Banks and the Importance of Equity

Principles of economics textbooks generally omit equity from the balance sheet equation, Assets=Liabilities+Equity, to focus on money creation. Given the financial crisis that became manifest in September 2008 and its continuing aftermath, this post reinserts equity or capital to focus on the risk of insolvency bankers take in lending. The example is provided by Juliusz Jabtecki and Mateusz Machaj, "The Regulated Meltdown of 2008," Critical Review, 21(2-3): 301-328, 2009. The article often refers to capital, a richer term than equity, the term used in class. When reading the quote, you can replace capital with equity with no loss of understanding. I added Figure 2 to the quote.

Figure 1

Assets		Liabilities
Cash	$10	Equity	$5
Loans	$90	Deposits	$95
Total	$100	Total	$100

Generally speaking, "capital" is the portion of a bank's assets that does not have to be ultimately repaid to creditors--such as depositors, who are, after all, merely loaning their funds to a bank. To see why capital should offer protection against unexpected losses, consider the following simple example of a bank's balance sheet (Figure 1).

The balance sheet consists of the bank's sources of funds (liabilities) and the uses to which those funds are put (assets). By definition, the two must be equal at all times We can see that our bank has collected $100 of funds: $95 in deposits from retail customers, representing liabilities; and $5 in "capital" which for the moment, we will assume is equity capital: income from issuing shares of common stock in the bank. Such income does not have to be repaid: Shareholders have no legal right to be paid dividends; and common shares have the lowest-priority claim on other assets in case of bankruptcy.

Of the $100 of liabilities (including the $5 in capital), 90 percent is then turned into credit by being loaned out, while 10 percent is held as cash in the bank's vault as cash reserves against potential withdrawals from depositors of a portion of the $95 they have lent to the bank. A bank's loans plus its cash reserves constitute its assets.

Figure 2

Assets		Liabilities
Cash	$10	Equity	$3
Loans	$88	Deposits	$95
Total	$98	Total	$98

Now imagine that some of those to whom the bank has loaned money unexpectedly default, rendering $2 of loaned assets worthless (Figure 2). The bank has to write off these losses, diminishing the total value of assets to $98. But while the value of the bank's assets has declined by $2, the amount that it owes depositors remains exactly the same ($95). Thus, for assets ($98) to continue to equal liabilities, capital must fall to $3. Suppose, by contrast, that the bank didn't initially have any capital, and that its assets ($90 in loans plus $10 in cash) were financed fully by the collection of $100 in deposits. Any unexpected (and unaccounted for) loss would then render the bank immediately insolvent, as the assets--all that the bank has--would not suffice to pay off all that it owes.

It is only due to the fact that a portion of its financing does not have to be repaid (e.g., the portion obtained from issuing stock) that the bank has the capacity to withstand unexpected losses on the investments that it makes with the funds entrusted to it. That is the primary reason that bank regulators believe it necessary to control the amount of capital that financial institutions hold. On the other hand, holding capital constrains risk-taking (and thus, potentially, profitability); that is the point of the capital regulations. To the extent that bank managers view regulatory capital as a tax imposed on them, they will tend to see capital regulations as obstacles to be gotten around.

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Acemoglu on Wealth Creation

(HT Mankiw) In, "What Makes a Nation Rich? One Economist's Big Answer," written for Esquire, Daron Acemoglu of MIT, one of the word's best economists and a favorite of mine, explains how a poor nation can become rich. The name, Acemoglu, and his answer, change incentives, will sound familiar to my students.

People need incentives to invest and prosper; they need to know that if they work hard, they can make money and actually keep that money. And the key to ensuring those incentives is sound institutions — the rule of law and security and a governing system that offers opportunities to achieve and innovate. That's what determines the haves from the have-nots — not geography or weather or technology or disease or ethnicity.

Put simply: Fix incentives and you will fix poverty. And if you wish to fix institutions, you have to fix governments.

Acemoglu also describes policies that the U.S. should avoid and advance in promoting wealth creation.

If we know why nations are poor, the resulting question is what can we do to help them. Our ability to impose institutions from the outside is limited, as the recent U. S. experiences in Afghanistan and Iraq demonstrate. But we are not helpless, and in many instances, there is a lot to be done. Even the most repressed citizens of the world will stand up to tyrants when given the opportunity. We saw this recently in Iran and a few years ago in Ukraine during the Orange Revolution.

The U. S. must not take a passive role in encouraging these types of movements. Our foreign policy should encourage them by punishing repressive regimes through trade embargoes and diplomacy. The days of supporting dictators because they bolster America's short-term foreign-policy goals, like our implicit support of Muhammad Zia-ul-Haq in Pakistan starting in the 1970s, and our illicit deals with Mobutu's kleptocratic regime in the Congo from 1965 to 1997, must end. Because the long-term consequences — entire nations of impoverished citizens, malnourished and hungry children, restive, discontented youngsters ripe to be drawn toward terrorism — are too costly. Today that means pushing countries such as Pakistan, Georgia, Saudi Arabia, Nigeria, and countless others in Africa toward greater transparency, more openness, and greater democracy, regardless of whether they are our short-term allies in the war on terror.

At the microlevel, we can help foreign citizens by educating them and arming them with the modern tools of activism, most notably the Internet, and perhaps even encryption technology and cell-phone platforms that can evade firewalls and censorship put in place by repressive governments, such as those in China or Iran, that fear the power of information.

There's no doubt that erasing global inequality, which has been with us for millennia and has expanded to unprecedented levels over the past century and a half, won't be easy. But by accepting the role of failed governments and institutions in causing poverty, we have a fighting chance of reversing it.

Acemoglu is writing a book about his theory of inequality with James Robinson; a book that I will both buy and read.
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Log Rolling Landrieu

From Jonathan Karl of ABC News ("The $100 Million Health Care Vote?") via the Drudge Report, we learn,

On page 432 of the Reid bill, there is a section increasing federal Medicaid subsidies for “certain states recovering from a major disaster.”

The section spends two pages defining which “states” would qualify, saying, among other things, that it would be states that “during the preceding 7 fiscal years” have been declared a “major disaster area.”

I am told the section applies to exactly one state: Louisiana, the home of moderate Democrat Mary Landrieu, who has been playing hard to get on the health care bill.

In other words, the bill spends two pages describing would could be written with a single world: Louisiana. (This may also help explain why the bill is long.)

Senator Harry Reid, who drafted the bill, cannot pass it without the support of Louisiana’s Mary Landrieu.

How much does it cost? According to the Congressional Budget Office: $100 million.

Log rolling is a legal and at times may be a useful legislative tool, but a $100 million payment to buy or sell a vote for a bill that will fundamentally change health care for 300 million Americans is immoral . It's like selling a vote to go to war. From Harry Reid's perspective, its cheap; thirty cents per American is a small price for Americans to pay to pass legislation that you support, particularly considering that it is other people's money. It also reveals that Reid is more concerned with "reforming" health care than with fiscal responsibility. It may also reveal Mary Landrieu's true measurement of the value of the bill. If Landrieu acted honestly for Louisiana's citizens and if Reid negotiated well for the rest of the country, the $100 million represents the state's opportunity cost. The people of Louisiana would be $100 million better off if the legislation fails.

In an earlier post, "Riddle Me This," I asked what is worse than Congress voting on bills that they have not read? My answer was proposing bills that cannot be understood if read. In that post, I referenced Nicholas Ballasy of CNSNews, ("Finance Committee Democrat Won’t Read Text of Health Bill, Says Anyone Who Claims They’ll Understand It ‘Is Trying to Pull the Wool Over Our Eyes’,") who quoted Sen. John Cornyn (Texas).

...the descriptive language the committee is working with is not good enough because things can get slipped into the legislation unseen.

“The conceptual language is not good enough,” said Cornyn. “We’ve seen that there are side deals that have been cut, for example, with some special interest groups like the hospital association to hold them harmless from certain cuts that would impact how the CBO scores the bill or determines cost. So we need to know not only the conceptual language, we need to know the detailed legislative language, and we need to know what kind of secret deals have been cut on the side which would have an impact on how much this bill is going to cost and how it will affect health care in America.”

Complex language may be part and parcel of writing legislation, but it also hides political payments that may be unpopular taxpayers. Perhaps this is why Reid is rushing the senate vote.
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Colorado and Medical Marijuana

From the Denver Post (Tim Hoover, "Suthers: Medical marijuana dispensaries subject to sales tax, retail license laws")via the Drudge Report,

Attorney General John Suthers said in a legal opinion released late today that the sale of medical marijuana is subject to taxation.

Responding to a query from Gov. Bill Ritter's office, Suthers, a Republican, said, "Medical marijuana is tangible property that is generally subject to state sales tax."

The opinion also said medical marijuana dispensaries must obtain retail sales licenses from the state.

Medical marijuana advocates applauded the opinion as a step in the right direction, saying the industry had been working on proposals to enact some sort of tax.

"I think the community is willing to pay taxes if it will help prove the legitimacy of their efforts," said Courtney Tanning, executive director of the Colorado Wellness Association, which represents medical marijuana dispensaries and the patients and doctors that deal with them.

"It (medical marijuana) has been an underground, black market community for so long that I think they're really willing to come out and pay dues to be taken seriously."

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Fiscal Policy

I have not taught fiscal policy in my principles classes for some time.  There seemed little need.  My reading of the macroeconomics literature was that the efficacy of fiscal policy was limited to the rare occurrence of a deep and long recession.  Based on the length of the Great Moderation, a period of low inflation, strong economic growth and high employment, I believed that monetary economists working inside the Federal Reserve had learned to better manage the business cycle.

A recession began when the housing bubble burst in 2007, straining our highly leveraged financial sector.  The economy headed south, leaving the desiccated memory of the Great Moderation in the dust, and beginning what many have termed the Great Recession, both long and deep, the conditions required for effective fiscal policy.

Fiscal policy is the sue of the federal government's taxing and spending authority to achieve or maintain full employment or price stability.  In times of recession, the government creates or enlarges deficits to maintain aggregate demand, the total level of demand for all goods and services throughout the economy.  Policy makers can cut taxes, increase spending or some combination of the two to reach desired deficits.  The additional spending by the government or recipients of tax cuts has a multiplied impact through the economy.  For example, Ben gets a $100 tax cut which he uses to buy a new Sony DVD player.  Sony uses the extra money to buy $90 of labor.  The $90 of wages buys $80 of groceries and so on. 

All theories are just good stories until empirically verified.  The focus of the empirical debate has turned on the size of the multipliers.  Multipliers greater than one stimulate growth while those less than one restrain growth.  Robert Barro and Charles Redlick describe the literature on empirically estimated multipliers as "thin" in "Macroeconomic Effects from Government Purchases and Taxes," NBER Working Paper No. 15369.  The authors estimate the multiplier at .7 when the economy is experiencing unemployment of 5.6%.  It increases .1 for every 2% increase in unemployment, implying that stimulus spending becomes beneficial (multiplier greater than 1) when the economy is experiencing 12% or greater unemployment.  In a Wall Street Journal article (Stimulus Spending Doesn't Work) that presents their findings, they conclude,

The bottom line is this: The available empirical evidence does not support the idea that spending multipliers typically exceed one, and thus spending stimulus programs will likely raise GDP by less than the increase in government spending. Defense-spending multipliers exceeding one likely apply only at very high unemployment rates, and nondefense multipliers are probably smaller. However, there is empirical support for the proposition that tax rate reductions will increase real GDP. 

Barro and Redlick have not given the final word on multipliers but their research is a good starting point for evaluating the effectiveness of fiscal policy and the size of multipliers
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Nice and the Creeping Nanny State

If any of the health care proposals before Congress pass and is signed into law, we will soon have a committee tasked with reducing health care expenditures similar to Britain's National Institute for Health and Clinical Excellence (Nice).  Some might remember Nice as the organization unwittingly killing patients who are terminally ill (see my previous post for more details and a Monty Python clip).  Nice takes its job seriously.  Robert Watts of Timesonline describes a new policy proposal in, "Health and safety snoops to enter family homes."

Health and safety inspectors are to be given unprecedented access to family homes to ensure that parents are protecting their children from household accidents.

New guidance drawn up at the request of the Department of Health urges councils and other public sector bodies to “collect data” on properties where children are thought to be at “greatest risk of unintentional injury”.

Council staff will then be tasked with overseeing the installation of safety devices in homes, including smoke alarms, stair gates, hot water temperature restrictors, oven guards and window and door locks.

The draft guidance by a committee at the National Institute for Health and Clinical Excellence (Nice) has been criticised as intrusive and further evidence of the “creeping nanny state”.

Creeping nanny state?  Daya think?  Matthew Elliot, a new found friend of freedom, nicely sums up problems with the proposal.

Matthew Elliott, of the TaxPayers’ Alliance, said: “It is a huge intervention into family life which will be counter-productive.

“Good parents will feel the intrusion of the state in their homes and bad parents will now have someone else to blame if they don’t bring up their children in a sensible, safe environment.”

Let me add my two bits to Elliot's.  Setting aside the insult to parents Nice's administrative shortcomings and the real possibility that collecting the information and applying safety equipment to households in Britain might well me more expensive then the medical costs, the plan has other problems.  The state officials know of safety devices, but not the household specific information about the children or their parents.  For example, a child may be a climber, and the state might notice that the parents don't have electrical socket plug covers.  The state might find the home safe but not know that the child spends ten hours a day with grandma.  Parents have that information, and nearly all parents love their children and are concerned about their welfare.  As Elliot suggests, why not let parents raise their kids?
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Shleifer: State versus Private Ownership

Chavez styles Venezuela as having a socialist economy and himself as the representative of the people. Simon Romero describes current problems with state production of electricity and water in a resource rich country (The New York Times, "Blackouts Plague Energy-Rich Venezuela."

CARACAS, Venezuela — This country may be an energy colossus, with the largest conventional oil reserves outside the Middle East and one of the world’s mightiest hydroelectric systems, but that has not prevented it from enduring serious electricity and water shortages that seem only to be getting worse.

President Hugo Chávez has been facing a public outcry in recent weeks over power failures that, after six nationwide blackouts in the last two years, are cutting electricity for hours each day in rural areas and in industrial cities like Valencia and Ciudad Guayana. Now, water rationing has been introduced here in the capital.

The deterioration of services is perplexing to many here, especially because the country had grown used to cheap, plentiful electricity and water in recent decades. But even as the oil boom was enriching his government and Mr. Chávez asserted greater control over utilities and other industries in this decade, public services seemed only to decay, adding to residents’ frustrations.

The bolded emphasis added to the quote is mine. Economists are not among the confused or perplexed. Andrei Shleifer concludes his Journal of Economic Perspectives article, "State versus Private Ownership (Vol. 12, No. 4, Fall 1998, Pgs. 133-150) as follows.

Private ownership should generally be preferred to public ownership when the incentives to innovate and to contain costs must be strong. In essence, this is the case for capitalism over socialism, explaining the "dynamic vitality" of free enterprise. The great economists of the 1930s and 1940s failed to see the dangers of socialism in part because they focused on the role of prices under socialism and capitalism, and ignored the enormous importance of ownership as the source of capitalist incentives to innovate. Moreover, many of the concerns that private firms fail to address "social goals" can be addressed through government contracting and regulation, without resort to government ownership. The case for private provision only becomes stronger when competition between suppliers, reputational mechanisms, and the possibility of provision by not-for-profit firms are brought into play. Last but not least, the pursuit by government officials of political goals and personal income, as opposed to social welfare, further strengthens the case for private ownership, as the dismal record of state enterprises around the world and the tragedy of communism illustrate all too well.

The benefits of private delivery-regulated or not-of many goods and services are only beginning to be realized. Health, education, some incarceration, some military and police activities, and some of what now is presumed to be "social" insurance like Social Security, can probably be provided more cheaply and attractively by private firms. It is plausible that 50 years from now, today's support for public provision of these services will appear as dirigiste as the 1940s arguments for state ownership of industry appear now. A good government that wants to further "social goals" would rarely own producers to meet its objectives.

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Glaeser on the Home Buyers' Tax Credit

Edward Glaeser, described the bad incentives created by the Home Buyers' Tax Credit in "Attack of the Home Buyers' Tax Credit," written for the New York Times.  Glaeser creatively applies economic tools to problems.  

One reason to fret about federal anti-recessionary fixes is that they often last long after the crisis that justified their creation.

According to Case-Shiller data, housing prices have been rising since May, yet Congress has just extended and expanded last year’s home buyers’ tax credit. They’ve made the program more regressive by upping the income limit for families from $150,000 to $225,000.

Even more problematically, the new, but definitely not improved, tax credit now offers up to $6,500 to current homeowners who have lived in their houses for at least five of the last eight years and buy new homes.

Who but a real estate agent could love this policy?...

Certainly, extending the tax credit to current owners doesn’t increase homeownership. I believe that our government bears some responsibility for the housing bubble because it encouraged Americans to leverage themselves to the hilt to buy homes. But just because I’d like to do less to encourage homeownership doesn’t lead me to favor more handouts that don’t increase homeownership.

A buyers’ credit that goes to everyone creates a strong incentive for purely mindless house swapping. If my cousin and I sell our houses this year, and then move back three years later, we can make $13,000. In some such transactions, people may decide to flout the law and continue to live in their old houses, pocketing quick money for a sham deal...

It subsidizes existing owners to trade up or down, which implicitly encourages people to pull up roots and sever their connections with their existing community. If you ever thought that encouraging civic engagement through housing policy was a good thing, then the current policy will push in exactly the opposite direction.

There is also no reason to think that a tax credit that encourages house-trading among current owners will help the overall housing market. A subsidy for existing homeowners provides an equal incentive for buying and selling. There will be no net decrease in the vacant housing inventory; basic economics suggests that any policy that provides equal incentives to buy and sell will do little to increase housing prices.

Increasing the scope of the program will also significantly increase its cost.

Recently, first-time home buyers have been accounting for close to one-half of home purchases, but before the tax credit particularly subsidized new home buyers, their share was lower. In 2006, only 36 percent of home purchases were first-time buyers, and a tax credit for existing owners will surely move us in that direction. If 40 percent of future transactions involve existing owners who can take advantage of the benefit, then giving the tax credit to existing homeowners could easily burn through $5 billion in five months.

The best thing about extending the home buyers’ tax credit is that it does at least have an expiration date; it is currently set to end in May 2010. Unfortunately, the events of the last week lead me to suspect that the tax credit will continue to exist, like a B-movie zombie, long after it should have settled in its grave.

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The 4-Week Moving Average of Initial Unemployment Claims Updated to November 7, 2009

This post updates a graph comparing the 4-week moving average of unemployment claims through the week ended November 7, 2009 in "Unemployment Insurance Weekly Claims Report" with the average of the three previous recessions.  A little technical information of the graph follows the post.  Seasonally adjusted initial claims was 502,000, down 12,000 from a revised estimate of initial claims of 514,000 for the week ended October 31, 2009. The 4-week moving average decreased 4,500 to 519,750. The average is down 139,000 from its peak.

Robert J. Gordon did research exploring the relationship between the 4 week moving averages of initial unemployment claims and found that recessions often bottom out shortly after the 4-week moving average of initial unemployment claims peaks. This is bittersweet news.  While average has decreased, the rate of decrease has been painfully slow.   

Using National Bureau of Economic Research estimates on the beginning and ending dates of recessions, I built a graph that compares the 4 week moving averages of initial unemployment claims for recessions that began in December 2007, March 2001, July 1990, and July 1981.  I have not attempted to adjust the initial claims data for changes in the size of labor market. The plots are measured over 112 weeks, beginning eight weeks before the recessions began. The horizontal axis begins in October 2007, the date the current recession began, and the data for the other recessions are superimposed on this date.
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Cassidy on Health Care

(HT Wall Street Journal, "Confessions of an ObamaCare Backer")  John Cassidy of The New Yorker makes a valuable contribution to the health care debate in, "Some Vaguely Heretical Thoughts on Health-Care Reform."  He begins by stating his normative priors.  While they are not mine, they are logical and well ordered.

I regard an expansion of the government safety net as ethically essential, economically justified, and long overdue. It is indefensible for a country as rich as the United States to fail to provide adequate health care for many of its citizens. In extending our health-care system, all we are doing is catching up with Otto Von Bismarck’s Germany, which recognized a hundred and twenty-five years ago that universal health and disability coverage, along with old age pensions and a system of public education, were essential elements of a modern society.

He believes that the bill may be the best that the Obama administration can achieve but that it only deals with one of two problems, coherent universal coverage.

Moreover, given the reluctance of “Blue Dog” Democrats, such as Nebraska Senator Ben Nelson, to support anything that smacks of big government, and President Obama’s determination to coöperate with moderate Republicans, the proposed reform may be the most that can be accomplished today. But we will be dealing with its consequences for decades to come, and I think it’s important to be clear about what the reform amounts to.

Let’s remind ourselves of the basics. There are two big (and linked) problems with the current health-care system. It excludes 46.3 million Americans, according to the Census Bureau, and it is inordinately expensive. The proposed reform purports to tackle both of these problems; in fact, it only addresses the first one in any systematic manner. The future cost savings that the Administration and its congressional allies are promising to deliver are based on wishful thinking and sleight of hand. Over time, the reform, as proposed, would almost certainly add substantially to the budget deficit, thereby worsening the long-term fiscal crisis that the country faces. Financing this measure alone wouldn’t break the U.S. Treasury. Other elements of the fiscal picture, such as the looming increases in interest payments on the national debt and an explosive growth in Medicare spending as the baby boomers retire—are far larger. But the numbers involved in health-care reform are still significant—perhaps one per cent of annual G.D.P.

Cassidy believes group coverage and third party payment are largely responsible for the escalation of medical costs.  I stated much the same in "Rationing Health Care."

The Pelosi bill, in particular, wouldn’t do much, if anything, to address the overall escalation in health-care costs, much of which is rooted in the nature of insurance, where individuals consume costly health services, and different people—the other members of their risk pool—pay for them. This is the “moral hazard” problem that the economist Kenneth Arrow identified as long ago as 1963. (For an easy-to-understand account of Arrow’s argument, see this riveting new book on market failure.) In the past twenty years, many ideas have been tried in the effort to restrict the growth of spending within a private insurance system, the most notable of which was the creation of H.M.O.s. Some have enjoyed temporary success. None have worked for long.

He also explains the political reasons that the attempts to pass a health care bill that is budget neutral will likely fail.  Oh how I wish that I would have used a Cadillac in my example rather than a BMW.  

According to the C.B.O., in summary, many more people will, with government assistance, buy private insurance coverage (some twenty-one million) and many others (about fifteen million) will become newly eligible for Medicaid, which is wholly financed by the taxpayer. Surely, this will cost considerable sums of money and add to the deficit. Or will it? The Democrat-controlled C.B.O. says that the Pelosi plan will actually reduce the deficit by a hundred and four billion dollars between 2010 and 2019, thereby satisfying President Obama’s claim that the reform will be deficit neutral. Furthermore, the C.B.O. suggests that the legislation’s impact on the deficit will continue to be negative in the following decade, from 2019 to 2029. I wish I could believe these figures, but I don’t.

Two large items underpin the Administration’s math: five hundred and seventy-two billion dollars of tax increases over ten years, and roughly the same amount of cost savings on Medicare and other existing government health programs. Most of the revenue increase would come from levying a 5.4 per cent surcharge on Americans individuals who earn more than five hundred thousand dollars a year and joint filers that earn more than a million dollars. I am a big supporter of progressive taxation, but at some point it becomes politically unsustainable. If health-care reform goes through, and the Bush tax cuts expire in 2011, top earners will face a marginal tax rate of forty-five per cent at the federal level. Add in state and local taxes, plus Social Security and Medicare payments, and wealthy people in New York, say, would be facing tax rates of about sixty per cent. As sure as night follows day, this would generate more tax evasion and a political backlash. Without a doubt, the next Republican-controlled Congress would reverse the changes.

If it decides to forgo soaking the rich, the Administration could return to its earlier proposal, which was included in a Senate Finance Committee bill that Senator Max Baucus put forward, to tax firms that provide their employees with costly “Cadillac” health-care plans. “A policy such as this is probably the number one item that health economists across the ideological spectrum believe is likely to stem the explosion of health-care costs,” Christine Romer, the chair of the White House Council of Economic Advisers, said in a recent speech. But this idea wouldn’t work politically, either. To raise enough revenue, the tax on swanky insurance plans would have to be set as high as forty per cent. When labor unions, some of whose members enjoy coverage in these plans, learned about this punitive levy they objected loudly, prompting Pelosi to drop the idea, which, broadly speaking, amounts to taxing the upper middle class to provide benefits for the lower middle class.

I particularly agree with the quote by Christine Romer.  If the goal is to increase the number of people insured, like Melissa Thomasson, I would prefer granting tax subsidies for private purchasers of health insurance rather than taxing employer provided plans. 

Cassidy concludes,

So what does it all add up to? The U.S. government is making a costly and open-ended commitment to help provide health coverage for the vast majority of its citizens. I support this commitment, and I think the federal government’s spending priorities should be altered to make it happen. But let’s not pretend that it isn’t a big deal, or that it will be self-financing, or that it will work out exactly as planned. It won’t.

Many Democratic insiders know all this, or most of it. What is really unfolding, I suspect, is the scenario that many conservatives feared. The Obama Administration, like the Bush Administration before it (and many other Administrations before that) is creating a new entitlement program, which, once established, will be virtually impossible to rescind. At some point in the future, the fiscal consequences of the reform will have to be dealt with in a more meaningful way, but by then the principle of (near) universal coverage will be well established. Even a twenty-first-century Ronald Reagan will have great difficult overturning it.

That takes me back to where I began. Both in terms of the political calculus of the Democratic Party, and in terms of making the United States a more equitable society, expanding health-care coverage now and worrying later about its long-term consequences is an eminently defensible strategy. Putting on my amateur historian’s cap, I might even claim that some subterfuge is historically necessary to get great reforms enacted. But as an economics reporter and commentator, I feel obliged to put on my green eyeshade and count the dollars.

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Scientists as Experts

I do not believe that scientists should ever exaggerate the threat of policy action or inaction. It threatens our credibility as scientists, yet it is all too common a practice and too often condoned. In "Economists as Experts: Would an Expert Exaggerate?," I quote Nobel laureate, Thomas Schelling, who believes that exaggeration may be necessary to sell legislation on climate change to the taxpayers because beneficiaries are not yet born and will probably not live in the United States.

Using an example from trade, Paul Krugman weighs in on exaggeration in his brilliant book, "Pop Internationalism" that is a must read for anybody interested in any type of international relations.

Many people who know that "competitiveness" is a largely meaningless concept have been willing to indulge competitive rhetoric precisely because they believe they can harness it in the service of good policies. An overblown fear of the Soviet Union was used in the 1950s to justify the building of the interstate highway system and the expansion of math and science education. Cannot the unjustified fears about foreign competition similarly be turned to good, used to justify serious efforts to reduce the budget deficit, rebuild infrastructure, and so on?

A few years ago this was a reasonable hope. At this point, however, the obsession with competitiveness has reached the point where it has already begun dangerously to distort economic policies.

I can think of a few reasons scientists might exaggerate a scientific claim to see a policy enacted. None are flattering. They may believe that they are smarter than the general electorate which needs a push to support the correct policy. They may want to secure a place in history. Their motive might be as simple as supporting a winning policy. Any thoughts?

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The 4 Week Moving Average of Initial Unemployment Claims and the Unemployment Rate as of November 6, 2009

Robert J. Gordon did research looking at the relationship between the 4 week moving averages of initial unemployment claims and found that recessions often bottom out shortly after the 4-week moving average of initial unemployment claims peaks. Barring a deep double dip recession, the average peaked at 658,750 for the week ended April 4, 2009. On November 5, 2009 the Department of Labor released the most recent data on initial unemployment claims for the week ended October 31, 2009 in "Unemployment Insurance Weekly Claims Report." Seasonally adjusted initial claims was 512,000, down 20,000 from a revised estimate of initial claims of 532,000 for the week ended October 24, 2009. The 4 week moving average decreased 3,000 to 523,750. The average is down 135,000 from its peak, signaling a probable peak for this business cycle.

Today, the government reported that the unemployment rate increased to 10.2% (Employment Situation Summary). There are few if any little green shoots in the report. One of my favorite economists and bloggers, James Hamilton, does a little graphical analysis in, "Current economic conditions," and comes to the conclusion that, based on current data, the recovery will be slow.

Using National Bureau of Economic Research estimates on the beginning and ending dates of recessions, I have included graphs that compare the recessions that began in March 2001, July 1990, and July 1981 with the current recession which began in December 2007. Each compares the 4 week moving average of unemployment claims and the unemployment rate of the recession beginning in 2007 to those of the previous recessions. I have not attempted to adjust the initial claims data for changes in the size of labor market or the unemployment rate for changes in the natural rate of unemployment. The plots are measured over 111 weeks, beginning eight weeks before the recessions began. The horizontal axis begins in October 2007, the date the current recession began, and the data for the other recessions are superimposed on this date. The graphs gives some insight into why economists, politicians and others have expressed so much concern about the current recession.



The current recession seems to have the depth of the 1981 recession but the 4 week moving average has fallen more slowly now than in the 1981 recession.  Unemployment peaked between the 85th and 89th weeks at 10.8% and began to fall in January of 1983.  By June, the unemployment rate of 10.1%, lower than current peak of 10.2% reached in October, 2009 during the 110th week of the current recession.



The 1990 recession was shallower than the current recession both in terms of length and depth.  It lasted eight months from peak to trough; the current recession has not officially ended.  The 4 week moving average hitting 501,250 forty-two weeks after the 1990 recession began compared to 658,750 seventy-four weeks after the current recession began.  The 4 week moving average in yesterday's announcement is still 22,500 above the peak of the earlier recession.  The recovery from the 1990 recession was slow.  Unemployment was still rising two years after the recession began and would peak at 7.8% in June 1992, one months later than the time frame pictured in the graph.  Still 7.8% is 2.4 percentage points lower than the current recession and we do not know when it will peak.



The recession which began in 2000 was similar in size, length, and depth to the 1990 recession.  It lasted eight months from peak to trough, with the 4 week moving average topping at 517,00 thirty-four weeks after the recession began.  Unemployment peaked at 6.3% approximately 118 weeks after the recession began.  Again, the current recession will last at least as long, experience higher levels of initial unemployment claims and unemployment.       
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The Fort Hood Shootings and Catch 22

I agree with the solemn remark by President Obama concerning the shooting death of thirteen soldiers at Fort Hood, Texas (Alexander Burns and Carol E. Lee, Politico, "President Obama: Fort Hood shooting 'horrific').

These are men and women who have made the selfless and courageous decision to risk and at times give their lives to the rest of us on a daily basis.  It is horrifying that they should come under fire at an Army base on American soil."

I have lived within an hour Fort Hood for more than a decade and have met many wonderful soldiers and their families.  I fully concur with President Obama. 

When evidence existed that the shooter had questioned U.S. military involvement in the Muslim world, why was he allowed to serve?  Joseph Heller's provides insight in his brilliant satire, Catch 22.

There was only one catch and that was Catch-22, which specified that a concern for one's safety in the face of dangers that were real and immediate was the process of a rational mind. 'Orr' was crazy and could be grounded. All he had to do was ask; and as soon as he did, he would no longer be crazy and would have to fly more missions. Orr would be crazy to fly more missions and sane if he didn't, but if he was sane he had to fly them. If he flew them he was crazy and didn't have to; but if he didn't want to he was sane and had to.

Heller criticized military bureaucracy, the quote being but one example.  I would like to use his words to defend the Army against charges that they should have recognized that the shooter, Major Malik Nadal Hasan, an Army psychiatrist, was crazy and should have been kicked out.  My opinion is based on information that has been released to the public as of 9:00 am.  It was easy to learn that he did not want to serve in Iraq.  He wrote crazy things on a web page and he hired an attorney to help him fight deployment.  Perhaps he did more crazy things.  But these acts might be considered those of a rational mind attempting to evade deployment.  If the military caved to all the demands of servicemen who did not want to serve, if they released servicemen from their obligations because they wrote crazy things, infinitely more crazy things would be written and done and the ranks of the military would be depleted.  The Army did not have the main data point, the shootings, when they made their decision.  I don't believe that it is easy to discern the crazy from those who want out of their contractual obligations. 
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Market Incentives and Health

There were two interesting stories yesterday about public health.  (HT Drudge) In the first, Maggie Fox reports on emergency Congressional legislation to require employers to pay wages to sick workers (Reuters, "Proposed law would require pay for sick workers"). 

U.S. employers who tell workers to stay home when they are sick will have to give them paid time off for up to five days under new federal legislation proposed on Tuesday.

The emergency law would cover pandemic H1N1 flu or any other infectious disease, said California Representative George Miller...who chairs the House Education and Labor Committee and who introduced the bill.

"Sick workers advised to stay home by their employers shouldn't have to choose between their livelihood, and their co-workers' or customers' health," Miller said.

"This will not only protect employees, but it will save employers money by ensuring that sick employees don't spread infection to co-workers and customers, and will relieve the financial burden on our health system swamped by those suffering from H1N1."

Representative Miller should think more about the incentives the legislation would create.  Under current law, employers have incentive to protect themselves, their business, their customers, and the public at large by sending home employees who may be sick.  The legislation would undermine that incentive creating a new financial cost for sending home sick workers let alone the new incentive workers would have to escalate allergy symptoms into early stages of H1N1.  Nor do business need government to force them to do what is in their own financial interest.  Alas, Miller does not show the same concern for employers that he shows for workers.  By shifting costs of illness to employers, the legislation would slightly increase the number of failing businesses.  Employers shouldn't have to choose between their livelihood, and their workers' or customers' health. 

If the public has a health interest, and I believe that they do in this instance, let the public pay for it through taxes.

In a second article related to consumer health (Dan Childs, "E. Coli Concern: Once-Tainted Meat Allowed Back Into System"), ABC does and admirable job of agenda setting, telling the public what issues are important by insinuating one story into another story.  In this case, the story is about E. coli in fresh ground meat and its potential threat to public health.  The insinuated story is about E. coli in cooked beef which, as the story notes, does not present a health threat but is "icky."  How much would you add to your food bill to eliminate a perfectly healthy product to silence the icky factor?  If you have any doubt as to what ABC wants you to think, listen to the video on the linked story.

Imagine a ton of freshly ground beef. The company in charge of processing this meat finds out during a routine test that it is contaminated with E. coli. They record the test results, which are read by a government inspector, who acknowledges that the meat is indeed tainted.

You might think that this beef would be headed straight for the garbage bin. But in many cases, this meat is instead cooked, prepared and packaged as a pre-cooked hamburger patty that you pick up from the grocery store. And it's all completely legal...

The issue of cooking and reselling formerly tainted beef comes to light as another E. coli scare has now spread to 11 states, although the meat in this new case was fresh ground beef, not pre-cooked meat that had been repackaged..

Dr. Ira Breite, assistant clinical professor of gastroenterology at the New York University Langone Medical Center, agreed that tainted meat is indeed safe to eat if it is properly cooked to decontaminate it. But he added that many consumers would not relish the idea of eating meat that had been considered tainted with E. coli at any point along its way to their tables.

"If something is coated with E. coli and you cook it, the E. coli is gone," Breite said. "So could you eat it? Yes. Would I want to eat it? No. Is it gross? Yes... It's the ick factor."

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Sowell on the Cost of Medical Care

Thomas Sowell wrote a very good article, "The "Cost" of Medical Care" for Real Clear Politics.  He uses economic ideas of economic cost rather than accounting cost, opportunity cost, and cost shifting to evaluate current health care reform proposals.  I originally intended to include a graph to illustrate a few of his points, but like the Fonz from Happy Days who looks in a mirror as he pulls out his comb only to find that he cannot improve upon perfection withdraws his comb, I reread the article and withdrew the graph.  The article is good and deserves to be read in its entirety.  I quote at length.

We are incessantly being told that the cost of medical care is "too high"-- either absolutely or as a growing percentage of our incomes. But nothing that is being proposed by the government is likely to lower those costs, and much that is being proposed is almost certain to increase the costs.

There is a fundamental difference between reducing costs and simply shifting costs around, like a pea in a shell game at a carnival. Costs are not reduced simply because you pay less at a doctor's office and more in taxes-- or more in insurance premiums, or more in higher prices for other goods and services that you buy, because the government has put the costs on businesses that pass those costs on to you.

Costs are not reduced simply because you don't pay them. It would undoubtedly be cheaper for me to do without the medications that keep me alive and more vigorous in my old age than people of a similar age were in generations past.

Letting old people die would undoubtedly be cheaper than keeping them alive-- but that does not mean that the costs have gone down. It just means that we refuse to pay the costs. Instead, we pay the consequences. There is no free lunch.

Providing free lunches to people who go to hospital emergency rooms is one of the reasons for the current high costs of medical care for others. Politicians mandating what insurance companies must cover is another free lunch that leads to higher premiums for medical insurance-- and fewer people who can afford it.

Despite all the demonizing of insurance companies, pharmaceutical companies or doctors for what they charge, the fundamental costs of goods and services are the costs of producing them.

If highly paid chief executives of insurance companies or pharmaceutical companies agreed to work free of charge, it would make very little difference in the cost of insurance or medications. If doctors' incomes were cut in half, that would not lower the cost of producing doctors through years of expensive training in medical schools and hospitals, nor the overhead costs of running doctors' offices.

What it would do is reduce the number of very able people who are willing to take on the high costs of a medical education when the return on that investment is greatly reduced and the aggravations of dealing with government bureaucrats are added to the burdens of the work...

Any one of us can reduce medical costs by refusing to pay them. In our own lives, we recognize the consequences. But when someone with a gift for rhetoric tells us that the government can reduce the costs without consequences, we are ready to believe in such political miracles.

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Questionable Stimulus Spending

Susan Ferrechio writing for the Washington Examiner in, "After a flurry of stimulus spending, questionable projects pile up," lists projects that she views as unworthy of public funding.  I narrowed her list to those that reeked of corporate or political welfare.  By the latter term, I mean projects designed to reelect and Congressman or Senator.  I purposely left off those that might be considered bad scientific inquiries; I do work at a college after all. 

The $787 billion stimulus bill was passed in February and was promised as a job saver and economy booster. Here is where some of the money went:

- $30 million for a spring training baseball complex for the Arizona Diamondbacks and Colorado Rockies.

- $11 million for Microsoft to build a bridge connecting its two headquarter campuses in Redmond, Wash., which are separated by a highway.

$430,000 to repair a bridge in Iowa County, Wis., that carries 10 or fewer cars per day.

- $800,000 for the John Murtha Airport in Johnstown, Pa., serving about 20 passengers per day, to build a backup runway.

- $300 apiece for thousands of signs at road construction sites across the country announcing that the projects are funded by stimulus money.

- $9.38 million to renovate a century-old train depot in Lancaster County, Pa., that has not been used for three decades.

- $2.5 million in stimulus checks sent to the deceased.

I consider payments to the deceased to be political welfare, a thank you statement for the dead who continue to support local politicians, and not a clerical error.   

Although all economists prefer good projects to bad, these projects highlight an issue in the debate between economists who supported and opposed the stimulus.  Some economists who opposed point to the low or negative returns to taxpayers from these projects.  They also believe that some projects crowd out private investment.  If the bridge connecting Microsoft's two headquarter campuses were profitable, Microsoft would build it without government money and government spending crowded out private investment. 

Supporters of the stimulus are less worried about the long term quality of investment.  They believe that spending now raises employment now, lowering costs associated with the recession and these lower costs now offset some or all of the future higher costs due to bad investment.  Using similar logic, if Microsoft planned to delay construction of the bridge until the economy rebounded, then the stimulus money could be considered the cost of building the bridge now when increasing activity if more valuable to the economy as a whole. 
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Health Care and the Miracle of Markets

I sent the following letter to the editor to the Waco Tribune-Herald.

Sunday’s front page article titled, “Public option would cover few,” quoted Eastman Kodak’s CEO, Antonio Perez, who correctly fears the public option, errs incorrectly asserting that there are no miracles to solve the health care problem. The miracles are in the markets which are locked out of the current political debate.

Why haven’t markets worked better in developing new medical services at lower costs? In part, it is the unintended consequence of the government’s price-wage freeze in 1942 designed to organize our war effort. While wages were frozen, the government allowed companies to attract valuable workers by increasing fringe benefits such as employer provided health insurance. The government exempted wages used by the employer to buy insurance from taxes while taxing wages used by households privately purchasing health insurance, giving incentives for households to push as much of their medical care costs through their employer obscuring the true cost of medical care through the third party payment system.

By putting insurance plans purchased by individuals on the same tax footing as employer purchased plans, the insured will again be forced to consider cost. Insurance providers will innovate. Low cost, high deductible plans will probably emerge. Health care innovators will focus not on just prolonging life, but doing it at a low cost.

Sincerely,

Brooks M. Wilson

For students who wish to read more on how a employee provided insurance plan leads to escalating costs, read "Rationing Health Care."

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