Reviewing Political Economics September 22, 2008

There are, of course, a broad range of economic theories.  But among our major political parties, there are fundamentally two opposing views: the “trickle down” or “top down” economics of the Republican Party, and the “bottom up” economics of the Democratic Party.  Both have supporters among economic theorists, so I suppose there is not really any one “correct” theory.  I’ll suggest, though, that recent top down implementations have gotten us into a really bad mess lately.

In top-down economics, there are a few central tenets:

• “In a rising tide, all boats float.”  In other words, if the economy is humming along, both the rich and the poor (yachts and rowboats) have improved positions.  Stimulating the economy means better lives for everyone.
• Less government.  The theory is that markets are more efficient than government is, and therefore government should keep its mitts off of most things.
• Hence, less regulation of industry.  Again, this is basic (and widely accepted) economics 101: the best outcome arises from free markets doing their thing.  Regulations reduce efficiency in markets.
• Taxes should be low, and tax breaks should tend to go to wealthier Americans.  The wealthy are capable of greater investment, so a break to them yields greater economic dividends.
• Reducing taxes and payroll costs for corporations (in addition to reducing regulations) will make them more competitive globally and will thus increase jobs and economic growth.
• Specific to energy costs: the removal of restrictions from oil and gas companies will encourage them to provide more oil, and thus reduce our cost at the pump.

None of this is entirely nonsense, and it has in fact worked very well in the past (as recently as the Reagan years).  It is certainly true that measures to stimulate the top of the economy will almost certainly relieve some pressure at the bottom.

What I wonder is this:  (1) Does top-down economics work for any given country in a global economy?, and (2) Have we underestimated the speed at which our economy has become fundamentally global?

Some of what has worked in the past is questionable in a truly global economy: (1) The wealthy, who formerly could be relied upon to make investments in America, now invest post-tax earnings wherever in the world they can get the highest returns.  In my industry (high-tech), most large venture capital firms now have funds in India or China — seeking increased returns over what they can get right here in Silicon Valley, of course, but at the same time encouraging innovation elsewhere and (relatively) discouraging it in the United States.  These firms are backed by wealthy individuals and funds, who are now investing overseas what they once invested right here.  (2) Corporations, including the oil companies and Wall Street firms, are now also truly global and will find low labor costs and high output wherever they will, anywhere in the world.

The point is this: what once inured to the benefit of the United States, now spreads out across the globe.  A tax cut or deregulation which could formerly be counted upon to “trickle down” across America, may now be trickling down elsewhere, thereby creating an even greater disparity between the haves and the have-nots than ever before in this country.  Are we failing to recognize this?  I think so.

Moreover, the recent melt-down of Wall Street (note that yesterday the last two remaining investment banking firms petitioned to become bank holding companies, thereby completing the cycle) was not the unpredictable “once in a century” perfect storm of which Alan Greenspan speaks.  The deregulation of the banking industry (spurred by top down economics) that started with the Deregulation and Monetary Control Act of 1980 and the Garn-St. Germaine Act of 1982, and continued throughout the last 25 years, has had an absolutely predictable effect: with fewer and fewer regulations on their behavior (and with a growing economy to back them), banks took more and more risk, seeking more and more reward.  They loaded up with debt (of increasingly low quality), until… well.   We all saw what happened.

A bottom-up economic theory takes as its central tenet that the growth and health of the American economy is rooted in the ability and productivity of its workers.  Therefore:

• Investment in the education and health of workers, and investments in infrastructure that will improve their productivity, will aid the U.S. economy far more than tax breaks to corporations and the wealthy will.
• When the financial security of our middle class, particularly, becomes unstable, our productivity drops and our economy suffers, since there is no purchasing power to absorb what we produce.
• Subsidizing basic research (as in alternative energy, for example) will harness creativity and productivity to produce new answers, new economic powerhouses, and new jobs.  Witness the high-tech industry as a classic example.

I’m suggesting this: not that either economic theory is entirely wrong, but that there are “horses for courses,” and the current course (globalization) calls for a re-establishment of a bottom-up economic theory in our government.

What’s Wrong With the Economy September 17, 2008

This is perhaps not as hard as it looks.  Let’s review what has happened recently:

• Two Bear Stearns hedge funds went belly-up.  We all cast stern glances toward the insane risk that was taken: for every $1 in equity in the funds, the fund managers had borrowed $10 to make investments.
• Apparently the lesson above wasn’t learned: when the entire bank was swallowed up by JP Morgan chase, it held $29.90 in debt for every dollar of equity.
• A major player in the subprime mortgage crisis, Lehman Brothers, declared bankruptcy after reporting almost $7 billion in losses over just the prior two quarters.  Again, debts vastly exceeded assets at the company.  Barclay’s swooped in and purchased the bank.
• After losing $51.8 billion in the subprime mortgage crisis, Merrill Lynch was purchased by Bank of America at a price that was a 61% discount from the company’s value a year earlier.
• As Lehman suffered a major decline in value and share price, potential investors began to compare the types of securities held by AIG to those held by Lehman, and found that AIG had valued their Alt-A and sub-prime mortgage-backed securities at rates 1.7 to 2.0 times those Lehman had used for what Lehman officials called similar securities.  From a 52-week high of $70.13, AIG shares plummeted to $1.25.  The Federal Reserve authorized an $85 Billion credit facility to save the company.
• Fannie Mae and Freddie Mac, two Government-Sponsored Enterprises (GSE’s), combined for losses of $14.9 billion.  Market concerns about their ability to raise capital and debt threatened to disrupt the U.S. housing financial market. The Treasury committed to invest as much as $200 billion in preferred stock and extend credit through 2009 to keep the GSEs solvent and operating. The two GSEs have outstanding more than $5 trillion in mortgage-backed securities (MBS) and debt; the debt portion alone is $1.6 trillion.

I think it’s interesting to note that three of these companies (AIG, Lehman and Merrill) exercised major stock buybacks in the past 18 months.  Hmm…

The simple answer to the question, “Why did these companies take insane risks?”, is simple: because there was absolutely no reason not to.

As CEO pay, and particularly CEO severance, has risen to insane levels, we’ve increased the incentive for a CEO to take risks.

Think of it this way: if you’re Carly Fiorina and the world tells you not to buy Compaq, but you knew that even if it was a major screw-up you’d walk away with $42 million, why not roll the dice?  If it works you’re a business superhero; if it doesn’t you’re insanely rich anyway.

The list is long: Fannie Mae and Freddie Mac’s CEOs received $9mm and $14mm, respectively, for their epic messes.  The bank accounts of Lehman, Bear and Merrill’s CEOs are overflowing with cash.  The CEO of Countrywide, one of the architects of our problem, made $414mm over the last few years, then walked away with another $110mm.

Ask yourself: what would you endure for $42mm?  $110mm?  Would you care very much whether people thought you’d messed up?

If you know you’re going to be incredibly wealthy no matter what, it begins to become all about heroics.  “Maybe I can really knock it out of the park!  And if I don’t, so what?”

This decoupling of risk from reward for CEOs is a major reason we’re in the mess we’re in right now.

To Whom Should we be Listening to Solve the World’s Problems? July 4, 2008

We’re hearing a lot these days from climatologists.  They are telling us that global warming is the world’s largest problem.

Meanwhile, other scientists think it’s malnutrition, or the harvesting of the rain forests, or the lack of safe drinking water, or…

The list is long.

Which branch of science should we look towards to help us decide which of these problems is the most important of all?  None of them, it turns out.  We need to listen to the economists.

Economics is a science of choices, really.  The job of the economist is to assess impacts.  And it turns out that a number of economists have now begun to turn their attention toward these problems of science.  The problem is a little different from the economist’s viewpoint: he doesn’t really assess the science — he simply determines what impact a dollar spent to help solve one problem would have, versus a dollar spent to help solve another.  It’s not just an evaluation of how big the problem is — it’s an assessment of how much impact we can have toward solving the problem, of how effective a dollar spent here can be, versus a dollar spent there.

Economist Bjorn Lundberg has taken a lot of well-deserved hits for his book The Skeptical Environmentalist because he overstepped his bounds and spent a lot of time assessing environmental science.  Unfortunately, that has caused too many people to ignore his fundamental premise: that global warming is one of our most intractable problems, and perhaps therefore it is one on which our efforts do us the least good.  When he has his head on straight, he admits that global warming is a huge problem, and it’s an important one.  It’s just that we can do a lot more good with a lot less money if we focus elsewhere.

The question isn’t: what’s a big problem?  It’s: How can we best apply scarce resources to alleviate suffering?

A lot of economists agree on this way of thinking.  The 2004 Copenhagen Consensus was a “dream team” of economists set to the task of assessing the solutions to our world’s biggest problems and producing a prioritized list.  The economists, including Lundberg and eight others (three of them Nobel laureates), produced the following list:

1. Controlling HIV/AIDS
2. Providing micronutrients (iron, zinc, etc.) to malnourished populations
3. Liberalizing trade to even out world prosperity
4. Control of malaria
5. Development of new agricultural technology
6. Improved water delivery and sanitation technologies
7. Reduced governmental corruption
8. Lowered barriers to migration for skilled workers
9. Improved infant and child nutrition
10. Scaled-up basic health services
11. Guest-worker programs for the unskilled
12. Climate control measures (carbon taxes, Kyoto protocol, etc.)

Note that this is not a prioritization of the world’s biggest problems.  It’s an assessment of how effective we can be in solving important problems.  Malaria, for example, can be hugely limited in the world through the wide-scale use of treated mosquito netting, each of which costs a couple of bucks.  Tremendous suffering could be alleviated very cheaply.

Meanwhile, hundreds of billions of dollars spent toward implementing the Kyoto Protocols would simply move the point in time when a coastal family in Bangladesh has their home flooded from 2100… all the way to 2106.  It’s not that it’s not a huge problem.  It’s that we’re not very effective (at least with what we know currently) at solving it.  More suffering can be alleviated if we focus elsewhere.

Isn’t this the way we should be thinking about our problems?

On the Dollar June 4, 2008

Bill Stellmon responded to one of my posts the other day, and asked about restoring the primacy of the dollar.  Since I’ve been on a little politics and economics binge, I thought I’d write about that.

First, I don’t see it as an absolute imperative that our currency be the world standard, or even that our economy overall is the biggest and best, at least by some measures. (I wouldn’t say that about Gross Domestic Product, for example, since our GDP is currently three times the size of the next-closest nation and nearly the size of the entire European Union.  It would be a long fall from #1.)  While it’s not necessarily optimal to be in second or third place, it’s not the disaster that some make it out to be.  I mean, it may not be perfect, but would you run from your homes screaming if our economy or our currency suddenly resembled, say, Japan’s?  Or maybe 5th-place England’s?

It’s worth paying attention to, but it’s not Dawn of the Dead.

But here’s where what National Review economics editor Larry Kudlow once termed the “King Dollar” matters: Weakness in our dollar is currently driving some inflation that is affecting me and you.

Even the dollar’s fall is not entirely bad news: it is more the result of a wonderful global expansion of prosperity than it is of a particularly weak U.S. economy.  (I’m not in love with what’s happening in our economy, particularly on the job front, but let’s not get carried away.)  It’s about China and India and the European Union doing very well.

But that has caused a slippage in demand for U.S. currency.  This goes to the fundamental question of how a dollar rises and falls in the first place, and the answer is the one common to all pricing: supply and demand.  People buy dollars in an open market, and the price is affected by: (a) how many dollars are circulating; and (b) how many dollars people want to buy.  If, with the same supply, buyers are buying more rupees and fewer dollars, the dollar will fall.

Both Fed chairman Ben Bernanke and Treasury Secretary Hank Paulson are finally signaling that they plan to do something about the dollar.  In a speech yesterday, Bernanke indicated (finally) that the Fed is “attentive to the implications of changes in the value of the dollar for inflation and inflation expectations,” and that it intends to do something about that.

Paulson has indicated the same thing, so you can expect an economic pincer move on the dollar, wherein the Fed restricts supply while the Treasury jump-starts demand by buying dollars.  This is precisely what happened in the mid-90s, with Alan Greenspan controlling the money supply while canny former Goldman Sachs trader Robert Rubin bought dollars, to great effect.

So, Bill: What will Sen. Obama (or any other candidate, really) do to prop up the dollar?  Probably watch the Fed and the Treasury play an old and effective game.