Fed Easing Explained

Quantitative easing from Marketplace on Vimeo.

Bailouts and Moral Hazard

For an economist, bailouts raise a lot of red flags regarding incentives. Wikipedia defines moral hazard as:

Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions.

The problem with bailouts: If the expectation is created that the government will bail out firms experiencing economic hardship, they will pursue riskier opportunities than they would otherwise. Of course there is no free lunch, taxpayers end up bearing the cost burden of the now risk enhanced behavior.

Funny

Extreme Losses

As part of the personal finance portion of my contemporary economics course, student spend $10,000 on a portfolio of the stocks of four companies and sell thirteen weeks later. Thus students hold the stocks for one quarter. Students bought their stocks on September 11, 2008 and sold on December 1, 2008. The S&P 500 over that time period lost 41%. Needless to say, students lost a bundle. The consolation is that the money was not real, so the losses are not real either.

Recession: Deep and Wide

The recession looks like it may be a scary one. Click here to read today's unemployment report which shows job losses of 533,000 and an unemployment rate of 6.7%. Get Greg Mankiw's opinion by watching this clip from CNBC.

Pigou Club, Hibbing Chapter

Professor Greg Mankiw of Harvard invites prominent economists and lawmakers who believe that the tax on gasoline should be increased to join the Pigou Club. I invite students to read Mankiw's Pigou Club Manifesto and make a comment below.

Do you support the idea of raising the gasoline tax by $1 over ten years?

What should the tax revenues be used for?

Should the tax be revenue neutral? (This means the new revenue would offset the revenue government receives from other taxes, resulting in no net tax increase on the American people)

Is this a good time to raise the gas tax? The chart below shows average U.S. gas prices over the previous twelve months. Notice the price of gas in Canada. The gap between the two lines represent the difference in the gas tax.




Defend your decision to support or oppose an increase in the gas tax using economic reasoning.

Update: China has bravely announced an increase in its gas tax. Read the full story here. It may interest you to see that it is being offset by reductions of fees and taxes elsewhere and being imposed during a slowing economy. Of course, the Chinese political system makes a tax increase an easier task.

The Paradox of Thrift

There is much talk of the paradox of thrift these days. Wikipedia defines it this way:

The paradox of thrift (or Paradox of Saving) is a paradox of economics propounded by John Maynard Keynes. The paradox states that if everyone saves more money during times of recession, then aggregate demand will fall and will in turn lower total savings in the population. One can argue that if everyone saves, then there is a decrease in consumption which leads to a fall in aggregate demand and thus leads to a fall in economic growth.

Game theory reasoning can also be applied where saving is the dominant strategy.

It's Official: Recession

The NBER has made the call, we are in recession and looks like the pain will last for a while. The full story is here.

The NBER — a private, nonprofit research organization — said its group of academic economists who determine business cycles met and decided that the U.S. recession began last December... Many economists believe the current downturn will last until the middle of 2009, and will be the most severe slump since the 1981-82 recession.

I.O.U.S.A.

Watch for a new film I.O.U.S.A. that attempts to do for fiscal responsibility what Al Gore's "An Inconvenient Truth" did for environmentalism.

Frank and Earnest

Funny stuff. I think the cartoonist was thinking of Alan Greenspan when this was drawn. I fear that Greenspan's statement implying that the free market did not adequately regulate itself in regard to CDOs might become license for over-regulation. As my University of Delaware Macro professor is fond of saying: The pendulum swings to far in both directions. There was probably too little regulation of the financial industry, but hopefully it does not result in too much regulation on the other side of this crisis.

A recession is when...

Click on the image to see a larger version.

Merry Christmas

Why Isn't GM Competitive?

Total compensation would include benefits as well as wages.



On his Blog, Nobel Laureate Economist Gary Becker explains the lack of competitiveness by GM not because of the skill level of American workers, but large differences in cost structure. In his words:

Nevertheless, I believe bankruptcy is better than a bailout for American consumers and taxpayers. The main problem with American auto companies is that during the good times of the 1970s, 1980s and 1990s, they made overly generous settlements with the United Auto workers (UAW) on wages, pensions, and health benefits. Only a couple of years ago, GM was paying $5 billion per year in health benefits to retirees and current employees because their plans had wide health coverage with minimal co-payments and deductibility on health claims by present and retired employees. In those days, the UAW was one of the most powerful unions in the US, and it bargained aggressively with the auto manufacturers, carrying out strikes when its demands were not met. When the American auto industry began to face tough competition from Japanese and German carmakers, they were saddled with excessive pay to their workers, and vastly excessive pensions and health benefits to their current and retired workers.

It is not that cars cannot be produced profitably with American workers: the American plants of Toyota and other Japanese companies, and of German auto manufacturers, have been profitable for many years. The foreign companies have achieved this mainly by setting up their factories in Southern and border states where they could avoid the UAW, and thereby introduce efficient methods of production. Their workers have been paid well but not excessively, and these companies have kept their pension and health obligations under control while still maintaining good morale among their employees. In recent years GM and the other American manufacturers have chipped away at their generous fringe benefits, but their health and retirement benefits still considerably exceed those received by American auto workers employed by foreign companies. As a result of lower costs, better management, and less hindrance from work rules imposed by the UAW, about 1/3 of all cars produced in the US now come from foreign owned plants.

More on Education

Because it became a campaign topic, it seems that education has become a popular conversation topic again. Below, I have a segment from this very interesting article, thanks to the Mankiw site for the linkage. It is true that income inequality seems to be a growing problem. The author gets to the root cause of income inequality, the growing income premium going to high skilled workers. Income redistribution solves the problem of poverty (lack of money), but does not get at the cause of poverty...low income. Education gives workers the opportunity to acquire the skills needed to earn a larger income.

The most effective anti-poverty program we could devise for the long run would have less to do with income redistribution than with ensuring that poor kids get a first-rate education, from preschool on. One recent study found that if American students did as well as those in several Asian countries in math and science, our economy would grow 20 percent faster.

So let’s break for a quiz: Quick, what’s the source of America’s greatness?

Is it a tradition of market-friendly capitalism? The diligence of its people? The cornucopia of natural resources? Great presidents?

No, a fair amount of evidence suggests that the crucial factor is our school system — which, for most of our history, was the best in the world but has foundered over the last few decades. The message for Mr. Obama is that improving schools must be on the front burner.

To Barack Obama, From Mankiw

Greg Mankiw writes a letter to President-Elect Barack Obama. It is fantastic, I would suggest reading the entire letter posted on the Mankiw blog. Here is what he has to say about Obama's economic advisors.


Listen to your economists. During the campaign you assembled an impressive team of economic advisers from the nation’s top universities, including Austan Goolsbee from University of Chicago and David Cutler and Jeff Liebman from Harvard. Your campaign’s director of economic policy, Jason Furman, is a smart, sensible, and well-trained policy economist. I know: He is a former student of mine.

Pay close attention to what they have to say. They will often give you advice quite different from what you will hear from congressional leaders Nancy Pelosi and Harry Reid. To make sure you hear the views of your economists, put them in offices close to yours. Tell your chief of staff to invite them to all the relevant meetings.

President Obama

Let's hope he lives up to the hype. Thanks to the Mankiw site for the picture.

End Adolescence?

Former Speaker of the House Newt Gingrich proposes a societal change in how we treat adolescence. In this BusinessWeek article he proposes to incentivize educational achievement and propel our young into adulthood at an earlier age.

In math and science learning, which are among the most important indicators of future prosperity and strength, America lags far behind such emerging powers as China and India. Studying to compete with Asian counterparts in the world market is going to keep U.S. teens busier than anyone ever imagined. This will require year-round learning, with mentors available online, rather than our traditional bureaucratic model of education. But we must go further, toward a dynamic, real-world blueprint for learning.

Indeed, going to school should be a money-making profession if you are good at it and work hard. That would revolutionize our poorest neighborhoods and boost our competitiveness.

The fact is, most young people want to be challenged and given real responsibility. They want to be treated like young men and women, not old children. So consider this simple proposal: High school students who can graduate a year early get the 12th year's cost of schooling as an automatic scholarship to any college or technical school they want to attend. If they graduate two years early, they get two years of scholarships. At no added cost to taxpayers, we would give students an incentive to study as hard as they can and maximize the speed at which they learn.

Once we decide to engage young people in real life, doing real work, earning real money, and thereby acquiring real responsibility, we can transform being young in America. And our nation will become more competitive in the process.

Should Everyone Vote?

Is it rational to not vote? Should everyone vote? As a social studies teacher it seems to be my role to encourage everyone to vote. Harvard's Greg Mankiw calls this logic into question. Read the story and comment. It seems more rational to not encourage people to vote and instead let each individual decide if he or she has the information necessary to make a good decision.

Tax Policy Reminder From Abe

Abraham Lincoln said, "You cannot help the poor by tearing down the rich. You cannot help the wage earner by hurting the wage payer."

Why America Needs an Economic Strategy

As we wait for election results and speculate of the economic ramifications of a change in administration, read Why America Needs an Economic Strategy, from the most current issue of BusinessWeek. The author, Michael E. Porter, maps out a strategy to make America more competitive in the global economy. I have a few questions about a few of the ideas, but it is a very thought provoking article. Porter has this to say about education:

A final strategic failure is in many ways the most disconcerting. All Americans know that the public education system is a serious weakness. Fewer may realize that citizens retiring today are better educated than the young people entering the workforce. In the global economy, just being an American is no longer enough to guarantee a good job at a good wage. Without world-class education and skills, Americans must compete with workers in other countries for jobs that could be moved anywhere. Unless we significantly improve the performance of our public schools, there is no scenario in which many Americans will escape continued pressure on their standard of living.

Economists for _______________.

Tomorrow is election day. Have you made up your mind? Economists have lined up behind their candidates. Check out the sites: Economists for McCain and Economists for Obama.

Will China and India Dominate the 21st Century?

Check out this video: Will China and India Dominate the 21st Century Global Economy? If so, is that bad for America? What will losing economic dominance mean?

Helicopter Ben to the Rescue

Watch this great video of superhero Helicopter Ben Bernanke saving the U.S. economy. Thanks to the Mankiw blog for the link.

Wikipedia explains how Helicopter Ben got his nickname via Milton Friedman:

In 2002, when the word "deflation" began appearing in the business news, Bernanke gave a speech about deflation. In that speech, he mentioned that the government in a fiat money system owns the physical means of creating money. Control of the means of production for money implies that the government can always avoid deflation by simply issuing more money. (He referred to a statement made by Milton Friedman about using a "helicopter drop" of money into the economy to fight deflation.) Bernanke's critics have since referred to him as "Helicopter Ben" or to his "helicopter printing press".

Where to Invest

I have stated before that this market provides a great buying opportunity for long-term investors. The question becomes what to buy. Picking the winners is always difficult, especially in a market like we have now. In this article Knight Kiplinger ("Knight" is a pretty cool name) suggests avoiding the risk of picking the winners and buying the whole market. I agree. I have been buying the market via the Vanguard Total Stock Market Index Fund. Indexing is a great way to invest, for a convincing case on index investing read A Random Walk Down Wall Street by Burton Malkiel, a Princeton economist.

Buffet Says its Time to Buy U.S. Stocks

Warren Buffet shares this wisdom in the New York Times, explaining why he sees now as a great time to buy U.S. stocks:

Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: “I skate to where the puck is going to be, not to where it has been.”

Who should you vote for?

Take the Select A Candidate survey and find which candidate matches your stand on the issues. On a related topic, much has been made of the fact that the stock market tends to do better while a Democrat is in the Whitehouse, Mankiw discusses the issue in this post. Remember that correlation is not the same as causation. After all, there are many stock market theories that are irrational such as the hemline theory and the NFC Super Bowl idea.

Tragedy of the Commons

Private property is the cornerstone of a market economy. The tragedy of the commons describes the dilemma in which multiple individuals acting independently in their own self-interest can ultimately destroy a shared resource even where it is clear that it is not in anyone's long term interest for this to happen. When resources are commonly owned, incentives ensure that the resource will be depleted. Think cows and whales. In spite of the fact that cows are a major food source and it is illegal to kill whales, it is whales that are in danger of extinction - mainly because of property rights. Play the Tragedy of the Bunnies game for fun with this concept.

Credit Crisis Explained

This link is a great clip on the cause of the crisis. Click on the streaming video clip.

AIG and Credit Default Swaps

Click on this link and then the streaming video link to for a great piece on AIG and credit default swaps.

Bailout Analogy

For a good analogy of why the bailout is necessary try this article by Charles Wheelan

The Fire Next Time

Here's the best analogy I can offer. Suppose a guy down the street has been smoking in bed for the last 20 years. That's a stupid, irresponsible thing to do, and lots of people have told him so.

He just happens to live next to another idiot who stores containers of gasoline in his garage. He, too, ought to be fully aware that this is a foolish thing to do.

Predictably enough, the guy smoking in bed starts a fire that explodes in force when it hits the gasoline-filled garage next door. Now there's a hell of a blaze going on. If these two guys lived alone in a remote area of rural Montana, we wouldn't have much to discuss. But they don't. Instead, the fire is spreading down their residential suburban street, burning houses where nobody smokes in bed or keeps gasoline in the garage.

Damage Control

That's about where we are right now with the financial crisis. The question isn't whether we should rush to save the morons responsible and put ourselves at risk in the process. We shouldn't. The question is whether we should intervene to save the rest of the neighborhood. We should.

The fire department may end up helping our smoker and gas-can man just because it's an unavoidable part of fighting the larger fire. That's unfortunate, but it's not a good reason to call off the fire department. I don't get enough utility out of standing amid the smoldering ruins of their houses to justify the risk that the same thing may happen to my house a few hours later.

If you want to fine these guys, or put them in jail, or take away what's left of their property -- fine. That seems perfectly appropriate. But just make sure you take care of the fire first, because that's what's dangerous here.

SNL and the Financial Crisis

Follow the link to Mankiw's blog and watch the SNL clip...funny stuff.

A Buying Opportunity?

The markets have taken a pounding, this might be a buying opportunity. Warren Buffett, richest man in the world, said, "you should get greedy when others are fearful and fearful when others are greedy."

The Ted Spread

The attention of most people during the current financial crisis has been on the stock market. While the crisis is reflected in the price of stocks, the real crisis is in the credit markets. Economists look at the Ted Spread, which shows the yield spread between U.S. Treasuries and inter-bank loans. The greater spread reveals the fear that banks have in lending to each other. For a more complete explanation, click here. Normally, the Ted spread is 10 to 50 basis points or .1 to .5 on the graph, for a current read click here.

Who is to blame: Wall Street or Washington?

Politicians are having a field day blaming the current financial crisis on Wall Street greed. True, the financial sector did not use good judgement in their risk management, but government has a much larger role than most are talking about. Check out a clip from this article by Russ Roberts:

David Klein

Part of this story is true. The fall in housing prices did lead to a sudden increase in defaults that reduced the value of mortgage-backed securities. What's missing is the role politicians and policy makers played in creating artificially high housing prices, and artificially reducing the danger of extremely risky assets.

Beginning in 1992, Congress pushed Fannie Mae and Freddie Mac to increase their purchases of mortgages going to low and moderate income borrowers. For 1996, the Department of Housing and Urban Development (HUD) gave Fannie and Freddie an explicit target -- 42% of their mortgage financing had to go to borrowers with income below the median in their area. The target increased to 50% in 2000 and 52% in 2005.

For 1996, HUD required that 12% of all mortgage purchases by Fannie and Freddie be "special affordable" loans, typically to borrowers with income less than 60% of their area's median income. That number was increased to 20% in 2000 and 22% in 2005. The 2008 goal was to be 28%. Between 2000 and 2005, Fannie and Freddie met those goals every year, funding hundreds of billions of dollars worth of loans, many of them subprime and adjustable-rate loans, and made to borrowers who bought houses with less than 10% down.

The Invisible Heart

Students,

As you are reading The Invisible Heart, feel free to post questions, comments, or concerns to the blog for your classmates to read and react to. I will also post a comment now and then.

Rent Control

Swedish economist Assar Lindbeck said:

Rent control appears to be the most
efficient technique presently known
to destroy city - except for bombing.

In spite of economists explaining the harsh costs associated with rent control, New York city still uses this inefficient system. Most New Yorkers also favor the policy, fearing the skyrocketing rents that might result if rent controls ended.

What do you think of rent control? Why is rent control bad policy? Is rent control "efficient" as your book describes it? In the comment area, address the previous questions and use your knowledge of markets to argue for the end of rent control and assure residents of NYC that the world will not end if rent control does. Post at least one statement and comment on a classmate's post.

To read the comments or post your own comment click "comments" below.

Economists See Bailout as Necessary

Economist usually prefer little government presence in areas where markets excel. The current financial crisis seems to be different, check out this article.

AIG and the Financial Crisis Explained

For an excellent explanation of things in the news try this article.

I posed this question to my Money and Banking professor at the University of Delaware, Dr. James Butkiewitz:

I am following the happenings in the financial sector like everyone else. I hear lots of politicians complaining about taxpayers being on the hook for AIG. Did the Fed issue the loan? If so, isn't the loan an increase in the money supply and not an increase in government debt? Isn't it similar to an open market operation, where this time the Fed is exchanging money for equity?

His response:

As I understand this, they are making the equivalent of a discount loan to AIG. By itself, this action increases the money supply, and would cause the federal funds rate to fall below the target. To keep the funds rate near the target, the Fed could undertake defensive open market sales to drain reserves from the banking system. However, as you probably have also read, the Fed is running low of T-bills to sell, and has made arrangements with the Treasury to obtain more T-bills to be able to maintain overall liquidity in the system at the desired level

To that end, Congress appears willing to authorize paying interest on banks’ reserve deposits with the Fed, effectively instituting the channel/corridor system we discussed this past summer. Thus, if the primary credit rate is 2.25% and the reserve deposit rate is 1.75% (just a hunch) the fed funds rate will stay close to the current 2% target, and will not fluctuate outside of the limits of the channel/corridor (1.75 – 2.25). Also, given the risk of lending, even for 24 hours, to some of the riskier banks, there may be a risk premium involved in fed funds lending that keeps the funds rate about the reserve deposit rate (I’m honestly not familiar with these intricate details of the fed funds market).

He also cited this release from the Federal Reserve.

Root Beer Bar Stool Economics

Our Tax System - Some guys go into a bar.....

Our Tax System Explained: In Root beer Bar Stool Economics

For those who understand, no explanation is needed.
For those who do not understand, no explanation is possible.

Suppose that every day, the same ten men go out for root beer and the
bill for all ten comes to $100. If they paid their bill the way we pay
our taxes, it would go something like this:

The first four men (the poorest) would pay nothing.
The fifth would pay $1.
The sixth would pay $3.
The seventh would pay $7.
The eighth would pay $12.
The ninth would pay $18.
The tenth man (the richest) would pay $59.

So, that's what they decided to do.

The ten men drank in the bar every day and seemed quite happy with the
arrangement, until one day, the owner threw them a curve. 'Since you
are all such good customers,' he said, 'I'm going to reduce the cost of
your daily root beer by $20.' Drinks for the ten now cost just $80.

The group still wanted to pay their bill the way we pay our taxes so
the first four men were unaffected. They would still drink for free.
But what about the other six men - the paying customers?
How could they divide the $20 windfall so that everyone would get his
'fair share?' They realized that $20 divided by six is $3.33. But if
they subtracted that from everybody's share, then the fifth man and the
sixth man would each end up being paid to drink his beer. So, the bar
owner suggested that it would be fair to reduce each man's bill by
roughly the same amount, and he proceeded to work out the amounts each
should pay.

And so:
The fifth man, like the first four, now paid nothing (100% savings).
The sixth now paid $2 instead of $3 (33%savings).
The seventh now pay $5 instead of $7 (28%savings).
The eighth now paid $9 instead of $12 (25% savings).
The ninth now paid $14 instead of $18 (22% savings).
The tenth now paid $49 instead of $59 (16% saving s).

Each of the s ix was better off than before. And the first four
continued to drink for free.

But once outside the restaurant, the men began to compare their savings.

'I only got a dollar out of the $20,'declared the sixth man.
He pointed to the tenth man, 'but he got $10'.

'Yeah, that's right, exclaimed the fifth man. 'I only saved a
dollar, too. It's unfair that he got ten times more than I got'

'That's true' shouted the seventh man. 'Why should he get $10 back
when I got only two? The wealthy get all the breaks!'

'Wait a minute,' yelled the first four men in unison. 'We didn't
get anything at all. The system exploits the poor!'

The nine men surrounded the tenth and beat him up.

The next night the tenth man didn't show up for drinks so the nine sat
down and had beers without him. But when it came time to pay the bill,
they discovered something important. They didn't have enough money
between all of them for even half of the bill!
And that, ladies and gentlemen, journalists and college professors, is
how our tax system works. The people who pay the highest taxes get the
most benefit from a tax reduction. Tax them too much, attack them for
being wealthy, and they just may not show up anymore. In fact, they
might start drinking overseas where the atmosphere is somewhat
friendlier.

David R. Kamerschen, Ph.D.
Professor of Economics
University of Georgia

Politics and Rent Seeking Behavior

Why was there not more regulation of Fannie Mae and Freddie Mac in spite of many efforts? Rent seeking.

From the Washington Post:

Sen. Christopher Dodd, the Democratic chairman of the Senate Banking Committee, has the gall to ask in a Bloomberg Television interview: "I have a lot of questions about where was the administration over the last eight years"... Meanwhile, Dodd -- who along with Democratic Sens. John Kerry, Barack Obama and Hillary Clinton were the top four recipients of Fannie and Freddie campaign contributions from 1988 to 2008 -- actively opposed such measures and further weakened existing regulation.

A Starting Point... the Energy Conundrum

It has been evident in the recent past that the price system is an effective way to address our current energy issues. We have been talking a good game on energy for several years, but it is not until prices increase that personal decisions start to change. Incentives matter. So, how about picking the low hanging fruit. Here are some common sense solutions to our energy crisis.

1) Take Makiw's advice. Increase the gas tax by $.10 per year for the next ten years. A gradual phase in gives consumer the assurance that gas prices will continue to increase so they can plan accordingly. We know that demand for gasoline tends to be relatively inelastic in the short run, but elasticity increases as time passes. As a result of increasing prices, we should see a continuation of the recent interest in fuel efficient cars. As consumer dollars flow to fuel efficient vehicles, producers will respond by competing to produce the most fuel efficient vehicles. Check out this article about a 65 mpg vehicle Ford will produce and sell in Europe, but won't be available in the U.S. because American consumers are not ready for diesel cars yet. Expensive gasoline will also make hybrids and electric cars more attractive.

2) Eliminate the ethanol subsidy. The subsidy is a wasteful example of rent seeking that warps the market for fuel as well as the market for food. Since the much touted benefits of ethanol are questionable (more likely doubtful), let it compete in the marketplace without the subsidy.

3) If you love the idea of ethanol, eliminate the tariff on imported ethanol. The Brazilians use sugar cane to produce ethanol. It is a more efficient process than using corn. Current protectionist policies to protect farmers make ethanol imports cost prohibitive. While this is still an energy import, it is from Brazil instead of Venezuela, Russia, Saudi Arabia, or Iran.

4) You wont find me chanting Drill Baby Drill, but I think we should allow more drilling on Federal lands than we currently do. Current technology allows drilling for oil without the environmental destruction of the past.

While more complicated proposals including CAFE standards tax incentives are being floated by politicians, I think markets may be able solve the problem more effectively though the gas tax.

Readers please feel free to make other suggestions in the comment section.

The Candidates Take on Social Security

We all know the impending problems with Social Security and Medicare. So far politicians have been able to mobilize their base by talking about solutions, but talk has not translated into policy. This article reports:

The McCain strategy:

Obama said McCain's campaign has suggested trimming Social Security benefits and raising the eligibility age...McCain has not specifically embraced such plans. But by saying "everything is on the table" in discussing changes to Social Security, he has opened himself to such criticisms from Democrats. Obama also said McCain wants to privatize a portion of Social Security. McCain has praised the notion of letting younger workers place a portion of their Social Security taxes into a package that is invested and follows them to retirement, but he has not made it a campaign promise."

The Obama strategy:

Obama cited his proposals to place a new Social Security payroll tax on incomes above $250,000 and to eliminate federal income taxes for older people making less than $50,000 a year. He also said he would "allow the government to negotiate with drug companies to lower costs for seniors, and we'll allow reimportation of drugs from other countries and ensure their safety."

Nothing new here for either party. Democrats prefer taxing the rich. I assume Obama would cap benefits for the rich as well, making Social Security more of a social safety net and wealth transfer program than it already is. Republicans preferring to cut benefits at the margins - McCain has discussed adjusting the cost of living benefit increase to more closely match the inflation rate. McCain has also discussed partial privatization, something economists have been talking about for quite some time.

3D Map of Global Economic Output

Click here to view a 3D map of global economic output. Very Cool.

Iowa Futures Market

Futures markets tend to be more accurate than polls. So what do the Iowa Futures Markets have to say about the future presidential election? Check here.

At this point in time, the Iowa market show a close popular vote, but gives Obama the electoral college. The Intrade Market predicts a similar outcome. Remember that market prices are determined with current information. As information changes, so do markets.

Build Your Econ Knowledge

I have discovered a nifty way to build your Econ knowledge and understanding while driving in your car - the Teaching Company sells lectures by some of the top instructors in the country. You may feel a little nerdy telling your friends that you listen to econ lectures instead of classic rock, but if you read this blog you are just a few steps away. :)

Here are my suggestions.

Economics, 3rd Edition hits all the major themes (without the numbers, charts, or graphs) you would encounter in a Principles of Micro/Macro course. (It's on sale right now)

History of the U.S. Economy in the 20th Century is just that. The lecture on the Great Depression is helpful. (It's also on sale right now)

Legacies of Great Economists gives a bio of 10 of the great economic thinkers - my favorite is Milton Friedman if anyone cares.

Modern Economic Issues gives the econ spin on issues from sports stadiums to health care.

Politics and Economic Growth

This paragraph from the Wall Street Journal does a fine job explaining a defining difference between Republican and Democrats:

In stark contrast to Barack Obama, Mr. McCain believes that tax policy should be used to foster the creation of jobs and higher wages through economic growth, rather than to redistribute incomes. The economy is not a zero-sum game in which some people can enjoy higher incomes only if others are made worse off.

One party's platform proposes policies that will grow the economic pie, thus making all pieces bigger at the same time. The other proposes cutting the pieces of the pie in a more equal fashion, making some pieces bigger at the expense of others.

GDP and Trade

As you Econ studs know GDP = C + I + G + (X - M). The year over year GDP reading for the second quarter (reported here) was a stronger than expected 3.3%. The reasons? One can safely assume that rebate checks turned into "C", but trade provided a nice stimulus of its own. Imports (M) were down 7.6% and exports (X) up by 13.2%. The reason? The weak dollar.

Budget Hero

Try Budget Hero and experience scarcity first hand. You will have the opportunity to be the fiscal policy commander and try to solve big problems like social security and medicare. Give it a try.

We're All Entrepreneurs

This article from Businessweek combines two themes that I studied to a great extent at the University of Delaware - globalization and entrepreneurship. In the article, author Marshall Goldsmith says:

"In the new era of uncertainty, we all need to think like entrepreneurs.

The West is just beginning to understand what globalization really means. We hoped it would mean a world of people competing to buy our products. We liked the idea of a globe producing products that we could buy for less money. Now we're beginning to learn that globalization means that people across the planet are competing for our jobs. We are just beginning to understand the impact of a world competing for food, oil, cement, wood, and natural resources... Young people in the West need to learn the meaning of one word that all successful entrepreneurs know well: compete."

The Demand for Smaller Houses

Many of the articles I have been reading lately have been extolling the market for smaller houses. After the building boom in McMansions that typified the late 90s and early 00s, all of a sudden the small house looks attractive again. Why? Let's start with the housing crisis. Turn the clock back a year or so - people borrowed huge sums of money with questionable credit. Mortgages companies went out of their way to make sure you could get any house you wanted, in spite of your ability to pay. Why bother with a small house when your mortgage company was more than willing to loan you the money for a big one? This is America right, bigger = better. Many of those ARMs are resetting at higher rates, giving people second and third thoughts. Back to reality, mortgage companies have realized there errors and buyers are finding harder to find mortgage funds. Reason number two, many of these McMansions were built on the undeveloped city fringes where the lots are big. This makes for a long commute. When gas is below $2 a gallon the cost of the long commute was about the opportunity cost of time. When gas hit four dollars, the McMansion looked a lot less attractive. Reason number three is utilities. We tend to focus on gasoline prices because they are posted on every street corner, but heating oil and natural gas prices have skyrocketed as well. The McMansion is big and therefore very expensive to heat. This Businessweek article brings in the retirement of the babyboomers, predicting that many will choose to retire to smaller homes..."As the population ages, smaller homes will be more in demand and many larger homes will be on the market". After all, if your wealth is tied up in home equity, you must sell the home to realize the gains. In order to use the gains, one must buy a less expensive home or move to a more affordable housing market. My prediction: smaller homes will appreciate at a faster rate than McMansions if these trends continue.

The Demand Curve for Gasoline

Businessweek reports a decline in gasoline consumption to the lowest level in five years. This brings to mind many phrases tossed around on CNBC lately such as "demand destruction" and "the cure for high prices is high prices". Both speak of the relationship displayed by the simple demand curve - as prices rise, the quantity demanded falls. When the prices rose, consumers reacted by buying less. The demand for gasoline is relatively inelastic which means that consumers are not very sensitive to changes in price. This doesn't mean that consumers don't complain about the change in price, it just means that consumers are not able to change their behaviors quickly in response to price changes. For instance, I still have the same car as I did last year when gas prices were lower and I still live the same distance to work, etc. If gas prices stay high I will make long-run adjustments and buy a more efficient car next time or move closer to work. In any case over time people make adjustments. Of course this same phenomenon could be used to easily cure our dependence on oil - a goal politicians have spoken of for decades but they have never had the political will to do something about it. The easiest solution is to use market forces - increase the gas tax. Read Greg Mankiw's plan and comment below. The gas tax has never been seriously considered in the U.S. because the Democrats think that the word tax should only be followed by "the rich" (and gas taxes are regressive) and Republicans think that the word tax should only be followed by the work "cut".

College Majors and Income

Students may want to check this link for income data. Money is not the only think to consider when picking a major, but it is does determine future consumption of goods and services.

Fed Meeting August 2008

One of my assignments at the University of Delaware this summer was to read up on the current state of the U.S. economy and make a policy recommendation for the Federal Reserve FOMC meeting of August 5. We will see if I was in the neighborhood of Bernanke, Mishkin, and the gang at the conclusion of today's meeting.

The Federal Open Market Committee (FOMC) finds itself stuck in the crux of its dual mandate of full employment and price stability. The economic times are further complicated by the crisis in the financial industry and volatile oil prices...

Policy Recommendation: The Federal Reserve’s dual mandate of full employment and price stability makes the current situation incredibly difficult. While weak growth numbers and falling consumer confidence is a worry, one of the biggest issues in our current situation is providing liquidity to the financial sector. If banks are unwilling to borrow and lend, money growth and therefore economic growth becomes difficult. Indeed, many of the steps taken by the Federal Reserve in the past months have been to shore up the financial sector and safeguard the larger economy from further damage. This said, I also am very concerned about inflation. The current inflation numbers are higher than we have seen in quite some time and I fear that these effects will spill over into expected inflation. Once rising inflation is built into expectations it is very difficult to tame. On the one hand, it seems that inflation has been confined mainly to food and energy, (confirmed by the much lower core-CPI rate) and the Fed continues to forecast lower inflation rates later this year and next year. Indeed, inflation pressures may be easing a bit evidenced by the recent decline in oil prices. On the other hand, the Fed was very aggressive in cutting rates over the past nine months. The lag time necessary for policy to have its intended effects means that the cuts of this earlier this year won’t be fully felt until late this year and into next year. As these cuts start to have their intended effect, the current inflation problem may well become even more pronounced. Another consideration is the political business cycle. While the incumbent president is not running for re-election, the Fed might appear least biased by not increasing the interest rates until after the election. As I weigh these very heavy issues, I recommend that the Federal Reserve maintain the current 2% Federal Funds Rate with a clear statement expressing inflation concerns and a clear signal that the Fed remains ready to raise rates if necessary. Leaving rates the same will give the financial sector breathing room while they recover from the current situation and it will give the Fed time to see if policy is working and if inflation is in the process of retreating.

Taking the market in perspective

The current market has many people worried. The top image shows valuation of the VFINX - Vanguard 500 Index Fund, which tracks the S & P 500. It looks scary.

The second is the five year picture of the same fund. This chart puts the current dip in perspective. Also realize that none of the above charts include the dividends paid to investors.

The last shows the same fund going back to 1987. The crash of October 1987 is at the far left. In retrospect the current situation is just a blip, so keep perspective and hold on for what could be a wild ride. Also, if you practiced dollar cost averaging during the 2001-2003 downturn, you took advantage of the dip by buying at what looks now like sale prices. By taking a broader view you can see that if you have a long time horizon, dollar cost averaging through the rough patches can pay off in the long run.

A Plan to End Our Oil Reliance

Legendary oil man T. Boone Pickens has made his fortune in the oil industry. Now he is spending his money to convince the American people it is time to end our reliance on oil. Click on this link to find out more about his plan. This link will show you the story as covered by CNBC.

The #1 Fiscal Problem for the U.S. Government

I visited the Brookings Foundation, The Heritage Foundation, the Cato Institute, and the American Enterprise Institute last week in Washington DC. All of the economists we spoke to expressed their concern for the impending crisis funding Social Security and Medicare. Economists have been warning of the problem for decades, but little has been done because of a lack of political will by the leadership represented in both parties. Click this link and watch a very important video clip. It is almost one year old, but the message is the same. Since the clip, David Walker has quit his job with the GAO to take this message on the road full time.

Looking Back at Gas Prices

Above is a six year chart of average gas prices in the U.S. from gasbuddy.com. Click on the chart above to see a bigger version.

Protectionism

Consider this: when we want to punish one of our enemies we use trade sanctions (think Cuba, North Korea, Iran). This is a logical way of punishing an enemy. So why do use the same mechanism to "protect American workers" that we use to punish foreign nations?

Economist Henry George said it this way:

What protection teaches us to do to ourselves in times of peace
is what enemies do to us in times of war.

Thoughts on Housing

I find myself reading and discussing the housing market often theses days, given the current credit crunch and housing slump. Here are some thoughts I have had recently.

First, the pervasive (and false) belief that we had come to believe, housing prices always rise. I am sure your Realtor told you that, or at least made the implication. Like all assets, we have had booms and busts. One concept borrowed from the world of finance is mean reversion. Mean reversion is a theory suggesting that asset prices and returns eventually move back towards the mean or average. This suggests that a period of price appreciation of 20% over four years might be followed by a negative return for a few years as the asset class returns to its mean. The graph above is good evidence for mean reversion. In hindsight, no one should be surprised by the falling housing prices, given the unbelievable increase in the price the last few years have seen. This can also be called the “greater fool” method of investing. People may knowingly buy an overvalued asset as long as they believe a greater fool will come along and buy it at a higher price. This works for awhile, but someone is always left holding the bag when prices start to fall.

Second, the tax treatment of housing makes it an attractive “investment”, actually houses are assets, not investments. Strictly speaking, an investment will provide a stream of income. Stocks provide dividends and the hope of capital gain. CDs and Bonds provide interest. Rental property provides rent payments. Your house is not an investment it is an asset. The tax code gives you a tax deduction for mortgage interest, which is a housing subsidy for those who use debt to purchase housing. Any time you subsidize an activity, you cause more of it to happen. We also subsidize the secondary mortgage market with government subsidized enterprises such as Fannie Mae and Freddie Mac. The code also excludes the capital gains on housing appreciation for most people. One the other end, there is no subsidy for the purchase of stocks and bonds, and the tax code taxes capital gains and dividends. As a result, Americans often choose housing over other assets. No wonder we are the land of huge houses and a negative savings rate. Many economists say our long term growth potential may suffer because people choose housing over more productive assets. More productive assets? If people put more money into financial markets and less into the housing market, more financial capital would be available to firms looking to expand and for entrepreneurs looking to innovate.

The Myth of the Rational Voter

Economics assumes that consumers act rationally. Sometimes this is a real leap of faith, but without the assumption of rationality, the predictive nature of the science becomes impossible. This creates difficulties when analyzing public policy because the result is rational voters and politicians that choose bad policies from the economic perspective: farm subsidies and trade barriers among the most common.

The standard explanation of this behavior goes something like this: the benefits of such policies are concentrated while the costs are diffused. Take sugar beet farmers in northwest Minnesota as an example. The combination of subsidies and the tariff on imported sugar means big money for a relatively small group of farmers, thus the farm bill means tens of thousands of dollars. The costs are spread out among all consumers of products with sugar, the resulting higher price of sugar may mean a few dollars a year. As a result, the beneficiaries (farmers) have a big incentive to lobby members of congress and work for protection from foreign competition and a continuation of subsidies. Because the cost to any individual consumer is relatively small, the consumer has little incentive to work for removal the wasteful policy. The explanation assumes that citizens know the policy is bad, they just don’t have the incentive to work end it.

In his book The Myth of the Rational Voter, George Mason University economics professor Brian Caplan has a different explanation. My blog post day is based on an interview with economists Russ Roberts found here. If you are interested in politics and economics and are willing to invest 80 minutes, you will enjoy listening. Caplan says voters actually approve of bad policy because they have incorrect information. Politicians continue to support these bad policies in order to get votes. He points to three biases as the source of much bad policy that citizens and therefore politicians continue to support. I discuss the “make work bias” below.

Caplan says many voters rate economic policy by the number of jobs created instead of how much is produced. We often hear people berate free trade and technology for the number of jobs that were lost as a result. They praise government policy that creates jobs, regardless of the cost. What voters miss is that what we consume as a nations is determined by what we produce and what we produce is a function of productivity, not the number of jobs. Therefore the key to a higher standard of living is policy that increases productivity, even if job losses result. Bastiat called the bias Sisyphism after the Greek mythological character that was condemned to roll a stone uphill forever – the lucky guy had eternal job security. If the amount of labor were the goal, the 19th century was more successful than our own, there was more than enough work to do on the farm and the workday was close to 14 hours a day. The easiest way to increase the number of jobs is to reduce productivity by reducing the amount of technology; a strategy employed by the Soviet Union to fulfill their promise of full employment. Of course this decreases productivity and therefore standard of living, but people seem to be more concerned about jobs. Maybe we should become luddites and ban calculators, personal computers, software, and the internet. We would create thousands of jobs as people would have to do computations, research and letter writing with paper and pencil again. Of course many of those people would be pulled from jobs that produced goods and services that people value that would not longer be produced.

This is not to say that the jobs and productivity have a negative correlation. Indeed, the period starting after the 1990 recession was a period of extremely low unemployment, but also a period of massive job losses due to new technology being applied in the workplace. Of course those workers found jobs elsewhere as the efficiency gains created wealth and spending in other sectors of the economy. In spite of this growth, it is easy for the media to focus on the massive job losses.

News Reporter: “Corporation XYZ announced it will be laying off 25,000 employees over the next 18 months due to foreign competition and new technology.”

The average viewer ends up cursing the greedy corporation for putting profits ahead of people. The solution proposed usually involves trade barriers or government assistance to prop up the failing business. What is more difficult to identify and less interesting to viewers is the thousands of new and small firms who start up every year and hire 10-20 employees at a time. Indeed, the number of jobs in an economy is not a static number.

I often tell my students that if Santa Claus were real, unions would actively try to ensure that he stayed away from American shores stating that his products destroy American jobs in the toy and retail industry. I am sure that the American voters would agree and politicians would respond with a ban-Santa law. However, the economist would say that Santa Claus frees up resources that can now be put to use in other parts of the economy.

I would suggest reading Bastiat’s essay The Candlemakers' Petition, it is an interesting read.

Principles of Economics, Rap Version

Check out the Principles of Economics in Rap version from Greg Mankiw's Blog.

Most Lucrative College Majors

Students of Economics may be interested in the following from Forbes Most Lucrative College Majors. Here are the top eight:

1. Computer Engineering
2. Economics
3. Electrical Engineering
4. Computer Science
5. Mechanical Engineering
6. Finance
7. Mathematics
8. Civil Engineering

Check out the article for median pay.

One Way to Avoid High Gas Prices.

Here's a creative way to get around high gas prices as reported in today's Wall Street Journal. Of course, the Mexican government may get tired of subsidizing American drivers.

China Increases Fuel Prices

China has decided to increase the price of fuel. This seems like an odd statement to us for two reasons.

1) Markets (supply and demand) determine prices for fuel in the United States (in spite of what many think). Government intervention in markets tend to make consumers and producers worse off. There are a few examples of market failure where government involvement can increase economic efficiency, but most economists believe that if the government gets involved in the fuel market it should be to increase the gas tax to reduce negative externalities (a topic for another day) not to subsidize its use.

2) The Chinese government is raising the price. While politicians in the U.S. climb over each other trying to find a way to decrease fuel prices here, the Chinese government is increasing the price. Why? Speaking economically, the current price in China is below equilibrium (the price determined by market forces). This requires the Chinese government to subsidize the price. The subsidy sends improper signals to consumers and requires massive government revenues. The lower price results in consumers using more than optimal. The massive government revenues required to fund the subsidy might be better used to fund infrastructure, education, assisting earthquake victims or meeting the extreme environmental issues in the country.

The higher price is good for the global oil market. Increased demand for oil from developing nations is one of the reasons oil prices are high. The higher price i n China will result in a decrease in the quantity demanded, relieving some of the pressure on rising prices. The amount by which the quantity is reduced by the higher price is measured by the elasticity of demand, a topic I will take on soon.

Don't Buy Stuff You Can't Afford

Americans save like they diet, they know they should consume less, but knowing and doing are not the same. Watch Don't Buy Stuff You Can't Afford, a Saturday Night Live skit. Millions of Americans could benefit from this simple lesson.

The Upside of $4 Gas

Gas Tax Guru and Harvard Economist Greg Mankiw points out this story listing several more reasons that the pain at the pump may bring positive changes in society.

Good Capitalism, Bad Capitalism

I really enjoyed reading a Good Capitalism, Bad Capitalism by Baumol, Litan, and Schramm. I like the way they discuss trade and protectionism from the standpoint of 50 states. If being self-sufficient is such a great thing, what if we used the same rationality to defend protectionism to save jobs within individual states. Why should we in Minnesota be totally dependent on foreign sources of orange juice (to California and Florida)? After all couldn't we generate jobs in Minnesota by developing a fruit and juice industry? Of course trade is all about comparative advantage and opportunity cost, but that point is lost on most people. All the more reason to push onward with Economic Education.

Gas Lines? Not in 2008!

Prices are of great interest to economists. The high price of gas is the topic of many conversations, but the price itself sends signals to both buyers and sellers. The gas shortages which caused rationing during the oil shock of early 1970s was caused by the politically popular price controls instituted by Richard Nixon. The artificially low price sent incorrect signals to buyers and sellers in the market, resulting in shortages and the resulting rationing. If the price controls had not been used, people would have felt more pain at the pump, but not the inconvenience of gas lines and the wasted fuel sitting in line waiting for gasoline could have been avoided.

The current situation is a prime example. Because the price has been allowed to rise to the equilibrium level, there are no shortages. The high price causes consumers to reduce consumption. The high price also induces suppliers to increase the quantity produced. Examples? Oil drilling in North Dakota (click the skip the welcome screen link) has become feasible at the higher price and the politics of drilling are changing. As a result of the reduced consumption and the increased production... no shortage. Another reason to love free markets.

Gas Prices and Social Change

The law of demand says that as price of an item rises, the quantity demanded of the item decreases. $4 seems to be the price that Americans sit up and take notice. For the first in years, total gas consumption has actually decreased.

For the first time in my adult life people are serious about conservation. A telling sign, after reigning as the top selling vehicle in America for many years, sales of the Ford F-150 pickup truck fell 30.1% in May (compared to the previous May), and sales of the Honda Civic increased 37.1% for the same time period. Economists call this cross-price elasticity; the amount by which a change in price of one good increases or decreases the quantity demanded of another product. This seems perfectly rational. In his recent article High Fuel Costs Could Spur a New Rationalism,Charles Wheelan (author of The Naked Economist) makes predictions about how the price of gas might affect other goods and services and how it might actually change society in some very real ways. It is worth reading.

Taking Wheelan's argument, how will high gas prices affect value of lakefront property in northern Minnesota?

Zero - Sum game anyone?

I continue with the topics of trade and politics. It is always an interesting one from the economic perspective because trade benefits society, but you would never know it talking to politicians or voters. Why do voters support policies that clearly slow the economic growth of the nation? Why do politicians gain big political points when the talk of restricting trade? Because most voters believe the rhetoric and do not understand the benefits of trade. The starting point is the understanding that economic transactions are not zero-sum games. A zero-sum game is one in which their is a winner and a loser. Think football; at the end of every game one team leaves as a winner, the other as a loser. Economic transactions are not the same. By their very nature economic transactions ensure that both parties leave as winners. This is because you (and the other party) will only enter into a transaction if you feel it will leave you better off than you were before. Think about the last time you bought milk at the local convenience store, chances are both you and the cashier said thank you at the end of the transaction. You wanted the milk more than the money and the cashier wanted the money more than the milk - you both benefit. So my first conclusion is that trade benefits both parties involved. I will address third parties (who sometimes lose as a result of trade) in later segments.

The big question involving the current political climate is what will happen with current trade policy. McCain supports free trade. Obama is a question mark. His campaign rhetoric has been anti-trade (opposition to NAFTA), but you may remember his economic adviser Austan Goolsbee secretly telling Canadian officials to ignore the anti-NAFTA tirade; saying it was merely campaign positioning. By the way, both of Obama's economic advisers unapologetic open market, free trade supporters (as are nearly all economists). This is an interesting story (Tariff to Nowhere) about the current state of politics and trade. Roger Lowenstein makes the case that in spite of perceptions, trade with China may actually be a bigger benefit to those at the lower end of the income scale - even though this income group traditionally is the most opposed to trade deals.

Trade, Adam Smith & David Ricardo

At the heart of the globalization debate is the issue of free trade. There are several issues that economists see very differently than the general population, trade is the foremost. The general population is attracted to the arguments of protectionism, the three classics that get repackaged, sold by politicians, and bought by the masses are:

1) national security - we must protect vital industries (steel, oil, agriculture) because they are vital to our national security therefore they must be protected with subsidies, quotas, and tariffs.

2) infant industry - some domestic firms may have difficulty competing against better developed foreign firms, therefore they must be protected with subsidies, quotas, and tariffs.

3) cheap foreign labor - domestic firms have difficulty competing against foreign firms because foreign worker are willing to work for less money, therefore they must be protected with subsidies, quotas, and tariffs.

The general population falls for these arguments, economists don't buy it, politicians use code words for protectionism like, "I am for fair trade, not free trade" or "I am for trade as long as it is fair".

In the next couple of post I will be exploring some ideas on trade, politicians, and economics. Remember that the arguments for trade has been around for 200+ years developed by the likes of Adam Smith and David Ricardo. My question is: Why do people continue to buy the idea that trade hurts America (think the latest discussion of NAFTA by Obama and Clinton) in spite of over two centuries of research to the contrary? Post your thoughts if you wish (click the comments link just below this post).

Shift Happens

Welcome to my econ blog. The goal of the blog is to discuss econ topics with friends and students. My first link is called shift happens (click on the link), think about the globalization as you watch. Post your comments if you wish. If that doesn't work, try this link.