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July 28, 2009

Economist's View - 5 new articles

Where are the Technocratic Institutions?

Brad DeLong wonders why the response to the financial crisis hasn't included technocratic institutions to limit executive power:

Conservative Interventionism, by J. Bradford DeLong, Commentary, Project Syndicate: At this stage in the worldwide fight against depression, it is useful to stop and consider just how conservative the policies implemented by the world's central banks, treasuries, and government budget offices have been. Almost everything that they have done – spending increases, tax cuts, bank recapitalisation, purchases of risky assets,... and ... money-supply expansions – has followed a policy path that is nearly 200 years old...

The place to start is 1825, when panicked investors wanted their money invested in safe cash rather than risky enterprises. Robert Banks Jenkinson, Second Earl of Liverpool and First Lord of the Treasury for King George IV, begged Cornelius Buller, Governor of the Bank of England, to act to prevent financial-asset prices from collapsing. "We believe in a market economy," Lord Liverpool's reasoning went, "but not when the prices a market economy produces lead to mass unemployment on the streets of London, Bristol, Liverpool, and Manchester."

The Bank of England acted: it intervened in the market and bought bonds for cash, pushing up the prices of financial assets and expanding the money supply. It loaned on little collateral to shaky banks. It announced its intention to stabilize the market – and that bearish speculators should beware.

Ever since, whenever governments largely ... let financial markets work their way out of a panic out by themselves – 1873 and 1929 in the United States come to mind – things turned out badly. But whenever government stepped in or deputized a private investment bank to support the market, things appear to have gone far less badly. ... [F]ew modern governments are now willing to let financial market heal themselves. To do so would be a truly radical step indeed. The Obama administration and other central bankers and fiscal authorities around the globe are thus, in a sense, acting very conservatively... I ... am somewhat reluctant to second-guess them. ...

Nevertheless, I do have one big question. The US government especially, but other governments as well, have gotten themselves deeply involved in industrial and financial policy during this crisis. They have done this without constructing technocratic institutions like the 1930's Reconstruction Finance Corporation and the 1990's RTC, which played major roles in allowing earlier episodes of extraordinary government intervention into the industrial and financial ... economy ... without an overwhelming degree of corruption and rent seeking. The discretionary power of executives, in past crises, was curbed by new interventionist institutions constructed on the fly by legislative action.

That is how America's founders ... envisioned that things would work. They were suspicious of executive power, and thought that the president should have rather less discretionary power than the various King Georges of the time. ...

So I wonder: why didn't the US Congress follow the RFC/RTC model when authorising George W. Bush's and Barack Obama's industrial and financial policies? Why haven't the technocratic institutions that we do have, like the IMF, been given a broader role in this crisis? And what can we do to rebuild international financial-management institutions on the fly to make them the best possible?

Equity and Efficiency in Health Care Markets

This is an attempt to clarify a few of the remarks I've made over the last several days regarding the need for government intervention in health care markets.

There are two separate reasons to intervene, market failure and equity. Taking market failure first, there are a variety of failures in health care and insurance markets such as asymmetric information, market power, and principal agent problems. These can be solved by the private sector in some cases, but in others government intervention is required.

But even if the private sector or the government can solve the market failure problems adequately, there's no guarantee that the resulting distribution of health care services will be equitable. We don't expect the private sector to, for example, make sure that everyone can live on the coast and have an ocean view if they so desire, we use market prices to ration those goods, but we may want to make sure that everyone can get health care when they have serious illnesses. So equity considerations may prompt the government to intervene and bring about a different distribution of health care services than would occur with an efficient market.

I believe that economists have something to offer in both cases. In the first, economic theory offers solutions to market failures, and though not every market failure can be completely overcome, the solutions can guide effective policy responses. I prefer market-based regulation to command and control solutions whenever possible, i.e. I prefer that government create the conditions for markets to function rather than direct intervention. But sometimes the only solution is to intervene directly and forcefully.

In the second case, the idea is a bit different. Here, equity is the issue so somehow society must first designate the outcome it is trying to produce before economists can help to achieve it. Right now, it is my perception that the majority of people want to expand to universal or near universal coverage if we can do so without breaking the bank, and without reducing the care they are used to. If we can find a way to do that, the majority will come on board. If that's the case, if that's what we have collectively decided we want, then the job of the economists is to find the best possible way of achieving that outcome (or whatever outcome is desired) given whatever constraints bind the process (whether political realities should be part of the set of constraints is a point of contention, so I'll stay silent on that).

So if we are only concerned about efficiency, we do our best to resolve the market failures and leave it at that. We make sure, for example, that people have the information they need to make informed decisions about their care, that there aren't incentives that cause doctors to order too much or too little of some type of care or test, that monopoly power is checked, etc., etc. There's no guarantee that everyone will receive care, or that the distribution of care among those who do receive care will be as desired.

But if we are concerned with equity too - and most of us aren't comfortable watching people suffer when we know that help is readily available (perhaps nature imposes this externality upon us purposefully) - if we won't let people die on the street or suffer needlessly due to our sense of fairness and equity - then we will want to intervene to achieve broad based coverage in the least cost and fairest manner we can find (and there may be other equity issue that are important too).

Both reasons, equity and efficiency, can justify government intervention into health care markets. I think equity is of paramount importance when it comes to health care, so for me that is enough to justify government intervention, and the existence of market failure simply adds to the case that government intervention is needed.

So those opposed to government involvement in health care markets have to first argue that there is no market failure significant enough to justify intervention, a tough argument in and of itself, and also argue that people who, for example, go without insurance or cannot afford the basic care they need deserve no compassion whatsoever from society more generally. That's an argument I could never make even for those who could have paid for insurance but chose to take a chance they wouldn't need care, let alone for those who cannot afford it under any circumstances. I want everyone to be covered as efficiently as possible, and to be required to pay their fair share of the bill, whatever that might be, for the care that's made available to them.

What's the Matter with the Blue Dogs?

Jacob Hacker wonders why the Blue Dogs oppose health care reform that could provide significant help to their constituents:

Health Care for the Blue Dogs, by Jacob S. Hacker, Commentary, Washington Post: The fate of health-care reform ... hinges on ... the ... "Blue Dogs" -- who are threatening to jump ship.

The main worry expressed by the Blue Dogs is that the ... leading bills ... won't bring down medical inflation. The irony is that the Blue Dogs' argument -- that a new public insurance plan designed to compete with private insurers should be smaller and less powerful, and that Medicare and this new plan should pay more generous rates to rural providers -- would make reform more expensive, not less. The further irony is that the federal premium assistance that the Blue Dogs worry is too costly ... would make health-care affordable for a large share of their constituents. ...

Increasing what doctors and hospitals are paid by the new public plan, as the Blue Dogs desire, would only raise premiums and health costs for their constituents. It would also fail to address excessive payments to hospitals and specialists...

Many Blue Dogs fret that a new public health insurance plan will become too large... Their concern should be that a public plan will be too weak. A public health plan will be particularly vital for Americans in the rural areas that many Blue Dogs represent. ...

Yet the Blue Dogs have mostly ignored the huge benefits of a new public plan for their districts. ... Right now, large swaths of farmers, ranchers and self-employed workers can barely afford a policy ... or are uninsured. They will benefit greatly from the premium assistance in the House legislation..., from additional subsidies for small businesses to cover their workers, and from a new national purchasing pool, or "exchange," giving those employers access to low-cost group health insurance that's now out of reach.

And given that Blue Dogs are worried about the ... cost of reform, they should applaud the House bill's requirement that all but the smallest of employers make a meaningful contribution to the cost of coverage. This will not just raise much-needed revenue..., it will also reduce the incentive for employers to drop coverage and let their workers go into the pool, increasing the size of the exchange and the public plan.

Blue Dogs have the future of health-care reform in their hands. If they hold firm to their principles of fiscal responsibility and effective relief for workers and employers in their districts, what's good for Blue Dogs will also be good for America.

Maybe their most important constituents aren't the voters in their districts?

Interconnectedness and the Distribution of Default Risk

I was asked what went wrong that caused economists to miss the financial crisis. For me, a key part of it was the belief in the risk distribution model. Let me give a simple example of how risk distribution works:

There are 100 people, each has $1,000 saved, and those balances are sitting idle, they have not been loaned out.

There are 100 different people who have loan projects that promise to pay more than simply putting the money in the bank (for simplicity, assume bank deposits earn no interest, but if they do, that won't change any of the conclusions drawn below). However, the default rate on these loans is 10%.

Suppose that the individuals with the accumulated savings are very risk averse. In particular, suppose that they only have this money temporarily, they will have their own bills to pay in the future (e.g. they will need to repay other types of loans), and they are just looking to put the money to work safely in the interim. If they lose any principal, they will go into default on the loans they need to repay in the future, and that's not a risk they are willing to take.

But this means no loans will be made. With a default rate of 10%, 10 of the 100 people will, in fact, lose everything, and that would mean going into default. Thus, without some means of sharing risk, none of them are not willing to risk losing all of their savings, at least not at an interest rate anyone would be willing to pay, and the market will not exist.

Now suppose that there are financial market intermediaries who come up with the following innovation to distribute risk. They will accept the deposits and pay 3.5% on them, and they will make loans at 15% (I'm assuming that the demand for these loans exists to avoid complicating things unnecessarily).

Let's see what happens if the savers take them up on their 3.5% offer, and then the deposits are lent at 15%. First, let's look at the original principal. There are 100 loans of $1,000 for a total value of (100)*($1,000) = $100,000. But not all of it is paid back. Subtract off the 10% of loans that default, i.e. subtract $10,000 leaving a payback of $90,000. So the original principal falls from $100,000 to $90,000 due to defaults (assuming a zero scrap value).

But the 15% interest rate is more than sufficient to cover the $10,000 loss so that nobody actually loses anything. To see this, the next step is to add interest to the $90,000 in good loans. Since 90 people pay back $150 in interest each, the interest return is $13,500, more than the $10,000 loss. Thus, the total amount paid back, with interest, is $103,500. Now divide this among the lenders, i.e. divide this by 100 to get $1,035 returned to each person who made a loan. Thus, with the risks distributed across all the lenders, instead of 10 people losing everything, everyone makes 3.5% (I didn't build bank profit into the example, but that's easy to do).

So in this example, rather than 10% of the lenders losing everything, a risk they won't take, they all make 3.5% on their investment. So long as the 10% default rate is accurate, this is a fairly certain return and they will be willing to enter the market.

(Note however that if the default rate turns out to be, say, 25% instead of 10%, then the lenders will lose principal, e.g. at 25% they are only repaid $8,625 each leaving an $1,375 shortage. This could cause them to default on their own loan payments, and that could in turn bring about more defaults in a spreading, domino style collapse.)

Before moving on to what I missed - I'm in no hurry to point that out - note one thing about this example. Risk distribution does not reduce risks overall. It does reduce the size of the risk that an individual faces - nobody loses everything unless every single loan defaults (with zero repayment in every case) - but overall the losses are still $10,000 whether individuals or intermediaries make the loans. There are ways in which financial intermediation can reduce overall risk, e.g. the expertise of the intermediaries at assessing risk is supposed to reduce the 10% default rate, and generally it would, I just didn't build this in. But the point is that risk distribution does what it says, it distributes risk, it does not reduce it. Many people misunderstood this.

O.K., here's where I went wrong, or one place anyway. I thought that default in the mortgage market would be like the default of these loans. The defaults would be distributed through complex financial products not just among U.S. lenders, but throughout the world, and that meant nobody would lose very much, certainly not enough to cause big problems. If problems developed, everyone would lose a little bit just like above. This belief was widespread among economists. The financial innovation driven by fancy mathematical models was supposed to assure that risk was widely distributed, and the insiders in these markets repeatedly reassured everyone that if problems did develop, they would be so widely dispersed that there was nothing to worry about.

But that's not what happened. Why? One reason is simple. The default rate was higher than expected, and that brought about unexpected losses. For example, above a 25% default rate means losses of $1,375 on the $10,000 investment leaving a shortage as this money is needed to repay other loans. But those losses still should have been widely dispersed, widely enough to avoid big problems.

But there's something else that explains how these losses spread to create such a big problem. The degree to which the people making the loans and taking out the loans were interconnected was misunderstood (that is, risks were more concentrated than we thought). The people borrowing and lending the money had far more financial interconnections than we noticed or knew about - there was a lot of borrowing and lending among them that was hidden or ignored - and when the higher than expected number of borrowers defaulted, that meant some of the people expecting payments from the lenders were forced into default as well. In the example above, remember that the lenders only had the money short-term, they would need the money later to repay their debts and were just trying to make something on the accumulated balances in the intervening period. But with losses of $1,375 rather than the anticipated gain, they are short on funds and hence must sell assets, call in loans, reduce consumption, etc. to try to accumulate sufficient cash balances to pay what they owe. But not everyone will be able to come up with the money they need, especially as asset prices fall as they are put up for sale, loans dry up, etc., and that will cause more defaults and the problems will spread. Thus, as lenders and everyone else try to rebuild what was lost so they can pay their own bills, that causes even more difficulty, and the result is more defaults on loans, and a process that feeds on itself in a downward spiral of defaults and further problems.

So a key thing I missed was the degree to which these markets are interconnected, and that may explain why I've emphasized finding better measures of interconnectedness, and then insulating markets against it as part of the reform process (and leverage is a key factor driving the interconnections).


Update: As a follow-up to some of the discussion in comments, here are some past posts on the cause of crisis:

links for 2009-07-28

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