquisitions -- also leads to a fatter tail in the firm-size distribution. These two structural changes amplify granular fluctuations, making business cycles more sensitive to individual firms’ shocks. At the same time, the boundaries of the firm are changing and production processes are becoming more fragmented. Some activities that used to be internal to the firm are now outsourced. This fragmentation takes place both within and across borders, and within and across sectors, adding further scope for shocks to individual firms to propagate throughout the economy as well as across countries.
Finally, one only needs to look at the most recent global crisis to note the importance of the transmission of shocks between sectors and firms. A shock that started in the financial sector spread rapidly to the rest of the economy. The dramatic fall in international trade highlighted how the international fragmentation of production processes was a powerful amplification mechanism of shocks.
References
Acemoglu, Daron, Vasco M Carvalho, Asuman Ozdaglar, and Alireza Tahbaz-Salehi (2012), “The Network Origins of Aggregate Fluctuations”, forthcoming, Econometrica, May.
Carvalho, Vasco M and Xavier Gabaix (2010), “The Great Diversification and its Undoing”, mimeo, CREi, Universitat Pompeu Fabra and NYU, October.
CNBC.com (2012), “Apple's iPhone 5 Sales Could Add Half a Point to GDP”, 10 September.
di Giovanni, Julian and Andrei A Levchenko (2012), “Country Size, International Trade, and Aggregate Fluctuations in Granular Economies”, forthcoming, Journal of Political Economy, October.
di Giovanni, Julian, Andrei A Levchenko, and Isabelle Méjean (2012), “Firms, Destinations, and Aggregate Fluctuations”, 2012, CEPR Discussion Paper, 9168.
Dupor, Bill (1999), “Aggregation and Irrelevance in Multi-sector Models”, Journal of Monetary Economics, 43(2), 391–409.
Foerster, Andrew T, Pierre-Daniel G Sarte, and Mark W Watson (2011), “Sectoral vs. Aggregate Shocks: A Structural Factor Analysis of Industrial Production”, Journal of Political Economy, 119 (1), 1–38.
Gabaix, Xavier (2011), “The Granular Origins of Aggregate Fluctuations,” Econometrica, 79 (3), 733–772.
Horvath, Michael (1998), “Cyclicality and Sectoral Linkages: Aggregate Fluctuations from Independent Sectoral Shocks,” Review of Economic Dynamics, 1(4), 781–808.
Horvath, Michael (2000), “Sectoral Shocks and Aggregate Fluctuations,” Journal of Monetary Economics, 45(1), 69–106.
Le Point (2012), “Équipementiers et automobile: les comptes ne sont pas bons”, 23 July.
Stockman, Alan C (1988) “Sectoral and National Aggregate Disturbances to Industrial Output in Seven European Countries”, Journal of Monetary Economics, 21, 387–409.

Footnotes

1 A closely related and older tradition in macroeconomics, starting with the seminal work of Long and Plosser (1983), explores the role of sectoral shocks in generating aggregate fluctuations (cf. Stockman 1988, Horvath 1998, 2000, Dupor 1999, Foerster et al. 2011, Carvalho and Gabaix 2010).

Friday, November 16, 2012

Solving the Too Big to Fail Problem

William Dudley, President of the NY Fed, on too big to fail (this is just a small part of his much longer, detailed discussion):

Solving the Too Big to Fail Problem, by William C. Dudley, President and Chief Executive Officer, FRBNY: ...I am going to focus my remarks today on what is popularly known as the “too big to fail” (TBTF) problem. In particular, should society tolerate a financial system in which certain financial institutions are deemed to be too big to fail? And, if not, then what should we do about it?

The answer to the first question is clearly “no.” We cannot tolerate a financial system in which some firms are too big to fail—at least not ones that operate in any form other than that of a very tightly regulated utility.

The second question is the more interesting one. Is the current approach of the official sector to ending TBTF the right one? I’d characterize this approach as reducing the incentives for firms to operate with a large systemic footprint, reducing the likelihood of them failing, and lowering the cost to society when they do fail. Or would it be better to take the more direct, but less nuanced approach advocated by some and simply break up the most systemically important firms into smaller or simpler pieces in the hope that what emerges is no longer systemic and too big to fail?1

As I will explain tonight, I believe we should continue to press forward on the first path. But, if we fail to reach our destination by this route, then a blunter approach may yet prove necessary. ...

Critics of our approach believe it would be better to just break up firms deemed TBTF now—perhaps through legislation requiring the separation of retail banking and capital markets activities or by imposing size restrictions that require firms to shrink dramatically from their current scale. My own view is that while this could yet prove necessary, it is premature to give up on the current approach: changing the incentives facing large and complex firms, forcing them to become more resilient, and making the financial system more robust to their failure.

In my opinion, there are shortcomings to reimposing Glass-Steagall-type activity restrictions or strict size limits. With respect to Glass-Steagall, it is not obvious to me that the pairing of securities and banking businesses was an important causal element behind the crisis. In fact, independent investment banks were much more vulnerable during 2008 than the universal banking firms which conducted both banking and securities activities. More important is to address the well-known sources of instability in wholesale funding markets and give careful consideration to whether there should be a more robust lender of last resort regime for securities activities.

With respect to size limitations, it is important to recognize that a new and much reduced size threshold could sacrifice socially useful economies of scale and scope benefits. And it could do this without actually solving the problem of system risk externalities that aren’t related to balance sheet size.

Evaluating the socially optimal size, scope and organizational structure of financial firms is a complicated business, and so is establishing a viable transition path to a system of much smaller firms. It would be helpful in this regard if advocates of break-up solutions would put a bit more flesh on the bones and develop detailed proposals that address essential questions of how such downsizing or functional separation would be accomplished, and what benefits and costs could be expected.

Such an analysis should answer several questions: How would you force divestiture (in good times and bad)? Should firms be split up by activity or reduced pro-rata in size? How much would they have to be shrunk in order for the externalities of failure to no longer create TBTF problems? How would global trading and investment banking services and network-type activities be supported? Should some activities be retained in natural monopoly form, but subject to utility type regulation? How costly would it be to replicate support services or to manage liquidity and capital locally? Are there ways of designing size limits that cannot be arbitraged by banks via off-balance-sheet structures and other forms of financial innovation? So far, advocacy for the break-up path has been strong, but without the detail to assess whether this is indeed superior to the course we are currently following. But, I’m open-minded.

It is important to recognize that any credible approach to addressing the TBTF problem, including the one we are pursuing today, necessarily implies changes to the structure and business mix of financial firms and financial markets. Moreover, it is important to stress that not all of these adjustments will be in the private interests of these firms, and some will result in changes to the price and volume of certain financial services. These are intended consequences, not unintended consequences.

Too big to fail is an unacceptable regime. The good news is there are many efforts underway to address this problem. The bad news is that some of these efforts are just in their nascent stages. It is important that as the crisis recedes in memory, that these efforts not flag—this is a project that needs to be seen to a successful conclusion and then sustained on a permanent basis.

Thank you...

One thing we really need to understand better is the minimum efficient scale for various financial activities. Whenever the topic of breaking banks into smaller pieces is raised, we hear that a "much reduced size threshold could sacrifice socially useful economies of scale and scope benefits." The key word is "could." As far as I can tell, the evidence on this point is very shaky -- we just don't know for sure what size is necessary to exploit efficiencies. My own view is that it is likely smaller than many firms today, and hence there would be no harm in reducing firms size. This may not help much with stability, but there are still perhaps many benefits (e.g. reduced political and economic power) from reducing firm size and increasing the number of institutions engaged in important financial activities.

Wednesday, November 14, 2012

Carbon Taxes and the National Debt

I am hearing a lot lately about using a carbon tax to fill the budget gap. I'm all for a carbon tax, internalizing externalities so that these markets work better is a good idea if we can somehow get through the political barriers, but we shouldn't be overly optimistic about how much revenue such a tax will bring.

In order to get support for such a tax and to implement it equitably, some groups will need to be compensated for the higher energy costs they will face. For example, these proposals often come with a proposal to return some of the tax as a lump-sum payment to lower income households (the microeconomics of a tax on carbon combined with lump-sum payments can be found here). Presumably, the higher the threshold for "low income," the easier it will be to get support for a carbon tax proposal, so there will be pressure for the compensation to extend, perhaps on a sliding scale, to middle class households.

And, at least in the initial years, there are other groups that will likely need to be compensated (okay, bought off) in order to garner the necessary political support.

All of these attempts to insulate various groups from the consequences of the tax (through fancy schemes that retain te incentive to save energy) will eat into potential revenue, and the fact that the response to the tax will be greater as more time passes -- for example as people switch to more efficient cars and appliances -- will also reduce revenue (this is not a problem in a larger sense, such substitutions are the whole point of the tax, but it does reduce the revenue).

Overall, the point is a simple one: don't overestimate the revenue from a carbon tax.

Tuesday, November 13, 2012

'Is Finance Too Competitive?'

I don't have any problem at all with the call for more competition in the financial industry, especially measures such as reducing bank size to the minimum efficient scale to reduce their systemic importance and political power. I do have a problem, however, with the idea that competition can substitute for regulation, i.e. that these markets can be left alone to self-regulate:

Is Finance Too Competitive?, by Raghuram Rajan,Commentary, Project Syndicate: Many economists are advocating for regulation that would make banking “boring” and uncompetitive once again. After a crisis, it is not uncommon to hear calls to limit competition. ...
The overwhelming evidence, though, is that financial competition promotes innovation. Much of the innovation in finance in the US and Europe came after it was deregulated in the 1980’s – that is, after it stopped being boring.
The critics of finance, however, believe that innovation has been the problem. Instead of Schumpeter’s “creative destruction,” bankers have engaged in destructive creation in order to gouge customers at every opportunity while shielding themselves behind a veil of complexity from the prying eyes of regulators (and even top management). ... Hence, the critics are calling for limits on competition to discourage innovation.
Of course, the critics are right to argue that not all innovations in finance have been useful, and that some have been downright destructive. By and large, however, innovations such as interest-rate swaps and junk bonds have been immensely beneficial... Even mortgage-backed securities, which were at the center of the financial crisis that erupted in 2008, have important uses... The problem was not with the innovation, but with how it was used – that is, with financiers’ incentives.
And competition does play a role here. Competition makes it harder to make money, and thus depletes the future rents (and stock prices) of the incompetent. In an ordinary industry, incompetent firms (and their employees) would be forced to exit. In the financial sector, the incompetent take on more risk, hoping to hit the jackpot, even while the regulator protects them by deeming them too systemically important to fail.
Instead of abandoning competition and giving banks protected monopolies once again, the public would be better served by making it easier to close banks when they get into trouble. Instead of making banking boring, let us make it a normal industry, susceptible to destruction in the face of creativity.

This seems to imply that breaking banks into smaller pieces makes the system immune to taking on too much risk and the problems that come with it, but we had banking problems in eras where most banks are small -- cascading bank failures in response to a large shock are still possible -- so making markets as competitive as we can, including breaking firms into smaller pieces and allowing easy failure, is no guarantee that financial meltdowns will be avoided (it may, in fact, be harder to step in and save the system when you have to fix many, many small banks instead of a few big ones). I think more competition in this industry is a good idea, but we shouldn't be fooled into thinking that means we can stop worrying about the stability of the system. The focus of the article is innovation, but that is not where the main vulnerability lies. Market failures that allow the equivalent of bank runs on the shadow banking system are a much bigger problem, and this problem cannot be solved by simply reducing firm-size. Regulation to reduce the chances of cascading failure will still be needed.

Thursday, November 08, 2012

We Must 'Stand Up to Concentrated and Powerful Corporate Interests'

Simon Johnson:

The Importance of Elizabeth Warren: One of the most important results on Tuesday was the election of Elizabeth Warren as United States senator from Massachusetts. ... Hopefully, Ms. Warren will get a seat on the Senate Banking Committee, where at least one Democratic slot is open.
President Obama should now listen to her advice. ... If President Obama wants to have impact with his second term, he needs to stand up to the too-big-to-fail banks on Wall Street.
The consensus among policy makers has shifted since 2010, becoming much more concerned about the dangers posed by global megabanks. ...
Senator Warren is well placed, not just to play a role in strengthening Congressional oversight but also in terms of helping her colleagues think through what we really need to make our financial system more stable.
We need a new approach to regulation more generally – and not just for banking. We should aim to simplify and to make matters more transparent, exactly along Senator Warren’s general lines.
We should confront excessive market power, irrespective of the form that it takes. We need a new trust-busting moment. And this requires elected officials willing and able to stand up to concentrated and powerful corporate interests. ...

I'm glad to see Simon Johnson at least hinting that this criticism goes beyond just banks. Growing economic power is not limited to the financial sector, and attempts to "stand up to concentrated and powerful corporate interests" must be broadened beyond "too big to fail" financial institutions:

The economics of enormity, The Economist: How big is too big? America's firms are growing in size and while there have been huge firms stretching back to Standard Oil the fact that so many firms are so big is a new phenomenon. This week's Free exchange print article—Land of the corporate giants—takes a look at the implications of the megafirm era. As many of the names towards the top of the list (Exon Mobil, ConocoPhillips) suggest, lots of the growth at the very top is due to mergers. In some cases this is a good thing because bigger firms can be more efficient when they exploit economies of scale. But evidence suggests that scale economies are starting to wear thin. That's a concern given that many mergers are justified on the basis of cost efficiencies (see Waddling forward, also in this week's newspaper, for example). Even more worryingly, other studies suggest that some companies are bulking up for entirely the wrong reasons. Bigger isn’t always better. Read the article here.

Monopoly power distorts both economic activity -- you pay more, and less is produced -- and the distribution of income. And if you are big enough, it also gives you political power and influence. We should do more, much more, to eliminate excessive economic power.

Tuesday, November 06, 2012

Hurricane Sandy’s Lesson on Preserving Capitalism

We are, as they say, live:

Price-gougingHurricane Sandy’s Lesson on Preserving Capitalism: With long gas lines and other shortages putting people on edge in the wake of Hurricane Sandy, the usual post-disaster debate over the economics and ethics of price-gouging is underway.  However, while the question of whether it is okay, even desirable, for businesses to raise prices after natural disasters is certainly important, there is a larger lesson that can be drawn from this debate. ...

The lesson is about when support for price-allocation systems -- the heart of capitalism -- breaks down. More here.

Wednesday, October 31, 2012

'The Insurer Of Last Resort'

Paul Krugman:

Disasters and Politics: ...let me just take a moment to flag an issue others have been writing about: the weird Republican obsession with killing FEMA. Kevin Drum has the goods: they just keep doing it. George Bush the elder turned the agency into a dumping ground for hacks, with bad results; Clinton revived the agency; Bush the younger ruined it again; Obama revived it again; and Romney — with everyone still remembering Brownie and Katrina! — said that he wants to block-grant and privatize it. (And as far as I can tell, even TV news isn’t letting him Etch-A-Sketch the comment away).
There’s something pathological here. It’s really hard to think of a public service less likely to be suitable for privatization, and given the massive inequality of impacts by state, it really really isn’t block-grantable. Does the right somehow imagine that only Those People need disaster relief? Is the whole idea of helping people as opposed to hurting them just anathema?
It’s a bit of a mystery, calling more for psychological inquiry than policy analysis. But something is going on here.

Some history from Tod Kelly (via):

One of the hard lessons one learns in risk management is that no one funds for catastrophic losses unless they are required by an outside agency to do so. In many cases this is because it is not feasible to do so; but even in those cases where it is feasible, no one does.

Were FEMA to be dismantled, for example, there would be no financial resources from which to quickly rebuild from disasters like Hurricane Sandy. Conservatives might argue that private insurers could provide such protection, and this is certainly correct – on paper. However, one of the axioms from my industry is that there is no such thing as an uninsurable risk, there are just risks people aren’t willing to pay enough premium for.

This is absolutely true for natural disasters. If your insurance provider offered you or your business coverage that would protect you from disasters like Sandy, you would not be willing to pay the premium required. You might disagree with that statement, but history shows that it is true. In fact, it is almost universally true. Governmental disaster insurance schemes didn’t appear magically in a vacuum; they were created because prior no one was willing to pay enough money in premiums to allow insurance companies to properly fund for them, and as a result the inevitable losses were uncovered.

That's true of government social insurance sprograms as well. They appeared for a reason, and generally the reason is the inability of the private market to provide adequate protection due to market failures or other causes. Pretending that those problems no longer exist -- that privatization would somehow be different this time -- is wishful thinking.

Saturday, October 27, 2012

Climate Change and 'Free Drivers'

Gernot Wagner and Martin Weitzman on the "allure of geoengineering" as a solution to global warming, and the temptation for individual countries to act on their own:

Playing God: ... All it takes is a single actor willing to focus on the purported benefits to his country or her region to pull the geoengineering trigger. The task with geoengineering is to coordinate international inaction while the international community considers what steps should be taken. The fate of the planet cannot be left in the hands of one leader, one nation, one billionaire.
Fortunately, we are still many years off from the full "free driver" effect taking hold. There's some time to engage in a serious global governance debate and careful research: building coalitions, guiding countries and perhaps even individuals lest they take global matters into their own hands. In fact, that is where the discussion stands at the moment, with a governance initiative convened by the British Royal Society, the Academy of Sciences for the Developing World, and the Environmental Defense Fund, among other deliberations guiding how geoengineering research should be pursued.
With time come the "free drivers"
The clock, however, is ticking. A single dramatic climate-related event anywhere in the world - think Hurricane Katrina on steroids - could trigger the "free driver" effect. That event need not be global and it need not even be conclusively linked to global warming. A nervous leader of a frightened nation might well race past the point of debate to deployment. The "free driver" effect will all but guarantee that we will face this choice at some point.
"Free riding" and "free driving" occupy opposite poles of the spectrum of climate action: One ensures that individuals won't supply enough of a public good. The other creates an incentive to engage in potentially reckless geoengineering and supply a global bad. It's tough to say which one is more dangerous. Together, these powerful forces could push the globe to the brink.

Sunday, October 21, 2012

Stavins: Cap-and-Trade, Carbon Taxes, and My Neighbor’s Lovely Lawn

Speaking of externalities associated with energy use, Robert Stavins throws cold water on "current enthusiasm about carbon taxes in the academic and broader policy-wonk community":

Cap-and-Trade, Carbon Taxes, and My Neighbor’s Lovely Lawn, by Robert Stavins: ...my conclusion in 1998 strongly favored a market-based carbon policy, but was somewhat neutral between carbon taxes and cap-and-trade. Indeed, at that time and for the subsequent eight years or so, I remained agnostic regarding what I viewed as the trade-offs between cap-and-trade and carbon taxes. What happened to change that? Three words: The Hamilton Project.
...In 2007, the Project’s leadership asked me to write a paper proposing a U.S. CO2 cap-and-trade system. ... The Hamilton Project leaders said ... they wanted me to make the best case I could for cap-and-trade, not a balanced investigation of the two policy instruments. Someone else would be commissioned to write a proposal for a carbon tax. (That turned out to be Professor Gilbert Metcalf of Tufts University ... who did a splendid job!) Thus, I was made into an advocate for cap-and-trade. It’s as simple as that. ...
In principle, both carbon taxes and cap-and-trade can achieve cost-effective reductions, and – depending upon design — the distributional consequences of the two approaches can be the same. But the key difference is that political pressures on a carbon tax system will most likely lead to exemptions of sectors and firms, which reduces environmental effectiveness and drives up costs, as some low-cost emission reduction opportunities are left off the table. But political pressures on a cap-and-trade system lead to different allocations of the free allowances, which affect distribution, but not environmental effectiveness, and not cost-effectiveness.
I concluded that proponents of carbon taxes worried about the propensity of political processes under a cap-and-trade system to compensate sectors through free allowance allocations, but a carbon tax would be sensitive to the same political pressures, and should be expected to succumb in ways that are ultimately more harmful: reducing environmental achievement and driving up costs.
Of course, such positive political economy arguments look much less compelling in the wake of the defeat of cap-and-trade legislation in the U.S. Congress and its successful demonization by conservatives as “cap-and-tax.”
A Political Opening for Carbon Taxes?
Does the defeat of cap-and-trade in the U.S. Congress, the obvious unwillingness of the Obama White House to utter the phrase in public, and the outspoken opposition to cap-and-trade by Republican Presidential candidate Mitt Romney indicate that there is a new opening for serious consideration of a carbon-tax approach to meaningful CO2 emissions reductions?

First of all, there surely is such an opening in the policy wonk world. Economists and others in academia, including important Republican economists such as Harvard’s Greg Mankiw and Columbia’s Glenn Hubbard, remain enthusiastic supporters of a national carbon tax. And a much-publicized meeting in July at the American Enterprise Institute in Washington, D.C. brought together a broad spectrum of Washington groups – ranging from Public Citizen to the R Street Institute – to talk about alternative paths forward for national climate policy. Reportedly, much of the discussion focused on carbon taxes.

Clearly, this “opening” is being embraced with enthusiasm in the policy wonk world. But what about in the real political world? The good news is that a carbon tax is not “cap-and-trade.” ... But if conservatives were able to tarnish cap-and-trade as “cap-and-tax,” it surely will be considerably easier to label a tax – as a tax! Also, note that Romney’s stated opposition and Obama’s silence extend beyond disdain for cap-and-trade per se. Rather, they cover all carbon-pricing regimes.
So as a possible new front in the climate policy wars, I remain very skeptical that an explicit carbon tax proposal will gain favor in Washington, no matter what the outcome of the election. ...
I would personally be delighted if a carbon tax were politically feasible in the United States, or were to become politically feasible in the future. But I’m forced to conclude that much of the current enthusiasm about carbon taxes in the academic and broader policy-wonk community in the wake of the defeat of cap-and-trade is – for the time being, at least – largely a manifestation of the grass looking greener across the street.

Saturday, October 20, 2012

Robber Barons

The entry below this one reminded me of this old post featuring Brad DeLong on the Robber Barons (he wrote this in 1998, the actual essay is much, much longer):

Robber Barons, by J. Bradford DeLong, 1998: I. Introduction "Robber Barons": that was what U.S. political and economic commentator Matthew Josephson (1934) called the economic princes of his own day. Today we call them "billionaires." Our capitalist economy--any capitalist economy--throws up such enormous concentrations of wealth: those lucky enough to be in the right place at the right time, driven and smart enough to see particular economic opportunities and seize them, foresighted enough to have gathered a large share of the equity of a highly-profitable enterprise into their hands, and well-connected enough to fend off political attempts to curb their wealth (or well-connected enough to make political favors the foundation of their wealth).

Matthew Josephson called them "Robber Barons". He wanted readers to think back to their European history classes, back to thugs with spears on horses who did nothing save fight each other and loot merchant caravans that passed under the walls of their castles. He judged that their wealth was in no sense of their own creation, but was like a tax levied upon the productive workers and craftsmen of the American economy. Many others agreed: President Theodore Roosevelt--the Republican Roosevelt, president in the first decade of this century--spoke of the "malefactors of great wealth" and embraced a public, political role for the government in "anti-trust": controlling, curbing, and breaking up large private concentrations of economic power.

Their defenders--many bought and paid for, a few not--painted a different picture: the billionaires were examples of how America was a society of untrammeled opportunity, where people could rise to great heights of wealth and achievement on their industry and skill alone; they were public benefactors who built up their profitable enterprises out of a sense of obligation to the consumer; they were well-loved philanthropists; they were "industrial statesmen."

Over the past century and a half the American economy has been at times relatively open to, and at times closed to the ascension of "billionaires." Becoming a "billionaire" has never been "easy." But it was next to impossible before 1870, or between 1929 and 1980. And at other times--between 1870 and 1929, or since 1980--there has been something about the American economy that opened roads to the accumulation of great wealth that were at other times closed.

Does it matter whether an economy is open to the accumulation of extraordinary amounts of private wealth? When the economy is more friendly to the creation of billionaires, is economic growth faster? Or slower? And what role does politics play? Are political forces generally hostile to great fortunes, or are they generally in partnership? And when the political system turns out to be corrupt--to serve as a committee for extracting wealth from the people and putting it into the pockets of the politically well-connected super-rich--what is to be done about it? What can be done to curb explicit and implicit corruption without also reducing the pressure in the engine of capital accumulation and economic growth?

These are big questions. This essay makes only a start at answering them.

Here's an interesting note:

And this is the third thing ... about the turn of the century robber barons: even though the base of their fortunes was the railroad industry, they were for the most part more manipulators of finance than builders of new track. Fortune came from the ability to acquire ownership of a profitable railroad and then to capitalize those profits by selling securities to the public. Fortune came from profiting from a shift--either upward or downward--in investors' perceptions of the railroad's future profits. It was the tight integration of industry with finance that made the turn of the twentieth century fortunes possible. ...

The jump in wealth of the founders of these lines of business was intimately tied up with the creation of a thick, well-functioning market for industrial securities. And that would turn out to be a source of weakness when Wall Street came under fire during the Great Depression. ...

And:

Progressives did not believe that the billionaires were just the helpless puppets of market forces. In 1896 Democratic presidential candidate William Jennings Bryan called for the end to the crucifixion of the farmer by a gold standard working in the interests of Morgan and his fellow plutocrats. Fifteen years later Louis Brandeis warned Morgan partner Thomas Lamont--after whom Harvard University's main undergraduate library is named-that it was in fact in Morgan's interest to support the Progressive reform program. If Morgan's partners did not do so, Brandeis warned, the Progressives would recede. Their successors on the left wing of American politics would be real anarchists and real socialists (DeLong, 1991).

Louis Brandeis and company did not much care whether the billionaires of what they called the "money trust" were in any sense economically efficient. In Brandeis's mind, they're evil because their interests were large..., size alone made a billionaire's fortune "dangerous, highly dangerous." ...

Populists from the American midwest found this set of issues a reliable one, and their senators took turns calling for political and economic changes to reduce the power exercised by the super-rich. ...

The political debate was resolved only by the Great Depression. The presumed link between the stock market crash and the Depression left the securities industry without political defenders. The old guard of Progressives won during the 1930s what they had not been able to win in the three earlier decades.

Ironically, it was Republican president Herbert Hoover who triggered the process. Hoover thought that Wall Street speculators were prolonging the Depression and refusing to take steps to restore prosperity. He threatened investigations to persuade New York financiers to turn the corner around which he was sure prosperity waited. Thus, as Franklin D. Roosevelt put it, "the money changers were cast down from their high place in the temple of our civilization." The Depression's financial market reforms act broke the links between board membership, investment banking, and commercial banking-based management of asset portfolios that had marked American finance before 1930. Investment bankers could no longer be commercial bankers. Depositors' money could not be directly used to support the prices of newly-issued securities. Directorates could not be interlocked: that bankers could not be on the boards of directors of firms that were their clients.

D. The Drying-Up of the Flow of Billionaires

Whatever else Depression-era financial reforms did (and there are those who think it crippled the ability of Wall Street to channel finance to new corporations) and whatever else the New Deal did (and it did a lot to bring social democracy to the United States and to level the income distribution), one important--and intended--consequence was that thereafter it was next to impossible to become a billionaire.

Not that it was ever easy to become a billionaire, mind you, but the channels through which lucky, skilled, dedicated, and ruthless entrepreneurs had ascended were largely closed off. ...

The hostility of Roosevelt's New Deal to massive private concentrations of economic power was effective: the flow of new billionaires dried up, as the links between finance and industry that they had used to climb to the heights of fortune were cut.

This is the important question:

Did the hostility of America's political and economic environment to billionaires between 1930 and 1980 harm the American economy? Did it slow the rate of economic growth by discouraging entrepreneurship? As an economist--someone who believes that there are always tradeoffs--I would think "yes." I would think that there must have been a price paid by the closing off of the channels of financing for entrepreneurship through which E.H. Harriman, James J. Hill, George F. Baker, Louis Swift, George Eastman, and others had made their fortunes.

But if so, there are no signs of it in aggregate growth data. ...

V. Tentative Conclusions

So what can Americans expect from their current crop of billionaires? Or rather what can they expect from the processes that have allowed their creation?

They should be extremely dubious about billionaires' social utility. Their relative absence from the 1930s to the 1970s did not seem to harm economic growth in the United States. Their predecessors' claim to much of their wealth is, to see the least, dubious. And their large-scale presence was associated with the serious corruption of American politics.

Perhaps those who are going to be industrial statesmen have as reasonable a chance of truly being industrial statesmen in an environment hostile to billionaires, as in an environment friendly to their creation: at that level of operations, after all, money is just how people keep the score in their competitions against nature and against each other. ...

On the other hand, their personal consumption is only an infinitesimal proportion of their total wealth. Much less of Andrew Carnegie's fortune from his steel mills went to his own personal consumption than has gone to his attempts to promote international peace, or to build libraries to increase literacy.

The child who in mid-nineteenth century Scotland painfully learned to read from the handful of books he had access to in his family's two-room cottage as they fell closer and closer to the edge of starvation--that child is visible in the Carnegie libraries that still stand in several hundred cities and towns in the United States, and is visible around us now. ...

So if there is a lesson, it is roughly as follows: Politics can put curbs on the accumulation of extraordinary amounts of wealth. And there is a very strong sense in which an unequal society is an ugly society. I like the distribution of wealth in the United States as it stood in 1975 much more than I like the relative contribution of wealth today. But would breaking up Microsoft five years ago have increased the pace of technological development in software? Probably not. And diminishing subsidies for railroad construction would not have given the United States a nation-spanning railroad network more quickly.

So there are still a lot of questions and few answers. At what level does corruption become intolerable and undermine the legitimacy of democracy? How large are the entrepreneurial benefits from the finance-industrial development nexus through which the truly astonishing fortunes are developed? To what extent are the Jay Goulds and Leland Stanfords embarrassing but tolerable side-effects of successful and broad economic development?

I know what the issues are. But I do not yet--not even for the late nineteenth- and early twentieth-century United States--feel like I have even a firm belief on what the answers will turn out to be.

He's a bit reluctant to take a strong position against the robber barons, they are, perhaps, "tolerable side-effects of successful and broad economic development." I see more costs and fewer benefits than Brad, so I wouldn't give as much ground here as he does. But this was written before the Great Recession, and I'd be curious to hear if his view of "the entrepreneurial benefits from the finance-industrial development," and the necessity of tolerating these "side-effects" has changed in light of recent events.

Tuesday, October 16, 2012

A Nobel Prize for Work that Matters in Our Everyday Lives

A few comments on yesterday's Nobel Prize in Economics (no link -- still stuck in editing at MoneyWatch link now active):

A Nobel Prize for Work that Matters in Our Everyday Lives: (MarketWatch) The Nobel Prize in Economics was awarded to Alvin Roth and Lloyd Shapley for their work on matching markets and mechanism design. What exactly do those terms mean, and why is their work important to people outside of economics?

In the textbook case when markets are perfectly competitive and prices are free to vary, the price-system produces an outcome that cannot be improved upon. But when substantial market failures are present, or when prices are restricted, missing, or otherwise prevented from responding to changes in market conditions, markets can break down.

In matching markets -- any market where both sides care about who they are matched with -- an important market failure is "jumping the gun." To illustrate this failure, consider the problem of matching graduate students to graduate programs. In an unconstrained market, a common strategy is to try to make offers to the best candidates earlier than competitors, and then give each candidates a short time until their offer expires. This forces the candidate to choose between taking the offer, or holding out for a better offer which may or may not come. In this situation, many applicants will end up taking offers they would have rejected if they had full information about the offers they'd receive in the future. The result is that some of the best candidates end up at less than the best schools, and the best schools end up with less than the best candidates. This is inefficient since there are applicants and programs that would prefer to be matched to each other, but aren't.

And that's not the end of the problems. Each competitor will have an incentive to make offers before anyone else to try to be the first to grab the best applicants, and this leads to offers being made earlier and earlier over time. For example, as Alex Tabarrok notes, "Prior to the currently used National Residency Matching Program,... hospitals were making offers to residents up to two years in advance!"

This "jumping the gun" behavior eventually causes the markets to break down, and in response participants usually agree to a centralized set of rules with penalties for non-compliance, or a centralized allocation system. At research universities, for example, by common agreement graduate students cannot be required to accept teaching or research assistant offers prior to April 15.

This can prevent the "jumping the gun" problem if the penalty for non-compliance is a sufficient deterrent, but unfortunately the resulting matches are not generally efficient -- better matches are possible.

"Jumping the gun" is not the only reason matching markets can fail. For example, the problem of matching kidney donors to recipients could be guided by a price system, and that would produce an efficient outcome under the proper market conditions, but the buying and selling of organs is prohibited. One solution is a centralized allocation system that tries to match donors with patients, but once again this is not generally efficient.

Lloyd Shapley's work, the Gale-Shapley algorithm in particular, is important because it overcomes these and other problems in matching markets. The algorithm uses a series of offers and rejections (which reveal valuations even when prices are absent from markets) to find a stable, efficient set of pairings -- there is no way to improve the outcome by changing the matches. In addition, the algorithm limits the ability of participants to manipulate the matching process in their favor.

Shapley's contribution was to provide the theoretical results. Alvin Roth recognized the importance of these results, and found ways to apply them to the real world. This is the "mechanism design" part of the process. In particular, Roth found ways to use the Gale-Shapely algorithm, suitably adjusted for the particulars of each application, for problems such as matching doctors and hospitals, matching organ donors with patients in need, and his work has also been used to match students to schools. Thus, in contrast to much of the work in economics, this work has had important impacts in the real world (and others have applied these results even more broadly, so this is only a small sample of the total impact of this work).

One final note. Economics is divided into two parts, macroeconomics and microeconomics. Macroeconomics is the study of entire economies, while microeconomics is the study of the individual decision making units within the economy.

Macroeconomic theory has come under considerable criticism lately, much of it deserved, and economics more generally has been tainted by the performance of macroeconomists and their theories prior to and during the crisis. Some aspects of the criticism apply to both macro and micro, e.g. the validity of the assumption that agents are rational, but for the most part this has not been fair to microeconomists.

As this award shows, microeconomists have made many useful contributions to the world, and they have also had success in other real world applications such as auction theory. Hopefully this award will help those outside the profession understand that the world of economics is more than macro, and highlight the important contributions from the microeconomics side of the profession that matter in our everyday lives.

[See also Prize for Stability and Market Design at Theory of the Leisure Class.]

A Nobel for Planning?

This is from Arindrajit Dube:

A Nobel for Planning?: “The combination of Shapley’s basic theory and Roth’s empirical investigations, experiments and practical design has generated a flourishing field of research and improved the performance of many markets,” said the committee awarding the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.
The use of the word "market" in describing exchanges of every sort has become ubiquitous, even in cases where there is no actual price that helps clear the market or channel information. Perhaps due to this slippage, an interesting fact about the work receiving the award has been largely ignored. The concrete applications that are discussed as ways of "improving the performance of many markets"--such as matching residents to hospitals, matching donors to organs, and students to schools--are not really "markets." At least not if we think of markets as institutions where prices help clear supply and demand. Instead, they involve non-market interactions, where the matches are actually formed by centralized exchanges. In these situations, decentralized and uncoordinated matching can produce unstable and inefficient matches, and gains are possible from centralization of some sort. Sometimes the price may not exist because of legal restrictions, but in other cases the participants may voluntarily forego using prices, as it might conflict with other objectives. This is exactly where the Gale-Shapley algorithm can be useful in implementing a "stable" allocation: an allocation where no pair-wise trades exist which can make both parties better off, which is one notion of optimality. In other words, this and similar algorithms can help implement … gasp! … economic planning.
I know the word "planning" makes most of us feel uncomfortable--it surely produces many more whispers and giggles in economics seminars than terms like "aggregate demand" and "Keynes." But the reality is that the technologies involved in designing exchanges for matching parties without using actual prices is at the heart of planning. In fact, this should not be a particularly controversial view, even though I think it's largely a neglected one. (To my knowledge, the only person who has alluded to this is David Henderson, who bemoaned that this would all be irrelevant if we could just have prices for kidneys--and presumably college admissions; and suggested that next year's award go to "the free market.") Mathematically speaking, the Gale-Shapley algorithm is part of a class of optimal matching algorithms which is equivalent to the Monge-Kantorovich optimal transport solution (see here, here), a signature accomplishment of Soviet mathematics. Oh, and it also implements the hedonic price equilibrium--you know, the same one if kidneys really did have a price.
A final note. A popular view today is that it is not possible to implement an efficient allocation using planning because people don't have the incentives to reveal their true preferences to begin with, which makes this whole exercise rather pointless. A variant of this position was originally articulated by Austrian economists, including Ludwig von Mises, during the so called "socialist calculation" debate of the early 20th century. And in many cases this criticism rings true. However, it does not follow that the truthful revelation problem is ubiquitous. For example, it is interesting to note that Alvin Roth and Elliott Peranson show (both theoretically and empirically) that when implementing optimal matching, this problem may be smaller than one might imagine: when each applicant only interviews a small number of positions overall, the gains from strategic manipulation of preferences are small. This, too, has important implications for the "socialist calculation" debate, as it suggests that for a range of cases, a centralized exchange implementing planning without using prices can (and indeed does) implement relatively efficient allocations. And it can do so without having distributional effects such as rationing kidneys out of the reach of the 99 percent by using prices to allocate organs.
So when asked by our students and friends "what was the 'Nobel' all about?" we could do a lot worse than by answering "economic planning."
PS: For those who may not know, Leonid Kantorovich was a Soviet mathematician and economist who, among other things, helped invent the technique of linear programming while trying to fix the Soviet plywood sector. Let's say that he was not entirely successful in the latter venture, but was the only Soviet economist to win the "Nobel" in economics. For much more on the promises and failures of Soviet planning, use of shadow prices in planning, and other fun stuff, read Red Plenty. You could do a lot worse.

Saturday, October 13, 2012

That Blurry Line Between Makers and Takers

Flight layover blogging -- this is from Tyler Cowen:

That Blurry Line Between Makers and Takers, by Tyler Cowen, Commentary, NY Times: Mitt Romney has apologized for his depiction of 47 percent of America as wealth takers rather than wealth makers. But his blunder touched inadvertently on some discomforting truths about the importance of politics in income distribution in the United States.
If Mr. Romney’s points were to be reformulated in a more defensible direction, the outline might look something like this...

Waiting for you to go read Tyler's column so my comments will make sense (hopefully, anyway). . . . Where Tyler and I differ most is not in the diagnosis of the problem. We both think, for example, that moneyed interests have captured far too much of Washington. Where we differ is the solution. His libertarian leanings lead him to propose getting government out of the way. If government is not involved, then moneyed interests can't screw things up. I have some sympathy for that point of view. But I suspect (strongly) I also have more faith than he does in government's ability to do good. Yes, we need to do our best to stop money from capturing politicians, something that increasing inequality makes worse. But we also need government to stand up for the typical household who does not have the power that comes with wealth. If government simply steps out of the way, stops regulating, etc., then the power that comes with wealth will exploit the powerless (think of things like workplace safety) and they will be even worse off than they are now -- I have no doubt about that. There are some areas where less government is the solution, but in many cases the answer is a government that represents all of our interests, not just those who can provide campaign cash in great volumes. Getting there is a problem -- how do you get a captured government to uncapture itself? -- but even with all its imperfections I just don't believe that no government at all will result in a better outcome for the vast majority of Americans. (A good analogy is monopoly power. I think the government should do more to reduce monopoly power, but it doesn't due to the influence of the wealthy and powerful who own these companies. But getting rid of anti-trust law altogether, i.e. getting government out of the way completely,  won't improve the outcome -- monopoly problems would simply get worse). I want to improve government, not kill it.

Tuesday, October 02, 2012

'The American Dream Has Become a Myth'

Spiegel interviews Joe Stiglitz:

'The American Dream Has Become a Myth', Spiegel: ...Spiegel: The US has always thought of itself as a land of opportunity where people can go from rags to riches. What has become of the American dream?
Stiglitz: This belief is still powerful, but the American dream has become a myth. The life chances of a young US citizen are more dependent on the income and education of his parents than in any other advanced industrial country... The belief in the American dream is not supported by the data. ...
Spiegel: We thought that as a rule Americans don't begrudge the rich their wealth, though.
Stiglitz: There is nothing wrong if someone who has invented the transistor or made some other technical breakthrough that is beneficial for all receives a large income. He deserves the money. But many of those in the financial sector got rich by economic manipulation, by deceptive and anti-competitive practices, by predatory lending. They took advantage of the poor and uninformed... They sold them costly mortgages and were hiding details of the fees in fine print.
Spiegel: Why didn't the government stop this behavior?
Stiglitz: The reason is obvious: The financial elite support the political campaigns with huge contributions. They buy the rules that allow them to make the money. Much of the inequality that exists today is a result of government policies.
Spiegel: Can you give us an example?
Stiglitz: In 2008, President George W. Bush claimed that we did not have enough money for health insurance for poor American children, costing a few billion dollars a year. But all of a sudden we had $150 billion to bail out AIG, the insurance company. That shows that something is wrong with our political system. It is more akin to "one dollar, one vote" than to "one person, one vote." ...
Spiegel: So your answer to the inequality problem is to transfer money from the top to the bottom?
Stiglitz: First, transferring money from the top to the bottom is only one suggestion. Even more important is helping the economy grow in ways that benefit those at the bottom and top, and ending the "rent seeking" that moves so much money from ordinary citizens to those at the top. ...

Nothing particularly new here, but I wanted to highlight the point about rent-seeking, anti-competitive practices, etc. once again since I don't think this cause of inequality receives enough attention.

Tuesday, September 18, 2012

Competition Will Not Reduce The Price Of Medicare

It wouldn't hurt to emphasize this point once again. Competition "won’t give us cheap healthcare":

Why Competition Will Not Reduce The Price Of Medicare, Cheap Talk: Mitt Romney and Paul Ryan have proposed a plan to allow private firms to compete with Medicare to provide healthcare to retirees. Beginning in 2023, all retirees would get a payment from the federal government to choose either Medicare or a private plan. The contribution would be set at the second lowest bid made by any approved plan.
Competition has brought us cheap high definition TVs, personal computers and other electronic goods but it won’t give us cheap healthcare. The healthcare market is complex because some individuals are more likely to require healthcare than others. The first point is that as firms target their plans to the healthy, competition is more likely to increase costs than lower them. David Cutler and Peter Orzag have made this argument. But there is a second point: the same factors that lead to higher healthcare costs also work against competition between Medicare and private plans. Unlike producers of HDTVs, private plans will not cut prices to attract more consumers so competition will not reduce the price of Medicare. A simple example exposes the logic of these two arguments. ...[gives example]...
But there is an additional effect. Traditional competitive analysis would predict that one private plan or another will undercut the other plans to get more sales and make more profits. This is the process that gives us cheap HDTVs. The hope is that similar price competition should reduce the costs of healthcare. Unfortunately, competition will not work in this way in the healthcare market because of adverse selection. ...[continues example]...
So, adverse selection prevents the kind of competition that lowers prices. The invisible hand of the market cannot reduce costs of provision by replacing the visible hand of the government.

Monday, September 03, 2012

Stiglitz: Mitt Romney’s Fair Share

Mitt Romney, and others like him, are weakening "the bonds that hold a society together":

Mitt Romney’s Fair Share, by Joseph Stiglitz, Commentary, Project Syndicate: Mitt Romney’s income taxes have become a major issue... Is this just petty politics, or does it really matter? In fact, it does matter... Economies in which government provides ... public goods perform far better than those in which it does not. But public goods must be paid for, and ... those at the top of the income distribution who pay 15% ... clearly are not paying their fair share. ...
Democracies rely on a spirit of trust and cooperation in paying taxes. If every individual devoted as much energy and resources as the rich do to avoiding their fair share of taxes, the tax system either would collapse, or would have to be replaced by a far more intrusive and coercive scheme. Both alternatives are unacceptable.
More broadly, a market economy could not work if every contract had to be enforced through legal action. But trust and cooperation can survive only if there is a belief that the system is fair. ... Yet, increasingly, Americans are coming to believe that their economic system is unfair; and the tax system is emblematic of that sense of injustice. ...
Romney may not be a tax evader; only a thorough investigation by the US Internal Revenue Service could reach that conclusion. But, given that the top US marginal income-tax rate is 35%, he certainly is a tax avoider on a grand scale. And, of course, the problem is not just Romney; writ large, his level of tax avoidance makes it difficult to finance the public goods without which a modern economy cannot flourish.
But, even more important, tax avoidance on Romney’s scale undermines belief in the system’s fundamental fairness, and thus weakens the bonds that hold a society together.

On the unfairness, beyond taxes Stiglitz also notes that:

...much of the money that accrues to those at the top is what economists call rents, which arise not from increasing the size of the economic pie, but from grabbing a larger slice of the existing pie. Those at the top include a disproportionate number of monopolists who increase their income by ... anti-competitive practices; CEOs who exploit deficiencies in corporate-governance laws to grab a larger share of corporate revenues for themselves (leaving less for workers); and bankers who have engaged in predatory lending and abusive credit-card practices (often targeting poor and middle-class households). It is perhaps no accident that rent-seeking and inequality have increased as top tax rates have fallen, regulations have been eviscerated, and enforcement of existing rules has been weakened: the opportunity and returns from rent-seeking have increased.

To the extent that this is true, those at the top are receiving income they didn't earn through their contributions to GDP. It is the result of rent-seeking -- they didn't "build that"  -- and clawing back those gains through taxes is not unfair, and it does not distort economic activity. Instead it reverses existing distortions that send income to the top of the income distribution instead of to the working class as a reward for their increased productivity.

Saturday, August 25, 2012

'Global Warming Has a Fairly Simple and Cheap Technical Solution'

Robert Frank:

Carbon Tax Silence, Overtaken by Events, by Robert Frank, Commentary, NY Times: ...Mitt Romney ... has been equivocal about whether rising temperatures are caused by human action. But he has been adamant that uncertainty about climate change rules out policy intervention. ...
Climatologists are the first to acknowledge that theirs is a highly uncertain science. The future might be better than they think. Then again, it might be much worse. Given that risk, policy makers must weigh the potential cost of action against the potential cost of inaction. And even a cursory look at the numbers makes a compelling case for action. ...
The good news is that we could insulate ourselves from catastrophic risk at relatively modest cost by enacting a steep carbon tax. ... A carbon tax would also serve two other goals. First, it would help balance future budgets. ... If new taxes are unavoidable, why not adopt ones that ... make the economy more efficient? By reducing harmful emissions, a carbon tax fits that description.
A second benefit would occur if a carbon tax were ... phased in gradually, only after the economy had returned to full employment. High unemployment persists in part because businesses, sitting on mountains of cash, aren’t investing it... News that a carbon tax was coming would create a stampede to develop energy-saving technologies. ...
Some people argue that a carbon tax would do little good unless it were also adopted by China and other big polluters. It’s a fair point. But access to the American market is a potent bargaining chip. The United States could ... tax imported goods in proportion to their carbon dioxide emissions if exporting countries failed to enact carbon taxes at home.
In short, global warming has a fairly simple and cheap technical solution. ...
Update: I didn't do a very good job of highlighting Robert Frank's point that we shouldn't "expect to hear much about climate change at the Republican and Democratic conventions," but "Many climate scientists ... are now pointing to evidence linking rising global temperatures to the extreme weather we’re seeing around the planet." Thus, "Extreme weather is already creating enormous human suffering, and "If the recent meteorological chaos drives home the threat of climate change and prompts action, it may ultimately be a blessing in disguise."

Thursday, August 23, 2012

'The Latest Tory Idiocy'

Chris Dillow:

"Nothing to fear"?, by Chris Dillow: Here's the latest Tory idiocy. Dominic Raab says the "talented and hard-working have nothing to fear" from a scrapping of "excessive protections" for workers.
Let's ignore the fact that the UK has some of the weakest job protection laws in the world. Let's also ignore the fact that there's no evidence that scrapping employment protection would create new jobs. And let's also ignore the fact that employment protection is of only marginal concern to small businesses, and that even a former director-general of the CBI has mocked the idea of abolishing the few protections workers have.
Is Raab right that the best workers have nothing to fear?
No. ...[explains why]... I'm pretty sure, then, that Raab is talking rot. What I'm not so sure about is why. One possibility is that he's so blinded by free market ideology and by romantic ideas about entrepreneurs and managers that he just cannot see that some free market reforms are of negligible benefit and that some bosses are less than heroic.
But you'd have thought that the experience of the crisis - which has seen bankers get multi-million bonuses whilst good workers lose their jobs - would have disabused anyone of the just world theory that capitalism rewards talent and effort. There's comes a point when a cognitive bias shades into a psychiatric disorder.
This leaves another possibility. It's that Raab is simply taking sides in a class war. He wants to further empower bosses to bully workers, even if this has no macroeconomic benefit.

Friday, August 10, 2012

Outsourcing Government: What Is Mitt Romney Talking About?

Brad DeLong is very puzzled:

Department of "Huh!?": What Is Mitt Romney Talking About?: An interview with Mitt Romney:

QUESTION: One thing that distinguishes this recovery is that public sector jobs, government jobs, have already fallen by 650,000. Given the conservative goal of shrinking government, is this a positive development or a negative one?

MITT ROMNEY: Well, clearly you don’t like to hear [about] anyone losing a job. At the same time, government is the least productive—the federal government is the least productive of our economic sectors. The most productive is the private sector. The next most productive is the not-for-profit sector, then comes state and local governments, and finally the federal government. And so moving responsibilities from the federal government to the states or to the private sector will increase productivity. And higher productivity means higher wages for the American worker. All right? America is the highest productivity nation of major nations in the world, and that results in our having, for instance, an average compensation about 30 percent higher than the average compensation in Europe. A government that becomes more productive, that does more with less, is good for the earnings of the American worker, and ultimately it will mean that our taxes don’t have to go up, that small businesses will find it easier to start and grow, and we will be able to add more private sector jobs. Don’t forget! It’s the private sector jobs that pay for government workers. So if you have fewer government workers doing work more and more productively, that means private sector work will grow.

Nobody can figure out what Mitt Romney is talking about here. He seems to be referring to some aggregate assessment of "productivity" across the four major sectors--private, non-profit, state and local government, and federal government. But nobody can figure out what he is talking about.

Does he really think that we should outsource the army to Blackwater? Or the NIH to Merck? Or the Marine Corps to Marriott? Or the Social Security Administration to Bain Capital?

Certainly our experience with for-profit hospitals and for-profit universities does not support the hypothesis that productivity inevitably goes up when we shift things over to the private sector.

Where is this coming from?

No reason to be puzzled -- Paul Krugman explained "the real motives for turning government functions over to private companies" several years ago (and it wasn't the first time):

Outsourcer in Chief, by Paul Krugman, Commentary, NY Times, December 11, 2006: According to U.S. News & World Report, President Bush has told aides that he won’t respond in detail to the Iraq Study Group’s report because he doesn’t want to “outsource” the role of commander in chief.
That’s pretty ironic. You see, outsourcing of the government’s responsibilities — not to panels of supposed wise men, but to private companies with the right connections — has been one of the hallmarks of his administration. And privatization through outsourcing is one reason the administration has failed on so many fronts.
For example, an article in Saturday’s New York Times describes how the Coast Guard has run a $17 billion modernization program: “Instead of managing the project itself, the Coast Guard hired Lockheed Martin and Northrop Grumman, two of the nation’s largest military contractors, to plan, supervise and deliver the new vessels and helicopters.”
The result? Expensive ships that aren’t seaworthy. The Coast Guard ignored “repeated warnings from its own engineers that the boats and ships were poorly designed and perhaps unsafe,” while “the contractors failed to fulfill their obligation to make sure the government got the best price, frequently steering work to their subsidiaries or business partners instead of competitors.”
In Afghanistan, the job of training a new police force was outsourced to DynCorp International, a private contractor, under very loose supervision: when conducting a recent review, auditors couldn’t even find a copy of DynCorp’s contract to see what it called for. And $1.1 billion later, Afghanistan still doesn’t have an effective police training program.
In July 2004, Government Executive magazine published an article titled “Outsourcing Iraq,” documenting how the U.S. occupation authorities had transferred responsibility for reconstruction to private contractors, with hardly any oversight. “The only plan,” it said, “appears to have been to let the private sector manage nation-building, mostly on their own.” We all know how that turned out.
On the home front, the Bush administration outsourced many responsibilities of the Federal Emergency Management Agency. For example, the job of evacuating people from disaster areas was given to a trucking logistics firm, Landstar Express America. When Hurricane Katrina struck, Landstar didn’t even know where to get buses. According to Carey Limousine, which was eventually hired, Landstar “found us on the Web site.”
It’s now clear that there’s a fundamental error in the antigovernment ideology embraced by today’s conservative movement. Conservatives look at the virtues of market competition and leap to the conclusion that private ownership, in itself, is some kind of magic elixir. But there’s no reason to assume that a private company hired to perform a public service will do better than people employed directly by the government.
In fact, the private company will almost surely do a worse job if its political connections insulate it from accountability — which has, of course, consistently been the case under Mr. Bush. The inspectors’ report on Afghanistan’s police conspicuously avoided assessing DynCorp’s performance; even as government auditors found fault with Landstar, the company received a plaque from the Department of Transportation honoring its hurricane relief efforts.
Underlying this lack of accountability are the real motives for turning government functions over to private companies, which have little to do with efficiency. To say the obvious: when you see a story about failed outsourcing, you can be sure that the company in question is a major contributor to the Republican Party, is run by people with strong G.O.P. connections, or both. ...

Going back to Romney's claims about productivity, we seem to be forgetting that there are some goods that the private sector won't produce at all due to market failures (e.g., the classic example is national defense). In those cases, the government is clearly more efficient than the private sector. The government may not be maximally efficient -- and there may be ways to improve upon that -- but it's certainly better than relying upon a private sector that won't produce the goods in anywhere near sufficient quantities, if they get produced at all.

Here's an interesting example from Shane Greenstein:

...with the benefit of ideological blinders, and a dose of lack of detail, several commentators — most notably, the Wall Street Journal editorial page (which David Warsh nicely summarizes) — recently have begun to argue that government’s investment in the Internet was not essential to its growth. That conclusion arises due from the (again, frightfully) unstated assumption that the Internet would have turned out the same way without government sponsorship at the outset.
Look, somebody can only say such things if they do not know the history of the Internet, and they make a concerted effort not to know the facts. (If you are neophyte, there are many places to start online, but I recommend starting here). There actually were attempts to make networking investments with private firms, and there were privately funded packet switching firms too. Those did not catch on widely, and they remained a niche service. I repeat: Attempts to build a private national packet switching network of the scale and size of the Internet failed to catch on. And it is very clear why it failed: because they were restricted to proprietary interconnection, with restricted rights to users and other firms. Nobody interconnected with anyone else.
But everyone would interconnect with the government sponsored Internet. It came out of universities, who took over funding for network development from the Department of Defense (who originally got into the business because DOD needed better computing for their own purposes). The standards coming from universities were not proprietary. That is actually why it worked.
Look, take the blinders off. Government sponsorship also was not perfect. That setting truncated application development. Private markets were great for exploring new uses, once the network was up and running. ...

There are lots and lots of things that government has no business doing. The private sector, appropriately regulated to ensure competitiveness, can take care of the provision of these goods and services. But there are other things that government must do if they are to be done at all. Sometimes the lines are fuzzy, and there can be legitimate debates about what should and shouldn't be in government hands. I suspect some people will still object to the claim above about the internet, for example. But there are also clear cases on both sides of the fuzzy line, something we seem to have forgotten.

Monday, July 23, 2012

Shiller: Bubbles without Markets

Robert Shiller argues that reining in markets is not the answer to bubbles:

Bubbles without Markets, by Robert Shiller, Commentary, Project Syndicate: A speculative bubble is a social epidemic whose contagion is mediated by price movements. News of price increase enriches the early investors, creating word-of-mouth stories about their successes... The excitement then lures more and more people into the market ... in successive feedback loops as the bubble grows. After the bubble bursts, the same contagion fuels a precipitous collapse, as falling prices cause more and more people to exit the market, and to magnify negative stories about the economy.
But, before we conclude that we should now, after the crisis, pursue policies to rein in the markets, we need to consider the alternative. In fact, speculative bubbles are just one example of social epidemics, which can be even worse in the absence of financial markets. In a speculative bubble, the contagion is amplified by people’s reaction to price movements, but social epidemics do not need markets or prices to get public attention and spread quickly.
Some examples of social epidemics unsupported by any speculative markets can be found in Charles MacKay’s 1841 best seller Memoirs of Extraordinary Popular Delusions and the Madness of Crowds.The book made some historical bubbles famous: the Mississippi bubble 1719-20, the South Sea Company Bubble 1711-20, and the tulip mania of the 1630’s. But the book contained other, non-market, examples as well.
MacKay gave examples, over the centuries, of social epidemics involving belief in alchemists, prophets of Judgment Day, fortune tellers, astrologers, physicians employing magnets, witch hunters, and crusaders. Some of these epidemics had profound economic consequences. The Crusades from the eleventh to the thirteenth century, for example... Between one and three million people died in the Crusades.
There was no way, of course, for anyone either to invest in or to bet against the success of any of the activities promoted by the social epidemics – no professional opinion or outlet for analysts’ reports on these activities. So there was nothing to stop these social epidemics from attaining ridiculous proportions. ...
The recent and ongoing world financial crisis pales in comparison with these events. And it is important to appreciate why. Modern economies have free markets, along with business analysts with their recommendations, ratings agencies with their classifications of securities, and accountants with their balance sheets and income statements. And then, too, there are auditors, lawyers and regulators.
All of these groups have their respective professional associations, which hold regular meetings and establish certification standards that keep the information up-to-date and the practitioners ethical in their work. The full development of these institutions renders really serious economic catastrophes – the kind that dwarf the 2008 crisis – virtually impossible.

Setting aside the extent to which these are really bubbles as commonly understood, nobody is talking about eliminating markets entirely. The push from those of us who want to "rein in the markets" is to regulate them so they function better than they did prior to the crisis. I don't see how these examples of so called non-market bubbles argue against regulating markets to make them work better. Modern economies may have something like the "free markets" Shiller talks about, but unregulated markets do not always function in the public's best interest and regulations that rein them in and make them more competitive, less subject to catastrophic failure, etc. can improve their social value. The question isn't about markets versus non-markets, the question is how to make our existing insitutions perform better and none of the above helps much with that question. How, for example, can we make business analysts, ratings agencies, accountants, lawyers, and regulators that Shiller lauds -- all of whom fell down on the job to some extent prior to the crisis -- do a better job next time?

Finally, I can't help asking: What is his definition of "really serious catastrophe"? How many millions of unemployed does it take? I'd hate to see a crisis that "dwarfs" this one, but this was no walk in the park. Perhaps the crowd Shiller hangs around in didn't think it was all that serious, but for many, many people it was quite catastrophic.

Update: I should have also added that the fact that this recession, while severe, didn't reach the depths of the Great Depression has more to do with improved social insurance, better automatic stabilizers, better policy (though far from perfect), and a higher initial level of wealth than it does the presence of free markets, business analysts, ratings agencies, accountants, auditors, lawyers, and regulators.

Saturday, July 21, 2012

"An Important Property of Cap-and-Trade"

Another quick one while I wait for a connection at the SF airport --- Robert Stavins explains the independence property for cap-and-trade systems. This property "allows equity and efficiency concerns to be separated. In particular, a government can set an overall cap of pollutant emissions (a pollution reduction goal) and leave it up to a legislature to construct a constituency in support of the program by allocating shares of the allowances to various interests, such as sectors and geographic regions, without affecting either the environmental performance of the system or its aggregate social costs":

Two Notable Events Prompt Examination of an Important Property of Cap-and-Trade, by Robert Stavins: ...In our just-published article, “The Effect of Allowance Allocations on Cap-and-Trade System Performance,” [Robert] Hahn and I ... focused on an idea that is closely related to the Coase theorem, namely, that the market equilibrium in a cap-and-trade system will be cost-effective and independent of the initial allocation of tradable rights (typically referred to as permits or allowances). That is, the overall cost of achieving a given emission reduction will be minimized, and the final allocation of permits will be independent of the initial allocation, under certain conditions (conditional upon the permits being allocated freely, i.e., not auctioned). We call this the independence property. It is closely related to a core principle of general equilibrium theory (Arrow and Debreu 1954), namely, that when markets are complete, outcomes remain efficient even after lump-sum transfers among agents.
The Practical Political Importance of the Independence Property
We were interested in the independence property because of its great political importance.  The reason why this property is of such great relevance to the practical development of public policy is that it allows equity and efficiency concerns to be separated. In particular, a government can set an overall cap of pollutant emissions (a pollution reduction goal) and leave it up to a legislature to construct a constituency in support of the program by allocating shares of the allowances to various interests, such as sectors and geographic regions, without affecting either the environmental performance of the system or its aggregate social costs.  Indeed, this property is a key reason why cap-and-trade systems have been employed and have evolved as the preferred instrument in a variety of environmental policy settings.
In Theory, Does the Property Always Hold?
Because of the importance of this property, we examined the conditions under which it is more or less likely to hold — both in theory and in practice.  In short, we found that in theory, a number of factors can lead to the independence property being violated. These are particular types of transaction costs in cap-and-trade markets; significant market power in the allowance market; uncertainty regarding the future price of allowances; conditional allowance allocations, such as output-based updating-allocation mechanisms; non-cost-minimizing behavior by firms; and specific kinds of regulatory treatment of participants in a cap-and-trade market.
In Reality, Has the Property Held?
Of course, the fact that these factors can lead to the violation of the independence property does not mean that in practice they do so in quantitatively significant ways.  Therefore, Hahn and I also carried out an empirical assessment of the independence property in past and current cap-and-trade systems: lead trading; chlorofluorocarbons (CFCs) under the Montreal Protocol; the sulfur dioxide (SO2) allowance trading program; the Regional Clean Air Incentives Market (RECLAIM) in Southern California; eastern nitrogen oxides (NOX) markets; the European Union Emission Trading Scheme (EU ETS); and Article 17 of the Kyoto Protocol.
I encourage you to read our article, but, a quick summary of our assessment is that we found modest support for the independence property in the seven cases we examined (but also recognized that it would surely be useful to have more empirical research in this realm).
Politicians Have Had it Right
That the independence property appears to be broadly validated provides support for the efficacy of past political judgments regarding constituency building through legislatures’ allowance allocations in cap-and-trade systems. Governments have repeatedly set the overall emissions cap and then left it up to the political process to allocate the available number of allowances among sources to build support for an initiative without reducing the system’s environmental performance or driving up its cost.
This success with environmental cap-and-trade systems should be contrasted with many other public policy proposals for which the normal course of events is that the political bargaining that is necessary to develop support reduces the effectiveness of the policy or drives up its overall cost.  So, the independence property of well-designed and implemented cap-and-trade systems is hardly something to be taken for granted.  It is of real political importance and remarkable social value.

Sunday, July 08, 2012

The Role of Government

A recent column:

The Role of Government, by Mark Thoma: The upcoming presidential election gives voters a choice between two very different philosophies of government. For Democrats, an activist government is necessary to keep markets functioning, and to smooth economic fluctuations. Without government oversight, markets would be captured by monopoly power, consumers would be at the mercy of unscrupulous producers, there would be distortions from adverse selection, information asymmetries, moral hazard problems, and so on. In addition, if government does not take action when a recession hits, the downturn will be much worse and much longer than necessary.

For Republicans, however, activism is exactly the wrong approach to take. They believe that the key to making markets work and smoothing economic fluctuations is for the government to get out of the way and let the private sector work its magic. In general, markets react faster, incorporate more information, and regulate commercial behavior better than humans will ever be able to do.

What is behind the stark difference in views about the role of government? Activists believe that market failures have large negative consequences, that these problems won't necessarily fix themselves, and that government is an effective way of overcoming these problems. Government isn't perfect, but neither is the private sector (see the bulldozed waste from the housing bubble), and on net it’s helpful for the government to take action when relatively severe market failures are present. Traditionally, those who take a more hands off approach do not deny that all markets fail to some degree – no market is perfectly competitive. But for the most part they do not see these failures as having large consequences, and even when they do government intervention is rarely the solution. In many, if not most cases, that just makes things worse.

In the modern Republican Party, these views have been taken to the extreme so that government is rarely, if ever, supported. But there are some areas where private sector will not provide goods and services by itself, public goods for example, and even when the goods are provided market failures distort the outcome. Who will build bridges, provide sewage systems, national defense, roads, airports, water systems, and so on if not the government? Who will force internalization of all costs of production if not the government? Who else can overcome adverse selection, information, and moral hazard problems in health and retirement markets? Conservatives can come up with stories about how the private sector will overcome these problems and provide goods in each case, but historically these goods simply haven't been provided, at least not at the scale and breadth needed. That's why government stepped in to begin with. To think it will somehow be different this time if government stepped out of the way is highly wishful thinking.

We cannot function economically without supporting infrastructure, we are already falling behind where ought to be and that will prove costly over time, and we cannot allow externalities, particularly those associated with global warming, to run rampant. Conservatives used to understand that government had an important role to play in these areas, and opposition to government was based upon coherent reasoning rather than a knee-jerk rejection of government.

This extremism within the Republican Party is hurting the economy. In the short-run, it makes it much harder to do anything about the recession. Even if you believe spending more on infrastructure will do nothing to help employment, letting infrastructure crumble will hurt our long-run growth, and presently the construction of infrastructure is about as cheap as it gets. Infrastructure is inherently a supply-side policy with attractive demand side effects in a recession, and the refusal of Republicans to support such spending looks far more like a political ploy than a well-reasoned position.

But that may pale in comparison to the long run consequences of failing to deal with global warming. Here we have a party that purports to be all about letting markets work their magic confronted with a clear market failure with considerable potential consequences, a problem that the private sector will not fix by itself. So what do they do? They know that there's no solution except government intervention if they admit to a consequential market failure, so they deny that a problem even exists.

There was a time when extremists were not the main voice of the Republican Party, a time when we had some chance of dealing with important issues. There were arguments about the precise location of the line separating when the government should and shouldn't step in, and there were debates about command and control versus market based mechanisms to solve problems. But both sides understood that the lines existed, and when both lines were crossed there was at least a chance the two sides would come together to solve our problems.

Unfortunately, those days are long gone, and if Republicans win big in November it will be a long time before we see them again.

Thursday, July 05, 2012

Bigger is Not Always Better

Robert Reich is pleased to see the Justice Department crackdown on "Big Pharma," but doesn't think think the government is doing anywhere near enough to solve the problem:

How Not to Get Big Pharma to Change Its Ways, by Robert Reich: Earlier this week the Justice Department announced a $3 billion settlement of criminal and civil charges against pharma giant GlaxoSmithKline — the largest pharmaceutical settlement in history — for improper marketing prescription drugs in the late 1990s to the mid-2000s.
The charges are deadly serious. Among other things, Glaxo was charged with promoting to kids under 18 an antidepressant approved only for adults; pushing two other antidepressants for unapproved purposes,... and, to further boost sales of prescription drugs, showering doctors with gifts, consulting contracts, speaking fees, even tickets to sporting events.
$3 billion may sound like a lot of money, but during these years Glaxo made $27.5 billion on these three antidepressants alone,... so the penalty could almost be considered a cost of doing business. 
Besides, to the extent the penalty affects Glaxo’s profits and its share price, the wrong people will be feeling the financial pain. ... Not a single executive has been charged — even though some charges against the company are criminal. ...
The Glaxo case is the latest and biggest in a series of Justice Department prosecutions of Big Pharma for illegal marketing prescription drugs. ... The Department says the prosecutions are well worth the effort. By one estimate it’s recovered more than $15 for every $1 it’s spent.
But what’s the point if the fines are small relative to the profits, if the wrong people are feeling the financial pinch, and if no executive is held accountable? 
The only way to get big companies like these to change their behavior is to make the individuals responsible feel the heat.
An even more basic issue is why the advertising and marketing of prescription drugs is allowed at all, when consumers can’t buy them and shouldn’t be influencing doctor’s decisions anyway. Before 1997, the Food and Drug Administration banned such advertising on TV and radio. That ban should be resurrected.
Finally, there’s no good reason why doctors should be allowed to accept any perks at all from [drug] companies... It’s an inherent conflict of interest. Codes of ethics that are supposed to limit such gifts obviously don’t work. All perks should be banned, and doctors that accept them should be subject to potential loss of their license to practice.  

Simon Johnson, summarizing Dennis Kelleher of the blog Better Markets, says banks have the same problem:

... Global megabanks have an incentive to deceive customers, including both individuals and nonfinancial corporations. Their size confers both market power and the political power needed to conceal the extent to which they engage in economic fraud. The lack of transparency in derivatives markets provides them with an opportunity to cheat, but the abuses are much wider – as the Libor scandal demonstrates. The ripoff is not just of retail investors. ...

This has motivated Samuel Brittan of the Financial Times to rethink his view of competitive markets. Sort of:

As one of the few commentators to have always favored competitive market capitalism I have had to ask myself a few questions. Apart from scandals such as the Libor rate fixing, we have had the behavior of banks before the great recession; a trend to much greater concentration of income and wealth, squeezing the living standards of ordinary citizens; and one could go on.

So, after asking himself these questions, what does he propose?:

Yet if anyone expects me to issue a clarion call for more state ownership and control, they will be disappointed. ... What then has gone wrong? ... Few of us like competition; and the tendency to form closely knit groups to keep outsiders at bay is probably as old as the human race. For pre-capitalist examples one has only to think of the medieval guilds, whether of craftsmen or Master Singers. More subtle are the practices of bankers, as they come disguised as services for customers. In summary, success has depended more on whom you know than what you know. Hence the catchphrase “crony capitalism”. ...
The biggest obstacle to reform is that insiders can devote time and energy to maintaining their position. For ordinary citizens, political reform is a sideshow that hardly repays such efforts. The protests in financial canters are a well-meant but ill-focused attempt to offset this bias.
Yet nil desperandum. The UK corn laws were repealed and the US antitrust acts were passed; and in time both the financiers and the Eurocrats will be brought down.

So, no cause for despair? Not so sure about that (the changes he describes did not come easily). It feels a bit like the Libor scandal has produced a turning point, but the power hold on politicians is still as strong as ever. We've seen how some Democrats react if Obama so much as points a finger in the direction of the financial industry, and if Romney is elected does anyone think the government will get tougher with big banks, big pharma, or big anything else?

Saturday, June 30, 2012

'Giving Health Care a Chance to Evolve'

Robert Frank discusses market failures in health insurance markets, and how the president's health care plan helps to overcome them:

Giving Health Care a Chance to Evolve, by Robert Frank, Commentary, NY Times: ...Nearly every economic analysis of the health care industry rests on the observation that individually purchased private insurance is not a viable business model...
The fundamental problem is that ... people ... with serious pre-existing conditions ... are likely to need expensive care. Any company that issued policies to such people at affordable rates would be driven into bankruptcy, its most profitable customers lured away by competitors offering lower rates made possible by selling only to healthy people.
Economists call this the adverse-selection problem. Because of it, unregulated private markets for individual insurance cannot accommodate the least healthy — those who most desperately need health insurance.
Many countries solve this problem by having the government provide health insurance for all. In some, like Britain, the government employs the care providers. Others, like France, reimburse private practitioners — as does the Medicare program for older Americans. ...
Modeled after proposals advanced by the Heritage Foundation, the American Enterprise Institute and other conservative research organizations in the 1990s, the main provisions of the president’s health care law were intended to eliminate the most salient problems associated with the current system. ...
It isn’t that people should buy health insurance because it would be good for them. Rather, failure to do so would cause significant harm to others. Society will always step in to provide care — though in much more costly and often delayed and ineffective forms — to the uninsured who fall ill. To claim the right not to buy health insurance is thus to assert a right to impose enormous costs on others. Many legal scholars insist that the Constitution guarantees no such right. ...
What’s important now is how ... the law will ... extend coverage to tens of millions who now lack it. In addition, new insurance exchanges will provide a broader array of care options. ... The point worth celebrating is that last week’s ruling will at last enable our distinctly dysfunctional health care system to evolve into something better.

[More on market failures in health insurance markets here and here.]

Friday, June 29, 2012

More on the Economics of the Mandate

In my discussion of the economics underlying the reason for the mandate (and the penalties needed to enforce it), I talked about the adverse selection problem, but I wish I would have talked about moral hazard as well since that is also part of the problem.

Under adverse selection, relatively healthy people drop out of insurance pools because they expect their health costs to be less than they would have to pay for insurance. As the relatively healthy people drop out, it raises the average cost of covering people (since the relatively healthy are no longer in the pool), which causes more people to drop out (the ones with expected costs that are now less than the higher premiums), which raises the price again, which causes more people to drop out, and so on until the market breaks down entirely.

But even healthy people have some chance of catastrophic illness, illness that could be deathly for example, so why wouldn't they purchase insurance in case this happens?

People know we are a compassionate society, and if they come down with a life threatening disease we will take care of them even if they don't have insurance, i.e. even if moral hazard causes them to shirk the personal responsibility conservatives hold so dear. Thus, relatively healthy people can take a chance and go without insurance secure in the knowledge that they will be treated if something awful happens. Broken bones, catastrophic illness and so on will be covered. But covered by whom? In many cases, the individual will not have sufficient resources to pay for the medical care, it would bankrupt them, so there is no choice but for all of the rest of us to pick up the bill.

A mandate stops this from happening. It forces those who would take a chance and go without care, those who are relying on all of the rest of us to insure them against large, unavoidable medical costs, to insure themselves against this. That is, it stops this moral hazard behavior. (Essentially, adverse selection is about the average or mean cost, moral hazard is about the variance -- loss of life, for example, can be viewed as a very bad draw that occurs with some probability and imposes very large, perhaps infinite costs.)

Adverse selection and moral hazard are not mutually exclusive. As you can see, they work together -- people with expected costs lower than premiums drop out knowing they are covered by the rest of us against a bad draw. A mandate, or its equivalent, helps to overcome both of these problems.

Sunday, June 24, 2012

"Reviving Real Estate Requires Collective Action"

Robert Shiller:

Reviving Real Estate Requires Collective Action, by Robert Shiller, Commentary, NY Times: Imagine that you are watching an outdoor theater production while sitting on the grass. You have difficulty seeing, so you prop yourself up on your knees. Soon everyone behind you does the same. Eventually, most people are kneeling or standing, yet they are less comfortable than they were before and have no better view. Everyone should sit down, and everyone knows it, but no one does.
This is a collective action problem, a phenomenon that is, unfortunately, all too common. At the moment, the trouble in our real estate markets and the drag these markets are placing on our entire economy may be understood as a collective action problem. In a nutshell, mortgage lenders need to write down the amounts owed by individual homeowners — that is, let everyone sit down and relax — but the different stakeholders have been unable to reach an agreement, even if it is in their common interest. ...
If such mortgage principal reductions could be applied on a large scale, there could be large neighborhood effects, raising a sense of optimism among homeowners and bolstering the value of all homes and, ultimately, the whole economy. But mortgage lenders in all their different forms lack a group strategy. ...

He goes on to suggest several solutions to this problem.

Thursday, June 14, 2012

A Back Door to the Public Option?

Robert Reich says there's still hope even if the Supreme Court strikes down the individual mandate in the Affordable Care Act:

A Back Door to the Public Option, by Robert Reich: Any day now the Supreme Court will issue its opinion on the constitutionality of the Accountable Care Act, which even the White House now calls Obamacare.
Most high-court observers think it will strike down the individual mandate in the Act that requires almost everyone to buy health insurance,... but will leave the rest of the new healthcare law intact.
But the individual mandate is so essential to spreading the ... cost of health care over the whole population, including younger and healthier people, that some analysts believe a Court decision that nixes the mandate will effectively spell the end of the Act anyway.
Yet it could have exactly the opposite effect. If the Court strikes down the individual mandate, health insurance company lobbyists and executives will swarm Capitol Hill seeking to have the Act amended to remove the requirement that they insure people with pre-existing medical conditions. They’ll argue that without the mandate they can’t afford to cover pre-existing conditions.
But the requirement to cover pre-existing conditions has proven to be so popular with the public that Congress will be reluctant to scrap it. This opens the way to a political bargain. Insurers might be let off the hook, for example, only if they support allowing every American, including those with pre-existing conditions, to choose ... something very much like Medicare. In effect, what was known during the debate over the bill as the “public option.” ...
The fact is, there’s enough the public likes about Obamacare that if the Court strikes down the individual mandate that won’t be the end. It will just be the end of the first round.

I'd like to think he's right, but hard for me to see this happening. [Here's an old post explaining why an individual mandate is needed.]