Is the Financial Sector a Utility?

Photo by:  futureatlas.com

I am a fervent believer in free markets.  More specifically I believe that they, much like Democracy, are flawed but vastly superior to any alternative.  As various elements in the world decry the current financial crisis as an indictment of the flaws of capitalism, I wait patiently for them to suggest the proven alternative.  Despite this, I am left wondering if the financial sector is an exception to the wisdom of free markets.

Does Regulation Even Work?

If I’m defending free financial markets, my first piece of evidence is the Office of Federal Housing Enterprise Oversight.   This organization was 225 people as of 2006, tasked solely with regulating and overseeing Freddie Mac and Fannie Mae.1 With both of those organizations now being operated by the government after becoming tremendously over-leveraged, the efficacy of regulation is certainly in doubt.  If an organization of 225 people cannot regulate a large financial entity, what good does adding more regulation to the system do? (more…)

1. OFHEO 2006 Performance and Accountability Report [↩]

A Different Kind of Stimulus – Rewarding Our Troops

Photo by: Aaron Escobar

Right now Barack Obama is dealing with resistance to spending trillions of stimulus dollars to help offset reductions in consumer spending.1  While it seems likely that this debt will create a burden for us to deal with later, the notion that we need to put out the fire seems at least somewhat compelling.  While many may question the Obama Administration’s reported claim that this government spending will have wide-ranging benefits, many economists feel that there is a need to replace the decrease in private sector spending.2

When the spending in question is for something that improves the country in the long term, the proposition seems even more appealing.  When we build roads, schools, or even electronic medical records, we’re creating infrastructure that should do long-term good.  It may not be the optimal use of the funds, but it seems a good way to inject some spending into a timid economy and reduce the risk of deflation.

However, while all of this spending is being debated and ramped up, we are simultaneously effectively cutting defense spending.3  This seems both counter-productive and distasteful for several reasons:

Soldiering Is a Shovel-Ready Job

One of the key complaints of Republicans about the spending in the stimulus bill is that it does not take effect quickly enough.4 Military spending, specifically increasing the pay of soldiers and recruiting more, can take immediate effect.  We could start paying our service men and women more tomorrow and that money would flow through the economy.  It would also certainly be a project of less than 1 year to increase recruiting.

Soldiering Is a Public Good

While studies on the effects are rare, anecdotally many soldiers report increases in personal discipline and responsibility due to time in the military.  If young men and women improve their qualities as citizens from military service, it is of great benefit to society.  Additionally, it certainly seems more beneficial than unemployment. 

Obviously having a strong military also benefits our ability to implement foreign policy and maintain peace around the world.  Given that we already have troops in active combat, it seems realistic that additional help would not hurt and give troops a better chance to get out of harm’s way.  It is pivotal however that this spending be on manpower, and not on new technology or other programs.  Modern warfare is rarely the kind of conflict for which stealth bombers were invented, and the goal is to quickly create jobs defending our country.

The Real Boon of an Increased Military

In a time of seeming moral hazard, it seems like a fine time to reward people of service and merit.  While we may have to bail out banks and Wall Street firms with taxpayer money, we can’t feel overly good about it.  Providing bonuses, increased pay, and other perks to our service men and women would not only be more appealing morally, it would have the benefit of creating a notion that the right people get rewarded sometimes.  Much like after World War II, where we rewarded our veterans with perks and programs designed to help them benefit in life, the time seems right for similar spending. 

Rather than cutting defense spending, we should be essentially directing a good portion of our stimulus into rewarding our soldiers that have given us such valiant service, and recruiting more to strengthen our ranks.  The turnaround time on the investment is nearly immediate and it will have long reaching benefits, as our military becomes stronger and perceived as a better destination for young men and women.  It has all the desirable characteristics of a good stimulus plan, with the additional perk that it feels good.

1. SFGate – Obama touts $3.6 trillion spending outline [↩]
2. Wall Street Journal – Government Spending Is No Free Lunch [↩]
3. The Weekly Standard – Senators Raise Concerns about Defense Cuts in Letter to Gates [↩]
4. CNN Money – Stimulus will take a while to work [↩]

AIG and Populist Rage

Photo by: Gene Hunt

Populist rage is all the…well…rage.  Everyone right now is outraged over how much people get paid to do their job poorly, or how much more some people have than everyone else.  Now of course you can make arguments that the income distribution of modern society is counter-productive, but one key question is:

Why Do We Care RIGHT NOW?

As of now Congress is considering passing a tax to basically recoup 100% of any bonuses paid to AIG employees.1  Everyone is incensed that people get paid these bonuses despite their companies doing poorly.  It seems that the public will not be satisfied until they get their pound of flesh.  This leads one to question why we stop at bonuses?  If the American government is willing to institute taxes to recoup money from the employees of this company, why not garnish their wages too?  

They did a bad job, so lets punish them, regardless of whether they were instructed to do what they did, and more importantly:  They have contracts stating they get this pay.2 These employees signed contracts indicating that if certain events happened they would get these bonuses.  We now want to invalidate them, simply because we don’t like what they are getting paid.  Imagine if you were guaranteed a signing bonus after one year of employment and then because the company did poorly, they decided to simply not honor that obligation.

“Yes But They’re Taking Our Bailout”

The justification for this 100% tax is that AIG took our bailout money so all their obligations are moot.  They want our money, they have to do whatever we say.  In theory that sounds fine, but then you have to question why we bailed out AIG in the first place.  The reason we bailed out AIG was so that the people to whom they had obligations would not be wiped out.  AIG had obligations to foreign banks and other institutions and investors that we didn’t want to see destroyed, so we bailed out AIG so they could meet those obligations.  Now we want to essentially pick and choose which obligations we’re willing to meet.

What’s interestingly lost in all of this is the release of AIG counterparties and where all your tax payer money has been going.  Among the recipients of these funds are foreign banks.3  In that same populist vein, had the bonus story not overshadowed this story, would the same people be advocating that we not pay back European banks?  Or other Wall Street firms?  Ultimately all of this bailout money is going to people who helped create the crisis, because if it wasn’t there wouldn’t be a crisis.  It is interesting that in all of this mess, alleged “populists” are getting outraged by individuals having their obligations met, but not institutions.

None Of This Is Fair

One thing you have to remember in all of this is that none of this is fair.  It’s not fair that poorly mismanaged companies get bailed out at all, while people who made much less egregious mistakes go without aid.  However the sum of these bonuses, $170 million dollars in a bailout in the trillions of dollars, seems like too little of a price to compromise the law.  Ultimately when it comes to the law we all like to have a certainty that if we have a contract to receive something, we will receive it.  I personally don’t think it’s wise to discard the law simply because of one of the smaller injustices in a story rife with injustice.  I’d rather not set the precident that in times of crisis, the law goes out the window.  My sharpest criticisms of the Bush administration were that when our principles were challenged we threw them all out the window in the pursuit of revenge, I have no desire to see us repeat that mistake.

1. AIG Bonus Checks May Be Taxed At Up to 100%, Says Sen. Chuck Schumer – U.S. News and World Report [↩]
2. The Case for Payout Out Bonuses at AIG – New York Times [↩]
3. AIG Outs Counterparties – Forbes.com [↩]

Protectionism: A Prisoner’s Dilemma?

Photo by: Kyle May

In game theory there is a “game” called the “Prisoner’s Dilemma.”  In the game, two players have been arrested.  If they cooperate and neither “rats” on the other, they will both go free. If one “rats” on the other, he receives a light penalty while the forsaken prisoner receives a stiff penalty.  If they both turn on each other, they both get a moderate penalty. 1  The basic lesson? Each of the parties would be best served if neither of them participated, but least served if they don’t participate while the other party does.

A real-world example of this could be a sporting event:  say something interesting happens and a spectator stands up to get a better view.  This causes more and more people behind him to stand up, just to get the view they had before.  At the end of this process, everyone essentially has the same view they had before, but now they’re exerting the effort of standing.  If they’d all just remained seated in the first place, they’d all be a bit better off. 2

What Does This Have To Do With Economics?

People say that our current financial crisis will not be as bad as the Great Depression because “we make much better decisions now.”  We know better than to resort to things like high interest rates and protectionism.  We won’t make the mistakes of Smoot-Hawley again.  But history shows that, in general, we were actually smart enough to know that at the time.  While economists rarely agree on anything, they were universally opposed to the Smoot-Hawley Tariffs.3 Yet they happened anyway.

Meanwhile, looking to the present, we see signs of the same kind of thinking again.  We know better than to adopt protectionist policies, but the new administration is already discussing whether to “punish” China with tariffs due to their manipulation of their currency value.4 This justification seems particularly unrealistic as we are creating 0% interest rates and pondering bailing out our auto-makers.  Bad decisions are often deemed bad only in retrospect.  People don’t plan to make bad decisions, they make what they think are good decisions in the vain pursuit of “fairness,” a concept that is ephemeral and non-existent.

So are we faced with a Prisoner’s Dilemma?  Will it deal a crushing blow to our economy if we do not “fight” other countries protectionism with our own.  History has little to say, except that free trade has usually been good for all the parties involved.  If we can buy something cheaper than we can produce it ourselves, then we are better off than if we make it at an inflated price.  It may not necessarily be the case that we need to follow suit if everyone else in the world starts pursuing protectionist policies.

How Does This Affect Me?

As Geithner and his fellows debate whether or not to implement tariffs on China, the most likely action item for you is to be very cautious.  While many may be telling you that this recession will not rival the Great Depression, you can watch as we take the same steps that we’ve decried before, thinking that “things are different this time.”  Almost any negative outcome is a possibility in the short and medium term, and it pays to have something that protects you in each case.  In the short term, deflation seems to be a likely demon, but longer term inflation seems to be the opponent.  Meanwhile, it’s difficult to know whether stocks can be expected to perform.  Ultimately, it is pivotal that you develop an investing strategy that involves protecting yourself and optimizing for your personal situation.

1. Stanford Encyclopedia of Philosophy – Prisoner’s Dilemma [↩]
2. Landsburg, Steven – More Sex Is Safer Sex: The Unconventional Wisdom of Economics [↩]
3. The Economist – The Battle Of Smoot-Hawley [↩]
4. The Washington Post – Geithner Say China Manipulates Its Currency [↩]