Light Bulbs

Governments face daunting yet ignored difficulties imposing efficiency standards on markets.  They presume to have the knowledge and foresight that producers and consumers acting in markets lack.  Hayek called this presumption the fatal conceit and famously wrote, “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”

The government’s imposition of energy standards for light bulbs illustrates the fatal conceit.  I believe that their thinking went something like this.

Edison’s incandescent light bulb is more than 100 years old.  When lighting the bulb, more energy is lost to heat than used in light.  Certainly, it would be easy to make lighting more energy efficient.  We will require bulbs to be 30 percent more efficient by 2014 and 70 percent more efficient by 2020.

In 2007, the Congress passed and President Bush signed legislation with this energy requirement and since that time manufacturers have had problems meeting new standards.  Compact Fluorescent Lights (CFL’s) cost more, don’t last as long as promised, and pose a small environmental hazard.  Light emitting diode bulbs (LED’s) are very expensive and will remain expensive even after production costs fall and competition increases.

Elected officials do not seem to realize that consumers pay attention to cost, both the purchase price and operating cost.  I own a minivan rather than an SUV because it gets better gas mileage.  My wife and I recently considered buying a bigger home.  We considered the extra energy and water cost of maintaining the home.  Manufactures have a profit incentive to provide products with characteristics that consumers desire and if consumers want energy efficient products, they will get them.

If our elected officials believe that energy consumption results in a negative externality, they should tax it and not establish “command and control” regulations like those imposed on light bulbs that are fraught with inefficiencies.  Faced with higher costs for electricity, the interaction between buyers and sellers will efficiently determine the lowest cost method to consumers for lowering the consumption of electricity. 

 
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Biofuels and Government Subsidies

The United States is not the only country that mandates that food crops be converted to fuel.  These mandates are a factor driving up food costs (“Biofuel rush driving up global food prices”). 

Each year, an ever larger portion of the world's crops - cassava and corn, sugar and palm oil - is being diverted for biofuels as developed countries pass laws mandating greater use of nonfossil fuels and as emerging powerhouses like China seek new sources of energy to keep their cars and industries running. Cassava is a relatively new entrant in the biofuel stream.

But with food prices rising sharply in recent months, many experts are calling on countries to scale back their headlong rush into green fuel development, arguing that the combination of ambitious biofuel targets and mediocre harvests of some crucial crops is contributing to high prices, hunger and political instability.

This year, the United Nations Food and Agriculture Organization reported that its index of food prices was the highest in its more than 20 years of existence. Prices rose 15% from October to January alone, potentially "throwing an additional 44 million people in low- and middle-income countries into poverty," the World Bank said.

These renewable sources of fuel were to make oil importing nations less dependent on Middle Eastern oil.  Maybe we are somewhat less dependent, but not sufficiently independent to free us from military entanglements. 

The article concludes

While no one is suggesting that countries abandon biofuels, Dubois and other food experts suggest that they should revise their policies so that rigid fuel mandates can be suspended when food stocks get low or prices become too high.

My blogging voice is small, but I would be honored to be the first to suggest that governments eliminate all programs that subsidize or mandate the use of crops for fuel.
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Carbon Regulation

Kimberly Schwandt, a FoxNews writer, reports on Obama administration efforts to control carbon emissions through EPA mandates rather than through legislation in “White House Plans to Push Global Warming Policy, GOP Vows Fight”.  The path was cleared for the EPA to regulate carbon emissions by the EPA’s “endangerment findings” as required by the Clean Air Act.  (I provide some thoughts on the “endangerment findings” here.).  The EPA mandates are controversial because the advocates of carbon regulation, including the administration, were unable to pass legislation to establish regulatory authority and because the Clean Air Act was not designed to regulate climate change.  Schwandt reports

After failing to get climate-change legislation through Congress, the Obama administration plans on pushing through its environmental policies through other means, and Republicans are ready to put up a fight.

On Jan. 2, new carbon emissions limits will be put forward as the Environmental Protection Agency prepares regulations that would force companies to get permits to release greenhouse gases under the Clean Air Act.

Critics say the new rules are a backdoor effort to enact the president's agenda on global warming without the support of Congress, and would hurt the economy and put jobs in jeopardy by forcing companies to pay for expensive new equipment.

She later quotes Ken Green of the American Enterprise Institute who claims that carbon regulation will kill jobs, and Dan Howells of Greenpeace who argues the opposite.  Green is aiming at the right target but misses the bull’s eye when he said,

They are job killers. Regulations, period -- any kind of regulation is a weight on economy. It requires people to comply with the law, which takes work hours and time, which reduces the profitability of firms. Therefore, they grow more slowly and you create less jobs.

The first issue is one of semantics and is probably not important.  The creation of property rights can be considered regulation, and I would bet dollars to donuts that Green would agree that good property rights are important.

The second issue is of more weight.  Green is correct in observing that carbon regulation makes firms less profitable by increasing the cost of producing goods and services.  That is exactly what the regulations are designed to do.  Howells is also correct in stating that the regulations will add jobs.  Companies and industries that find adjustment costly will shrink and those that find it less costly will grow. In the long run, we will experience full employment.

The real question is whether carbon regulation makes us better off.  If carbon pollution is a real threat to future wealth creation and the regulation effectively reduces our carbon emissions and other countries do not free ride off our efforts by increasing their carbon emissions, then carbon regulation will make us better off.  I have problems with all three clauses, particularly the last two.

The timing of the new carbon regulations is also bad.  Unemployment is still high, many businesses were financial weakened from the Great Recession, and those same business are attempting to internalize health care reform.  Others are trying to digest regulatory reform of the financial sector, regulatory reform of the food sector, and possibly new regulation of the Internet.  While carbon regulation may not kill jobs, it will certainly delay our return to something akin to full employment.
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McDonalds and Healthcare Waivers

Thirty companies and organizations including McDonald's were granted health care coverage waivers from the Department of Health and Human Resources allowing them to offer insurance plans that do not meet new health insurance guidelines of the new healthcare legislation to approximately one million workers.

The “mini-med” plans run afoul of the legislation for two reasons.  First, insurance plans must spend at least 85% of their revenue on medical care (David Leonhardt, “Health Care’s Uneven Road to a New Era”).  This is a big hurdle for insurance plans geared to young, healthy consumers.  After all, a $200 medical bill for a simple checkup is likely to have much the same administrative cost as $200,000 bill for bypass surgery.  Second, the new health care legislation requires that companies provide a minimum of $750,000 in coverage in 2011, increasing to $1.25 million in 2012, $2 million in 2013 and unlimited in 2014 (Drew Armstrong, “McDonald's, 29 other firms get health care coverage waivers”).  That amounts to a huge salary increase for low skilled workers.  The mandated increase in salary will result in less demand for low skilled workers and an increase in the price of goods and services that they produce.   Leonhardt gives a good positive description of mini-med plans and their limitations mixed with his normative views in the article linked above.  Three sentences exemplify many of my objections to healthcare reform.

…people will be required to buy insurance, to spread costs among the sick and the healthy. Second, insurers will be prohibited from cherry-picking only the healthiest customers, again to spread costs. Finally, the government will give subsidies to people, like McDonald’s workers, who can’t afford insurance on their own.

Leonhardt puts much less value on freedom and trust in markets than I do.  Words like “people will be required to buy” and “insurers will be prohibited from” make me cringe.  Who is the government to tell me what I need to buy or designing products for private companies?  Nor do I have a problem with cherry-picking of the healthiest consumers.  That leaves a market segment for insuring the chronically ill, a group more deserving of subsidies than workers who are generally young and healthy.  In fact, most analysis that I have read conclude that the young will subsidize the old and the ill.  Finally, the government may “give subsidies to people” but they do so with taxpayer money.

In regards to the reform in general, it weakens market incentives that would lead consumers to watch medical costs and providers from producing low cost products because taxpayers will subsidize insurance plans with unlimited costs.

Taxpayers and healthcare consumers would have been better served by legislation that increased market incentives.  See “More on Rationing Health Care” for a short explanation of how the tax code weakened market incentives for healthcare and a comparison of government rationing vs market rationing of healthcare. 
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The Crisis Paradox and Taylor's Assessment of Financial Regulatory Reform

Like so many news stories and commentaries, John B. Taylor's article in the Wall Street Journal, "The Dodd-Frank Financial Fiasco," brings to mind what I called the Crisis Paradox: crisis is the best time politically and the worst time economically to enact fundamental economic reform.  While I coined the phrase, it is Robert Higgs' work that laid its foundation.  He offered the "Crisis Hypothesis," that the supply of and demand for government oversight and control of a market economy increases in times of crisis, in "Crisis and Leviathan," and the uncertainty hypothesis that increased government oversight and control during the Great Depression dampened investment in "Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War" (The Independent Review, Vol. 1, No. 4, Spring 1997),(see also, "Depression, War, and Cold War").

Taylor believes that the Dodd-Frank financial reform bill's complexity is a risk to economic growth.  This is the Uncertainty Hypothesis.  He also observed that the bill misdiagnosed the causes of the financial crisis, perhaps because it was passed before the congressionally mandated Financial Crisis Inquiry Commission finished its work.  Simply put, Congress struck while the iron was hot to pass reform some legislators sought prior to the financial crisis.  This is the Crisis Hypothesis.   

The sheer complexity of the 2,319-page Dodd-Frank financial reform bill is certainly a threat to future economic growth. But if you sift through the many sections and subsections, you find much more than complexity to worry about.

The main problem with the bill is that it is based on a misdiagnosis of the causes of the financial crisis, which is not surprising since the bill was rolled out before the congressionally mandated Financial Crisis Inquiry Commission finished its diagnosis.

The biggest misdiagnosis is the presumption that the government did not have enough power to avoid the crisis. But the Federal Reserve had the power to avoid the monetary excesses that accelerated the housing boom that went bust in 2007. The New York Fed had the power to stop Citigroup's questionable lending and trading decisions and, with hundreds of regulators on the premises of such large banks, should have had the information to do so. The Securities and Exchange Commission (SEC) could have insisted on reasonable liquidity rules to prevent investment banks from relying so much on short-term borrowing through repurchase agreements to fund long-term investments. And the Treasury working with the Fed had the power to intervene with troubled financial firms, and in fact used this power in a highly discretionary way to create an on-again off-again bailout policy that spooked the markets and led to the panic in the fall of 2008.

Taylor's intent was not to offer support for Higgs' work but to describe false remedies the 2,319 page bill mandates and his criticism that it increases the power of the government in areas unrelated to the financial crisis should be addressed.  The bill creates "orderly liquidation" authority for the Federal Deposit Insurance Corporation that implicitly supports the "too big to fail" policy strengthening the moral hazard caused by the socialization of losses.  The bill does not reform Fannie Mae and Freddy Mac, the two government sponsored entities that underwrote or purchased a large percentage of subprime loans, nor does it reform the bankruptcy code to allow large, complex financial firms to go through an orderly liquidation.  Those interested in reform of the financial sector should anxiously read the article.    
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Oil Spill Risk Analysis

Neil King Jr. and Keith Johnson wrote an interesting article about the Mineral Management Service, the regulatory agency charged with overseeing offshore oil drilling (Wall Street Journal, "BP Relied on Faulty U.S. Data").  The Mineral Management Service requires oil companies to file contingency plans (oil spill risk analysis) for oil spills based on the government's models that showed little oil would reach shore even in a worst-case scenario.

BP PLC and other big oil companies based their plans for responding to a big oil spill in the Gulf of Mexico on U.S. government projections that gave very low odds of oil hitting shore, even in the case of a spill much larger than the current one.

The government models, which oil companies are required to use but have not been updated since 2004, assumed that most of the oil would rapidly evaporate or get broken up by waves or weather. In the weeks since the Deepwater Horizon caught fire and sank, real life has proven these models, prepared by the Interior Department's Mineral Management Service, wrong...

The oil companies may have bought into the competency of the MMS's scientists.

The government's optimistic forecasts reinforced the oil industry's confidence in its spill-prevention technology, leading to decisions that left both oil companies and the government ill-prepared for the disaster that has unfolded in the Gulf since April 20.

Although the oil companies may have believed the ocean flow models, some other scientists did not.

The government's spill models have been at the center of years of debate among scientists that study oil spills. One study in the late 1990s used satellites to track almost 100 "drifters" set loose in the Gulf of Mexico to mimic floating oil. The paths of the drifting objects were compared with what the model predicted. After 30 days, the average discrepancy was 300 miles. "We have observed differences of some magnitude," a 2003 paper said, summarizing the study.

Scientists at the Mineral Management Services remained confident of their model's prediction even as they accepted other's findings and attempted to update their models.

But the researchers, led by a team of scientists from the Interior Department's MMS, concluded that the results were "neither surprising nor disappointing," and "do not negate the utility" of the model. The scientists said the findings could lead to improvements in oil-spill modeling.

The inaccuracy of the Service's model and their requirement that oil companies use these projections are typical of inefficiencies of regulatory agencies and only add to doubts about the ability of regulation to limit catastrophic events.  They could have required the oil companies to use the MMS's oil flow projections as a base, allowing the companies to offer plans for more costly outcomes than projected by the government.

The oil companies too may have failed to plan for worst-case scenarios.  The fear of losing tens of billions in a worst-case scenario should have prompted them to have internal contingency plans that differed from the government's plans.  Maybe all oil companies with the exception of BP have such plans.  If not, why not?  Several possible explanations come to mind.  They, like many in today's society, could have believed in the omniscience of government and that government scientists had an absolute advantage in measuring the impact of a spill.  I could be persuaded that there are economies of scale and scope in developing the models and that the government, which also studies climate change, fisheries, and other subjects that might benefit from ocean flow models.  They may have believed that their liability was capped at $75 million.  If this is so, bad regulation limiting liability through law is a problem and, given the oil industry's deep pockets to influence legislation, will remain one.  The Deepwater Horizon oil spill is truly tragic and it is not possible to avoid the consequences of the occasional worst-case scenario. 
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BP and the Worst-Case Scenario

Cass Sunstein is a leading legal scholar and has engaged in a great deal of economic research in behavioral economics.  He is currently the administrator of the White House Office of Information and Regulatory Affairs and the target of right of center groups who oppose President Obama's regulatory reform agenda.  I am more market oriented that Sunstein and disagree with many of his policy recommendations, but I am pleased that he advises the president because he is thoughtful and approaches problems from many angles.  He recently wrote, "Worst-Case Scenarios" which asks how the government should treat low probability, high risk events like the Deepwater Horizon oil spill.  I must confess that I have not yet read the book, but I have listened to his interview about the book on EconTalk with Russ Roberts. 

The main idea is that people are not particularly good at analyzing low probability, high risk events.  In his discussion, he mentions two vice presidents, Cheney and Gore who each pushed expensive responses to these type of events: the September 11 terrorist attacks and anthropogenic global warming.  He treats both issues as having approximately the same approximate probability and cost of inaction.  For the sake of exposition, I will do the same.  Why have we spent much more on terrorism? 
Sunstein offers several reasons.  The most important is the availability of a salient event such as September 11.  It skews our probability judgments making us believe that an unlikely event is much more likely because we have a recent example; we rely on emotions and neglect probability.  Anthropogenic global warming does not have a similar catastrophic event to sell a policy response.  The probability that we ignore probability increases if our outrage is provoked because there is a single face that can be attached to the event.  In the case of September 11, the face was Osama bin Laden, the leader of al-Qaeda; there is no good face to represent global warming. 

According to Sunstein, we should beware of worst-case entrepreneurs, people who fan the flames of fear a salient event might ignite to push policy in a direction they favor.  By "fan the flames" I mean convince us that the probability of an event is much more likely because a salient event is immediately before us.  Overreaction to an unlikely event can be costly and entail its own risks.  The War on Terror has been costly in terms in lost life and budget expenditures. A cap-and-trade system to reduce carbon emissions would likewise be costly.  

An oil spill like the Deepwater Horizon is a low probability event.  Oil companies have drilled in the gulf and other places around the world for years with no comparable event.  Perhaps some, in search of a solution, are neglecting probability and our outrage has been aroused by the sloppy corporate practices of Tony Hayward, the CEO of BP.  We should beware of political entrepreneurs who would oversell the spill as a likely event to sell their programs.  I believe that a moratorium on all drilling in the gulf was an overreaction and I am surprised that it came from a White House taking advice from Sunstein.  A moratorium on new deep water drilling would be reasonable.  I also believe that pushing increased ethanol production through government subsidies is another overreaction.  Increased corn production would cause farmers to substitute corn for other crops and take corn out of the food chain driving up food prices.  It would also lead to new, less productive land being cultivated.  Increased agricultural production entails more use of nitrogen and phosphorus based fertilizers.  These chemicals spill into the water supply causing algae blooms which deplete oxygen and weaken ecosystems lowering animal and plant populations.  Besides, ethanol is simply an expensive alternative to gasoline that cannot complete in markets without taxpayer subsidies.  Rather than pick a new power source, the government would be better advised to increase the tax on gasoline and see how the market responds, but if gasoline is taxed for the pollution it causes, so should ethanol. 
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Additional Thoughts on BP

When news of the leak at the BP operated Deepwater Horizon broke, many blamed corporate greed as the prime cause of the disaster.  I wrote what I still consider the correct economic response concerning greed: it is a universal constant (see "BP a Bad Corporate Actor?," "Reid on Greed," and "The Oil Spill and the Government).  I also expressed doubt over the government's ability to effectively regulate oil exploration, a doubt that I maintain.  As I continue to read about the accident, I have rethought an initial conclusion. 

First and most importantly, BP does appear to a bad corporate actor, either through incompetence or intentional neglect.  Because BP has always said that they would compensate all legitimate claims, I would tentatively conclude that BP is simply incompetent.  (HT Econbrowser)  The Christian Science Monitor ("Five crucial moves by BP: Did they lead to Gulf oil spill disaster?") list five crucial drilling decisions all made to cut costs that BP made that contributed to the rig failure as determined by the Democrats leadership on the House Energy and Commerce Committee. The steps include

1.  Well design

2.  Insufficient "centralizers"

3.  Failure to run a key test

4.  Improper mud circulation

5.  Failure to secure the wellhead.

James Hamilton at Econbrowser ("More on BP") adds a sixth error, the lack of a standard failsafe device, the acoustic shut-off switch.

If BP is a bad corporate actor rather just the unlucky "victim" of an unforeseeable event then the economic consequences should apply to them and not more efficient corporations.  What type of regulation would punish BP and protect other oil companies, consumers of oil products, and third parties whose livelihoods have been impacted by the spill?  BP's feet should be held to fire to assure that they do pay all legitimate claims through the legal system.  I still believe that further regulation by the federal government would be redundant and perhaps counterproductive.  Elected officials tend to overreact to low probability, high cost events. The government should not decide what constitutes the best practices.  If they do, those practices will be cemented in place in an industry that had previously seen technological advances that have allowed safer drilling at deeper sights.  I would also remove caps on damages.  Although the caps can be exceeded for negligence or misconduct oil companies would have better incentive to internalize societal costs of oil spills if the caps were removed. 
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Reynolds on Unemployment and the Economy

Alan Reynolds, a senior fellow with the Cato Institute had a different take on why the recent unemployment data has been interpreted so negatively (Wall Street Journal, "Don't Believe the Double Dippers").  It's the political spin and it comes from both sides of the aisle.

Using all of this statistical trickery to convert a weak job market into an imminent recession has become a bipartisan political strategy. Robert Reich and other big government Democrats play the "double dip" card to peddle more deficit spending on refundable tax credits and transfer payments. Conservative Republicans often become double-dippy for very different reasons—to argue (quite plausibly) that hundreds of billions in "stimulus spending" has proven counterproductive so far, contributed to the debt, and will eventually lead to higher taxes.

Reynolds does an excellent job describing various measures of unemployment (U2, U4, and U6) and the "Job Opening and Turnover Survey."  His interpretation is well worth the read.

In addition to interpreting the employment data, he describes the general economic outlook.  If it were a weather forecast, he would report that the sky is not falling, but the dawn is overcast.    

Those who want to know what is going on must sift through all of this bipartisan gloom to distinguish between (1) agenda-driven dire warnings and (2) the boring reality of a sluggish recovery being partially paralyzed by ominous threats of punitive taxes and onerous regulation.

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Parallels Between the Great Depression and Great Recession

Growth in the U.S. gross domestic product was revised downward to 3.0% from 3.2% for the first quarter of 2010.  Initial claims for unemployment remain stubbornly high, falling 15, 000 to 460,000, but the 4-week moving average of initial claims climbed 2,250 to 454,250 (Jeannine Aversa, "Slow-motion recovery keeps unemployment high").  British and European monetarist have a possible explanation, the money supply as measured by M3 is falling at rates not seen since the Great Depression.  Ambrose Evans-Pritchard summarizes monetarist research in "US money supply plunges at 1930s pace as Obama eyes fresh stimulus" noting that M3 fell from $14.2 trillion to $13.9 trillion or 9.6% in the first quarter and the assets of institutional money market funds fell by 37%, the biggest decline ever.  As money assets contract, government debt swells.  Gross public debt will reach 97% of GDP in 2011.

The economy could slip back from weak recovery into recession with another negative shock.  The administration is pushing a $200 billion stimulus to sustain the growth that they believe that the original stimulus created.  Evans-Pritchard quoted Larry Summers, whose words acknowledge the dangers of the expanding deficit, as stating that Congress must "grit its teeth" to pass the stimulus and that it would be "pennywise and pound foolish" to fail to pass it.

In "Crisis and Leviathan," Robert Higgs proposed the crisis hypothesis which states that national crisis increase both the demand for and supply of government regulation of the economy.  Evans-Pritchard also interviewed Tim Congdon who believes that regulation comes at a cost...

"It’s frightening," said Professor Tim Congdon from International Monetary Research. "The plunge in M3 has no precedent since the Great Depression. The dominant reason for this is that regulators across the world are pressing banks to raise capital asset ratios and to shrink their risk assets. This is why the US is not recovering properly," he said.

Steven Gjerstad and Vernon Smith see other parallels between the Great Depression and the Great Recession ("Monetary Policy, Credit Extension, and Housing Bubbles: 2008 and 1929," Critical Review, 21(2-3), 269-300).  They document how housing bubbles formed in both 1929 and 2008 based on expansion of housing and mortgage financing for the least qualified borrowers.  They describe the boom and bust cycle.

The massive bubble in housing prices(driven by self-reinforcing price expectations) and the supporting expansion of credit, undisciplined by traditional equity requirements, as well as tiered internal structure of the housing market, had all depended on further unsustainable housing-price growth, premised on unfathomable easy mortgage credit--fueled by easy money.  Once that momentum turned negative, buyers of homes, mortgages, and bank obligations reined in their activity, the stock market plummeted, and monetary policy was impotent to stem the collapse.  Monetary policy was "pushing on a string" that only absent buyers could have pulled.

Traditional policy tools, fiscal policy, monetary policy and regulation seem limited and ineffectual at best and counterproductive at worst.  It is the actions of economic agents working through markets that will end the recession. 
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BP a Bad Corporate Actor?

In the two previous posts, "Reid on Greed" and "The Oil Spill and the Government," I suggested that oil company executives have always been and will be self interested and that self interest is likely to lead them to avoid costly oil spills.  I also suggest that regulation beyond law requiring oil companies to pay damages may be a costly, redundant, and unnecessary burden on taxpayers or consumers who ultimately pay for the regulatory structure. 

To guard against confirmation bias, I looked for information that suggested that BP was negligent and found an editorial in the Houston Chronicle, "Spillover effects: Some success, but new questions to answer about Deepwater Horizon disaster," that did just that.

It does not help BP's cause in the Gulf spill that two of the company's refineries account for 97 percent of all flagrant violations found in the industry, according to the Center for Public Integrity. While these matters are not specifically related, they contribute to a growing impression that BP is a corporate bad actor.

As reported in Tom Fowler's energy blog this week, most of BP's citations were classified by OSHA as “egregious willful.” A willful violation is defined as “one committed with plain indifference to or intentional disregard for employee safety and health.” That is bad news for BP, and likely will be used by critics to tar the entire industry.

These statistics do not prove BP malevolently negligent or negligent, but they are suggestive. BP could be incompetent, miss measuring the danger of a spill and the associated cost.  It could simply be an unavoidable accident given knowledge before the spill.  I have still not found information to suggest that a different regulatory structure would decrease the probability of an oil spill.      Replace this text with...
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The Oil Spill and the Government

Information about the BP's response to the damage caused by the Deepwater Horizon oil rig and the government's regulation of rig inspections cast serious questions about the value of government regulation of leasing and inspection of offshore drilling.  To know why firms don't need regulation, just follow the money; cleaning up an oil spill is bad for business.  BP has acknowledged responsibility for all legitimate costs of the cleanup.  The costs are estimated at between a few hundred million to $12.7 billion.  BP's stock value has fallen 15%, lowering the firm's market value by about $30 billion (Reuters, "BP says oil spill costs $350 million so far, shares hit").  Although part of the market decline could be due to the Greek financial crisis, certainly much of the decline is due to the costs of the spill.  If oil companies pay the cost of cleanup, why do we need to regulate leasing and drilling?  It is an unnecessary cost to taxpayers, oil producers, and consumers. 

Drilling for oil is a complex business as seen by responses of BP, Transocean and Hilliburton before congressional hearings.  President Obama remarked on the confused testimony (Real Clear Politics Videos, "Obama: Finger Pointing By Oil Companies Is "Ridiculous Spectacle"").   

I did not appreciate what I considered to be a ridiculous spectacle during the congressional hearings into this matter. You had executives of BP and Transocean and Halliburton falling over each other to point the finger of blame at somebody else. The American people could not have been impressed with that display, and I certainly wasn't.

He missed the major point: while nobody is sure what happened, BP said it will pay for the cleanup.  He also missed the most likely explanation for the confused testimony; the representatives of these firms don't know what happened.  Those who rely on government regulation to reduce oil spills miss a point as well; the government relies on the firms to explain events to them.  Regulators do not have independent insights. 

Minerals and Management Services (MMS), the federal agency in charge of oversight, has 55 inspectors in the gulf who are required to inspect 90 drilling rigs once per month and the approximately 3,500 oil production platforms once per year (Justin Pritchard, AP, "IMPACT: Fed'l inspections on rig not as claimed").  Assuming that only one inspector is need at each site, and that no time is lost in the office or traveling, each production unit gets something less than 3.5 inspector workdays annually.  Perhaps the MMS, which collects revenues from oil companies, is doing a bad job of allocating resources to inspection because, as President Obama believes, there is too cozy a relationship between the agency and the oil companies, but I don't think so.  My guess is that someone else in the federal bureaucracy determines how many inspectors to hire and how to spend oil revenues.  A possible cozy relationship does not explain why the MMS presented the Deepwater Horizon operation with a safety award.

If the Obama administration believes its job and that of MMS inspectors is to stop all possible oil spills, and that they have the ability to accomplish it, they deserved to be tagged with the insult delivered by the Klingons to Captain Kirk.  They are a bunch of "tin plated over bearing swaggering dictator(s) with delusion(s) of godhood."  If American voters believe that the government can regulate oil production and stop all spills, they are simply delusional. 
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The Little Engine Who Could?

On Friday, the Bureau of Labor Statistics released unemployment data for April.  Like the little engine that could, the data tells the story of a little engine, the American market economy, carrying an oversized train over a high mountain pass on the track to economic recovery.  GDP growth for the first quarter of 2010 groaned in at 3.2%, a rather anemic rate for the second quarter of economic recovery, but sufficient to invigorate discouraged workers who come out of the shadows and reentered labor markets bumping up the labor force participation rate to 65.2% in April from 64.9% in March and better exposing the burden of unemployment which jumped to 9.9% from 9.7%.   

How did we get to the point that the little engine's success is in doubt?  It left the station in good mechanical order and properly packed and began its journey at a full head of steam.  Although the little engine is imperfect, many of its problems were created or compounded by those in charge of maintaining the track.  Unhappy with that important assignment, they wished to choose the direction of the track, the speed of the train and the loading of cargo.  As the little engine chugged through the plains, a man in charge of the rails gave a wonkish wink to the little engine as he added home ownership goals and weaker lending standards to achieve those goals to the little engine's burden. 

Further down the line, another man compassionately raised the home ownership goals.  Imprudent workers on the train responded and grew bloated on bad loans that were needed to meet the new goals.  It was like creating a downhill run before the little engine began its uphill battle but the dirt had to go somewhere and it wass added to the top of the mountain.  

The train raced downhill, but it knew excess speed on a flat run is as dangerous as the long pull uphill.  It feared both “The Boom and Bust.” A wise man with long experience working the track saw the looming disaster, but rather than keeping the track clear, stoked the little engine's fire with lower interest rates, adding to the train's speed but depleting its fuel. 

Finally, as home loans started to go bad and the bloated banks fail, the long uphill battle began and the little engine chanted, "I think I can, I think I can."  Terrified by the slowing train and the long climb, the compassionate man yelled at the little engine, "This is your fault; you are letting your cargo (the bad loans) fall off the train.  Banks that are too big are failing.  People on Main Street will be hurt!"  He quickly arranged a bailout for the banks that added to the debt burden of the lumbering train. 

A post partisan man who supported the bailout pushed the compassionate man and his followers out of the way and pontificated, "Can't you see what you have done?  You have let the little engine choose its path.  You trusted the little engine too much and it is hurting Main Street!"  He quickly organized shovel ready projects to help the little engine but added more debt to its burden.  Angry at those who made the little engine run and refusing to recognize the jobs and products it carried or the burden created by the track maintenance crew, the post partisan man cried, "You earn too much.  We should be more like Europe.  It's time to give back to the community."  He raised taxes, but only on the wealthy, to pay for a health care program, further adding to the weight of the train. 

The train slowed but continued to groan, "I think I can, I think I can."  At its side it sees Greece's little engine wrecked and smoking.  Those in charge of their track had promised too much for too long are facing an angry mob demanding that their little engine maintain their benefits, but the train’s cargo has already been looted. 

The little engine passes other European little engines whose track maintenance crews fear that Greece's wrecked engine will run into theirs further burden their own little engines with more debt to bailout Greece.  The little engines of Spain, Italy, and Portugal look hopefully to the larger European engines whose debt burden is growing. 

Will the European engines crash and burn?  More importantly to American's, will our little engine follow suit?  If we as an electorate continue to support expanded entitlements through increased debt, it will.  It we continue to expand the size and scope of government, it will. If we continue to bail out failed enterprises, it will.  If we view the market economy, our little engine, as a goody bag from which policy makers can take from one group and give to another, it will.  It is past time to return our trust to the spontaneous actions of economic agents and to limit the actions of government officials who would hamper growth and prosperity by redistributive rules or worse, taking over part or all of the economic planning function.
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A Broadband Free Lunch?

(HT to the Drudge Report)  The Federal Communications Commission is considering a plan to allocate spectrum to free or very low cost broadband Internet service nationwide ("U.S. considers some free wireless broadband service").  The Reuters article suggests that the provision of this service is some sort of free lunch by not mentioning tradeoffs.

WASHINGTON (Reuters) – U.S. regulators may dedicate spectrum to free wireless Internet service for some Americans to increase affordable broadband service nationwide, the Federal Communications Commission said on Tuesday.

The FCC provided few details about how it would carry out such a plan and who would qualify, but will make a recommendation under the National Broadband Plan set for release next week. The agency will determine details later.

One way of making broadband more affordable is to "consider use of spectrum for a free or a very low cost wireless broadband service," the FCC said in a statement.

What is the tradeoff?  At a time of imposing deficits, the FCC could auction off the spectrum to the highest bidders lowering the deficit.  Companies with winning bids value the spectrum more presumably because they can repackage it and sell services to end users.  One function of markets is to allocate goods and services to those who value it most.  An auction achieves that goal but a government give away does not.  There is not such thing as a free lunch and this lunch is paid for by taxpayers and consumers who would be happy to buy products utilizing the spectrum that the government plans to give away.  
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Llosa on Paulson and the Fear Factor

Alvaro Vargas Llosa of the Independent Institute reviewed former Treasury Secretary Henry Paulson's memoirs, "On the Brink," on the bursting of the housing bubble, the ensuing financial crisis, and government response in, "Paulson and the Fear Factor."  I quote a three paragraphs of his insightful review.  The remaining review is very much worth the time and effort to read.

WASHINGTON—There is a moment in former Treasury Secretary Henry Paulson’s memoirs when—during a Capitol Hill discussion over a financial rescue plan—he succumbs to stress and suffers an attack of dry heaves in front of a U.S. senator.

This episode is symbolic of what was happening in the country—the panicked spasms of government action to save big banks from going under that Paulson narrates in On the Brink, his inside account of the U.S. financial catastrophe. It is punctuated with episodes of fear; at one point he tells his wife: “Everybody is looking to me, and I don’t have the answer. I am really scared.” The entire government was scared. The result was that between the rescue of Bear Sterns in March 2008 and the rescue of the auto companies in December of that year, an array of bailouts, takeovers and money-pumping acts of desperation gave the U.S. government near-dictatorial control over much of the world’s foremost economy.

We think of statism as born out of altruism or megalomania. But here a third cause transpired: naked, primeval fear. The notion that people could be left to sort themselves out in the biggest financial crisis since the 1930s was terrifying even for Paulson, a true believer in free markets who keeps repeating in his book that he disliked what he was doing. The fear was so overpowering that Paulson, his colleagues and Wall Street decided to put unconditional faith in the very institution, the federal government, that the author tells us was responsible for the conditions under which the housing bubble occurred: easy money, political incentives for homeownership and regulatory incompetence.

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Clinton, Bush and Obama and Budgets

Our political process often highlights the difference between presidential administrations rather than their similarities. I wandered into Bankrupting America, through Cafe Hayek and found a couple of posts on the federal budget that are of interest.  The first, "The Odd Couple: 5 unfortunate similarities between Bush and Obama," gives a backward countdown of the similarities.

5. They love to spend. Bush passed a $3 trillion budget for 2009.  Obama posted a $3.5 trillion budget in 2010.  Bush doubled the debt to almost $6 trillion and Obama’s plans would leave us with an IOU of an additional $8.5 trillion by 2020.

4. They shop at the same stores. Contrary to popular belief, defense and homeland security spending only made up about 40 percent of Bush’s new spending.  He increased spending across most non-defense categories – like education, Medicare, Medicaid, income security and regional development – by four to six times the rate of inflation.  In Obama’s first half year in office, as he demanded a departure from the “investment deficit” years under Bush, these budgets rose another 70 percent or 40 times the rate of inflation.

3. They dabble with stimulants. In 2001 and 2008, Bush spent billions on rebates to stimulate consumer spending.  In 2009, Obama upped the ante with his $862 billion stimulus package.

2. They give sweetheart deals to failing corporations. Obama carried out Bush’s unpopular $700 billion bailout for failing corporations.  Together, the presidents have bailed out over 600 businesses since Spring 2008.

1. They enjoy regulating in their free time. Once again contrary to popular belief, President Bush was the biggest regulator since Richard Nixon.  Under his leadership in 2007, the number of pages of regulation added to the Federal Register reached an all-time high of 78,090  – a 21 percent increase from Bush’s first year.  And spending on regulatory activities rose to $42 billion in 2009 – a 62 percent increase.  Since taking office, Obama has proposed a large and sweeping increase in regulation that many worry could lead to another financial crisis in the future.

The second post, "A quick ode to the relative fiscal restraint of the Clinton years," correctly notes that President Clinton is the odd man out in spending and wishes the former president a speedy recovery from hearth surgery.  I concur. 
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A Comment from a Reader on Forceps

I thank CrisisMaven for the comment and the questions to "Forceps," a post that describes how as many as one million babies and mothers died because a doctor named Chamberlen kept secret his innovation of the use of forceps in delivery.  I encourage you to visit "CrisisMaven's Blog."   CrisisMaven wrote,

But what do you suggest? That every inventor be tortured to own up? And how does one find out that he/she invented anything to be elicited in the first place? And what if Chamberlen had shared the fate of semmelweis? Maybe he had other good reasons to keep his secret and it only came out into the open when the world was prepared to accept it? Don't we remember Galilei?

For those not familiar with Semmelweis, he was a doctor who in 1847 conducted research into the cause of high death rate of mothers and their newborns in Vienna General's maternity ward compared to those who gave birth in their homes.  Doctors at the hospital were required to perform autopsies on all who died at the hospital.  Semmelweis discovered that doctors picked up bacteria in performance of the task which they carried with them as they assisted mothers with birth.  The solution was simple.  Semmelweis required doctors to wash their hands and the death rate plummeted.  Sadly, he was not hailed as a hero and his findings and solution were not only ignored but ridiculed by many in the scientific community.  Semmelweis did not handle the criticism well, growing bitter and developing strange lewd behavior that may have been due to insanity or perhaps the onset of Alzheimer's; he died at forty-seven in a sanitarium. 

Galileo Galilei history is better known.  A great scientist, he was persecuted by the church because he stated that some had misinterpreted the Bible. 

CrisisMaven asks what would I suggest?  Often history is simply lamentable and I believe this is such a case.  Lives were saved because of Chamberlen's innovation.  More would have been saved if he or his descendants had shared this knowledge earlier.  As a lover and defender of liberty, I would not suggest that the government try to elicit secret knowledge from its citizens through torture or force.  However, well defined markets that protected new ideas and innovations through copyrights, trademarks and patents might make sharing ideas more profitable than keeping them secret.  The innovator would have to compare the potential profit of the innovation through secrecy with the risk of discovery to the potential profit through time limited copyright, trademarks and patents.  If the innovator chooses secrecy, society is no worse off.  If she chooses protection through law, she benefits as well as society.  It is a difficult, yet proper function of government to design law that best protects the innovator to encourage innovation and limit monopoly granted privileges to maximize benefits to society.   

CrisisMaven is invited to make a response as a guest post if he desires.
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The BCS Is Under Bipartisan Busybody Attack

Every year a slew of unhappy fans claim that their favorite college football team was unfairly excluded from BCS college football national champion game.  Politicians feeding into that discontent, either from a ghoulish desire to ride populist discontent or an earnest desire to serve disgruntled constituents, propose government action to reform the BCS.  The latest effort is described by an AP writer for SI.com ("Justice Dept.: Obama administration may take action on BCS," Jan 29, 2010).

WASHINGTON (AP) -- The Obama administration is considering several steps that would review the legality of the controversial Bowl Championship Series, the Justice Department said in a letter Friday to a senator who had asked for an antitrust review.

In the letter to Sen. Orrin Hatch, obtained by The Associated Press, Assistant Attorney General Ronald Weich wrote that the Justice Department is reviewing Hatch's request and other materials to determine whether to open an investigation into whether the BCS violates antitrust laws.

"Importantly, and in addition, the administration also is exploring other options that might be available to address concerns with the college football postseason," Weich wrote, including asking the Federal Trade Commission to review the legality of the BCS under consumer protection laws.

Several lawmakers and many critics want the BCS to switch to a playoff system, rather than the ratings system it uses to determine the teams that play in the championship game.

"The administration shares your belief that the current lack of a college football national championship playoff with respect to the highest division of college football ... raises important questions affecting millions of fans, colleges and universities, players and other interested parties," Weich wrote.

I oppose the busybody, partisan attack for at least four reasons.  First, a playoff system may not do a better job at selecting a national champion as James Hamilton explains here.  The BCS is adaptive and has repeatedly demonstrated that they are a profit maximizing organization.  If there is additional profit to be had in a playoff structure, it will make its way to college football.  Third, President Obama, Senator Hatch, and the staff at Justice have better things to do than fix a nonproblem.  Isn't a War on Terror fought on two fronts, trials of terrorists, 10% unemployment enough?  And most important, it is not the government's role to attempt to fix every problem, some should be beneath their notice.  Let individuals and private organizations solve their own problems; their track record is better than yours.  If the BCS has violated antitrust or consumer protection law, it is the law that should change, not the BCS system.  
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The Nanny State and Tax Returns

The Obama administration does not believe that consumers are sufficiently wise to select tax preparers.  The Review & Outlook section of the Wall Street Journal reports and comments on the news in "H&R Blockheads."

We're guessing that when Americans think of outlaw industries, tax preparers aren't the first rogues that come to mind. But lo, the nation's green eyeshades are now destined to come under the regulatory rule of the Internal Revenue Service as part of the Obama Administration's latest revenue grab.

Under the plan, which would begin with the 2011 tax season, anyone who takes money to help people with their taxes will have to register with the IRS, and eventually pass competency tests and sign up for continuing education. So having made tax filing so complicated that most Americans need help with their forms, Washington now wants to raise the price of such counsel by regulating advisers in a way that may reduce their supply.

Defending the undefendable is a fools errand, but Commissioner Shulman is up to the task...

Defending the decision, IRS Commissioner Douglas Shulman declared that regulating tax preparers was reasonable because "In most states you need a license to cut someone's hair." Yes, the cosmetology guild does like to raise the barriers to entry for competitors.

Elaborating on the Journal's point, we do not need to license cosmetologist because we can and do readily view a bad haircut.  A bad cosmetologist would be out of business pronto.  Besides Commissioner Shulman, didn't your mother ever tell you that two wrongs don't make a right?

H&R Block likes the regulation.

Cheering the new regulations are big tax preparers like H&R Block, who are only too happy to see the feds swoop in to put their mom-and-pop seasonal competitors out of business. Kathryn Fulton, senior vice president for government relations, told the Washington Post the company was glad to support rules that meant H&R Block "won't be competing against people who aren't regulated and don't have the same standards as we do." With fewer tax preparers in the market, H&R Block will find it easier to raise prices.

In an EconTalk interview conducted by Russ Roberts, Milton Friedman observed that,

...it's always been true that business is not a friend of a free market. I have given a lecture from time to time under the title Suicidal Impulses of the Business Community, something like that, and it's true. It's in the self-interest of the business community to get government on its side. It's in the self-interest of a particular business.

It may get worse.  The Senate's odd couple, Max Baucus and Chuck Grassley are working on a project to let the IRS compute your taxes.

The feds are now getting in on this act, with Montana Democrat Max Baucus and Iowa Republican Chuck Grassley supporting a free e-file portal at the IRS Web site that would compete directly with private tax preparation software. In March, Treasury Secretary Timothy Geithner told a Ways and Means Committee hearing that he'd also like the IRS to begin sending taxpayers pre-completed returns.

The government could probably reduce the cost of criminal justice by doing away with juries and letting the prosecuting attorneys determine guilt or innocence, but I don't think that is a good idea either.

The Journal concludes that the Obama administration is trying to increase tax revenues without going to Congress for a new law.  I concur. 
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Banks, Equity, Liquidity, and Insolvency

It was my intention to write a number of posts on bank operations and tie them into a narrative of the 2008 financial crisis.  I got no further than explaining the role of capital in protecting banks against losses (Banks and the Importance of Equity) before the exigencies of finishing my classes in the fall semester delayed my plans.  A question by an anonymous reader has placed me back on path.

Brooks,
Thanks for taking a simple example to explain a complex issue such as this. Could you please explain the following for me:

- As loans given out by banks result in profits (e.g., through interest/fees less operating costs), these get added to the equity capital and thus, the equity capital account line grows. However, to me this does not feel like a "real thing" that is available to a bank to absorb losses. It feels like "Cash" is the thing that is ultimately available to the bank to absorb losses. If that is true, then why worry about equity capital at all?

In this post, I attempt to distinguish between insolvency and liquidity.  An institution is insolvent if its liabilities are greater than its assets.  It is illiquid if it does not have sufficient cash to meet its liabilities as they come due.  In the short run, an insolvent institution can be liquid if it has sufficient cash to pay its most immediate liabilities.  Obviously, it will eventually become illiquid as more liabilities become due.  I will also demonstrate that leverage, the number of dollars of liabilities per dollar of equity, magnifies both profits and losses.  
As a quick review, a bank's balance sheet is described by the equation, Assets=Liabilities+Equity.  The owners of a bank have a goal of maximizing profits for a given level of risk.  The risks are the probability that the bank will suffer losses from operations ( expenses exceed revenues) or a decline in asset value.  I will begin with the example provided by Juliusz Jabtecki and Mateusz Machaj, "The Regulated Meltdown of 2008," Critical Review, 21(2-3): 301-328, 2009.  At the beginning of operations (Year 0), the bank's leverage ratio is $20 of liabilities (deposits) for every $1 of equity. 

Figure 1. Year 0

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

To keep the math simple, assume that in the first year of operations (Year 1), the bank earns a return of $5.00, or a 100% return on equity.  The bank must decide how to distribute the profit between dividends and retained earnings (I will show retained earnings as an increase in equity.), and if the profit is retained, how it will be invested.  In Figure 2, the bank did not pay dividends, increasing equity by $5.00, and it held all new equity as reserves (cash).  As it begins its second year of operations, it has $9.50 of liabilities for every $1.00 of equity; its leverage has decreased.  

Figure 2. Year 1: The Conservative Option with Profit

Assets		Liabilities
Reserves (Cash)	$15	Equity	$10
Loans	$90	Deposits	$95
Total	$105	Total	$105

If the bank earns a return of 5% ($90*.05=$4.50), the resulting return on equity is ($10/$4.50*100=) 45%.  

Figure 3. Year 1: The Aggressive Option with Profit

Assets		Liabilities
Reserves (Cash)	$2	Equity	$7
Loans	$100	Deposits	$95
Total	$102	Total	$102

Alternatively, if the bank had taken a more aggressive, riskier position as it began is second year of operations, paying $3.00 as dividends, increasing equity by $2.00, and investing the additional $2.00 of equity and $3 of returns in new loans, its balance sheet would be depicted by Figure 3.  Its leverage is $13.57 of liabilities for every $1.00 of equity.  In this case, a 5.0% return on loans ($100*.05=) $5.00, results in a return on equity of ($5/$7*100=) 71.4%.  The additional leverage magnified the return on equity. 

Figure 4: Year 2: The Conservative Option with Losses

Assets		Liabilities
Reserves (Cash)	$9.40	Equity	$4.60
Loans	$90.00	Deposits	$95.00
Total	$99.40	Total	$99.40

Now consider the bank's financial position if it had lost 6% on loans.  Figure 4 adjusts Figure 2 for losses in operations.  The bank's return on equity is (-$5.40/$4.60) -117.4%.  The bank's equity position is weaker, but it is both liquid and solvent.  Compare that outcome to that of the more aggressive investment strategy.  Figure 5 adjusts Figure 3 for a 6% or $6.00 loss on loans after one year of operations. 

Figure 5.  Year 2: The Aggressive Option with Losses from Operations

Assets		Liabilities
Reserves (Cash)	-$4	Equity	$1
Loans	$100	Deposits	$95
Total	$96	Total	$96

The bank is still solvent (Assets-Liabilities>0), but it is illiquid, it does not have cash to meet short term depositor demands.  Its return on equity is (-$6.00/$1.00) -600%.  The higher leverage magnified the losses.  The bank might be able to secure short-term loans to meet its cash demands.  If not, it will be forced to liquidate.

Figure 6.  Year 1: Operating losses

Assets		Liabilities
Reserves (Cash)	$4.60	Equity	-$.40
Loans	$90.00	Deposits	$95.00
Total	$94.60	Total	$94.60

Compare this outcome to a 6% loss on loans ($90*.06=$5.40) in the first year of operations (Figure 6).  If the same level of losses had occurred before implementing an aggressive investment strategy after a profitable year, the bank would have been liquid, but insolvent.  If the losses had occurred after a year of profitable operations, even with the aggressive strategy and illiquid cash position, the increase equity from the first year of operations protected it against insolvency.

My next post on banking will explain maturity mismatching (long-term assets and short-term liabilities), and how it impacts the regulation of banks. 
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