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A Quick Lesson in Cap-and-Trade

April 30, 2010 2 comments

Pollution is one of the few issues where government involvement may actually be prudent.  This is because there is a common property problem involved.  If I could snap my fingers and make everyone on Earth understand one economic concept it would be the Coase Theorem.  Luckily, this concept is not that complicated and it is essential to understanding common property problems like pollution so I will start with a brief explanation of the theorem.

The Coase Theorem states that when property rights are well-defined and transaction cots are zero, resources will be efficiently allocated (assuming free trade).  The basic idea is that if every valuable resources is owned by someone and can be traded at no cost, it will always end up being traded to the person with the highest value.  One interesting aspect of the theorem is that it doesn’t matter who owns it to begin with since it can be freely traded.  To see what I mean consider the following example.

Imagine you and I live on the Earth.  I own a factory and enjoy producing goods for sale, and you like breathing clean air.  When I produce goods, I pollute the air and impose an externality upon you.  If I “own” the air, meaning I have the right to pollute it as much as I want, then barring some intervention, I will produce goods until the marginal cost is equal to the marginal benefit.  The problem is that I don’t realize all of the costs.  Some of them take the form of dirtier air for you to breathe.  This will result in me producing more than the efficient amount.  However, if this is the case (and there are no transaction costs), then you can intervene by offering to pay me to produce less.  The maximum amount you are willing to pay will represent your marginal value of less pollution and this will then become incorporated into my production decision causing me to produce the efficient amount. 

Similarly, if you own the air (meaning you have the right to prevent me from polluting), then you would want me to produce zero.  This would be inefficiently low.  I would be willing to pay you to let me pollute.  You will be willing to accept no less than your marginal value of clean air.  This cost will again be incorporated into my production decision and I will end up producing the efficient quantity. Either way the quantity of goods and pollution is efficient.  The difference is that the resource (air) is valuable and the value of it accrues to its owner.  So if I own it, I am better off and if you own it you are better off. 

Now it is interesting to note that if you have only two parties, property rights can’t help but be well-defined.  Either you have the right to stop me from polluting or you don’t, in which case I have the right to pollute.  If my pollution affects multiple people there is a problem though.  If they all paid me their marginal values of clean air, it would work out efficiently.  The problem is that individually, they have no incentive to do this because their payment would have such an insignificant effect on my output that they would all prefer to pay nothing and let everyone else pay.  This is essentially a free rider problem and can be thought of as a transaction cost.  If you could allocate some portion of the sky to each person, the problem would go away but this is impossible because you can’t contain pollution to only the sections of the sky who agree to allow it.  In other words property rights cannot be well-defined in this way.  The problem is further complicated when you have multiple polluters but further discussion on this point is probably not germane.

The government has a unique ability do deal with problems like this because it can represent an entire population and essentially force each individual to take part in whatever action it takes.  Remember, this is the only thing governments can do that markets can’t.  Usually this is harmful but in the case of a free rider or common property problem, it can be beneficial.  There are two ways it can deal with this problem.  One is to apply a Pigovian tax.  This is essentially a tax on pollution which adds a marginal cost to the activity in order to distort the quantity back down to the efficient level in the same way as when I have to pay you for permission to pollute.  If the government chooses the right tax rate, then they will get the efficient outcome.  Of course choosing the right rate is not easy.

The other approach is a cap-and-trade regime.  This means that you cap the total amount of pollution at some level (ideally the efficient level) and let people trade the rights to it in a free market so that the rights find their highest value owners.  If you pick the right cap, you can get the same outcome as with the Pigovian tax but again, this level may be difficult to identify. 

Now you may imagine that a property rights nut like myself would be a big fan of a cap-and-trade plan, and you would be correct.  But here is how it should be done. 

Step 1:  Choose the level of the cap.

Step 2:  Hold a public auction for that amount of pollution rights.

Step 3:  Put the proceeds in the general fund to offset other taxes.

That’s it, simple huh?  How many thousands of pages do you think it would take to write that bill?  If we did that, we would give the government a new power, the power to choose the efficient quantity of pollution.  Of course normally I am against giving the government powers, but there is a reason for giving this power to the government and it is unlikely to be too destructive.  For the record I have little confidence in their ability to choose the right cap but we know we get the wrong one when we do nothing and at least it doesn’t undermine our freedom in a significant way.  Unfortunately, this is not what they will do.  The additional thousands of pages that will no doubt be in this bill will be for another purpose, one that gives them a power that does undermine our freedom in an important way.   

The reason government intervention regarding pollution is justified is that it is needed to represent a true collective interest.  The pollution affects everyone and the transaction costs are too high for them to mitigate this damage by themselves.  The value of the property rights generated by this system represent (in some sense) the cost of the pollution to the public.  So it makes sense for this value to be accrued by the public.  This is not what I predict will happen though.  Some funds may end up in the treasury but most if it will be captured by private interests.  This is because the government will assign the rights to people and then let them trade.  This means the people whom the government decides “deserve” the right to pollute will make money and the rest of us will lose.  This is the destructive power they are claiming, it is just another way of redistributing wealth.

Recall that the difference between me owning the sky and you owning the sky is in who has to pay whom and therefore in who captures the value of the sky.  With cap-and-trade, the government will invent a certain amount of pollution rights (which I have no problem with) and then hand them out to people they like (which I have a huge problem with).  They will do essentially two things with this power.  One will be to further line the pockets of their pals who contribute to their campaigns and the other will be to transfer wealth overseas to other countries that they consider unfortunate victims of the pollution caused by developed nations. 

Obama, famously remarked that cap-and-trade would cause energy rates to skyrocket.  Well, that’s basically the point of it, after all the problem is that energy is too cheap without it.  This wouldn’t necessarily be a bad thing because we would pay more for energy but we would get cleaner air and lower taxes.  The size of the cap could be adjusted so that what we get in the form of the first two would be greater than what we lose in the form of higher energy rates.  But this plan is going to transfer most of the benefits to certain private interests so we will get higher energy costs without saving any taxes.  Furthermore, there will be an incentive for them to set the cap too low to raise the price of the pollution rights and make their friends richer.  

The magnitude of the carbon crisis we face is certainly debatable.  I am not an expert on these things (although I know enough about statistics and academia to know that a lot of the research contributing to the alarm is highly questionable).  But if we do need an energy plan to deal with it, let’s have one that works for the public instead of giving government new ways to enrich special interests.

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Financial Unification Act

April 27, 2010 1 comment

I found this link on Mankiw’s blog.  The key concept here is “discretion.”  Discretion = rule of men.  It means that some guy will decide what is fair in any given situation.  This is fundamentally different from the rule of law where parties can see the rules and know (or at least predict) what will happen in any given situation based on the law.  It means that people will fail or succeed based on how well they are connected in Washington.  For instance:

Moreover, the discretion given to the government in the Senate proposal opens the door to undesirable actions such as allowing the administration to write checks to favored parties. This concern is not theoretical: such mischief took place in the bankruptcies of Chrysler and General Motors, as the two auto companies were used as conduits to transfer billions of dollars from TARP to the president’s political supporters.

This is how property rights die.

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Sign of the Times

April 27, 2010 Leave a comment

It’s little things like this that signal the decline of the rule of law.  Note the declining faith in Warren Buffet and Berkshire Hathaway’s not because of a lack of ability but a lack of political clout.  We’re turning into a country where you succeed or fail based on your ability to manipulate the government.  This should be concerning.

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My New Hero

April 26, 2010 Leave a comment

I just noticed Peter Schiff has a blog on the Campaign for Liberty site and he is saying many of the same things I am (and often in more elegant ways).  Here he sums up the spirit of my post “Maybe it’s an Art After All” in one concise paragraph.

The effect of current Chinese currency policy (which, despite Beijing’s protests to the contrary, is manipulation pure and simple) is to make the U.S. dollar more valuable and the yuan less valuable. As a result, the benefits of manipulation accrue to Americans, not the Chinese. We get pay raises; they get pay cuts. Americans use their stronger dollars to buy products they would otherwise not have been able to afford. On the flip side, the Chinese people do without products that they otherwise would have been able to afford had their government not transferred their purchasing power to us.

Schiff goes on to express his concern at the fact that nobody, including the Chinese, seems to understand this.  Now as a guy who talks to macroeconomists, I can tell you that this hypothesis is not that far-fetched.  But it’s not the only explanation for the current situation.  Economists tend to make a lot of assumptions without noticing them.  One assumption that is common and probably flimsy at best is that the motivations of government are aligned in some way with the interests of their citizens.  If we believe this assumption with respect to China, ignorance is the only explanation for their monetary policy since their people are certainly the losers in the deal.  If, on the other hand, we imagine that the Chinese government has other motivations like, for instance, becoming the world’s new economic and political super-power, then this policy might be ingenious, not because it helps their economy but because it puts them in the position to dynamite the US economy whenever they feel like it (and to do so by reluctantly giving into our demand no less). 

I don’t know what their motivation really is.  Maybe they don’t realize they are making bad economic decisions.  Maybe they are after a pound of American flesh.  But one thing is for sure either way.  For us to act like they need our market is like Antonio saying to Shylock  “I’ve got you right where I want you.”

Also, this post is excellent.

He neglects to mention that during the five years from 1945 to 1949, federal spending dropped by 58% and taxes fell by 12%. Meanwhile, the budget deficit fell by 66% in 1946 and was in surplus from 1947 to 1949. [i] In other words, although we did not pay down our nominal debt in the decade after the war, we did succeed in massively shrinking government and the burden that it places on society. Could it be that this had something to do with the post-war boom, or should we give all the credit to the monetary policy? (It is important to point out that our national debt did initially decline from 1945 to 1949, but the extra spending necessary to finance the Korean War reversed that trend.)

Contrary to the standard progressive (Keynesian) account taught in history class of the massive government spending during WWII bringing us out of the depression, or the more nuanced neo-Keynesian/monetarist theory that it’s all due to monetary policy, the case for a property rights explanation presents itself quite clearly.  By all accounts that I have seen, the standard of living during the war wasn’t particularly high despite inflated “output” (GDP).  How excited are you that the country is producing a lot of equipment that is getting blown up in Europe and the Pacific while at home, common things like gas, rubber, and silk are rationed and you have to grow your lunch in your back yard?  Spending doesn’t make us rich as Keynesians would have us believe.  We only started to experienced prosperity after the government got out of the way.

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It’s Property Rights, Stupid!

April 23, 2010 1 comment

Freedom is the greatest economic innovation in history.  It’s not a coincidence that the greatest period of scientific, economic, and philosophical progress in the ancient world (at least in the west) coincided with the rise of democracy in Greece and continued through the years of the roman republic.  Then once the republic descended into totalitarianism and collapsed, Europe was stuck in a “dark age” for nearly a thousand years ruled by kings and queens.  When the renaissance finally came to Europe it began in the merchant republics of Italy.  Marco Polo didn’t go to China on the orders of the King of France, or some German warlord, he set out from the Venetian Republic, in an attempt to get rich, and the did.  In 1215, England imposed the Magna Carta upon King John and then spent over four centuries in a back and forth struggle between kings and subjects which culminated in the civil wars of the mid 17th century and the establishment of the Commonwealth of England.  Following this, England quickly became the world’s economic and military super power.  Finally, the ultimate realization of individual liberty occurred in the formation of the United States.  The industrial revolution and the greatest era of prosperity the west has ever known soon followed.

If we want to continue to reap the benefits of freedom we have to rediscover the connection between freedom and prosperity.  John Locke said that “no one ought to harm another in his life, health, liberty, or possessions.”  The last area, possessions, seems to be commonly overlooked these days and it is quite possibly the most important part.  Indeed, it was even changed to happiness by Jefferson in the declaration of independence.  But the pursuit of happiness must be viewed as inclusive of the pursuit of property as well as other pursuits an individual may desire.  To say that this applies to any pursuit from which a person may derive happiness except property makes no sense.  If  the policy of the government is that you are free to do whatever you want but if your actions lead to the accumulation of any physical property we may or may not take it at any time, are you really free?  “Freedom” without property rights is a misnomer.  More importantly, it is the property rights that are responsible for the marvelous economic implications of freedom.

The motivation for people to produce in a free society is (at least primarily) the anticipation of enjoying the fruits of their labor.  The motivation of a slave to produce is to avoid the lash.  But the second motivation can only induce some minimum level of effort.  It cannot drive men to great achievement.  If you are the king of a nation with a million subjects, maybe one of them is capable of inventing the lightbulb after a lifetime of careful specialized study.  Are you going to point a gun at every subject and order them to invent something you’ve never heard of and don’t know is possible or else you will shoot them?  The lash can make a man work, but it can’t make him think.

If you want a man to think, you must do two things.  First leave him alone and let him decide the best way to apply his ability.  He is the one who knows his ability best.  But this is not enough, if you let him decide what to do but tell him you will take whatever he produces, you will no doubt get a lot of philosophers and video game testers.  The most important part of the equation is to make them confident that they will get to keep the benefits of their creative activities.  This is so obvious, that it is taken entirely for granted by economists when analyzing markets in “developed” nations.  The same people who go around claiming that classical models are useless because transaction costs aren’t zero, never notice that everything they do carries the implicit assumption that property rights are well-defined and stable.  So let’s examine the validity of this assumption.

When people invest in some economic activity, they do so because they anticipate that the revenues will be greater than the costs in the long run.  Coming to this conclusion often requires them to be able to anticipate revenues and costs years in advance.  In order to do this you must have some idea of what the marketplace will look like in the future.  Some aspects of this are determined by nature and are beyond the control of men.  Such risks have always existed and always will and their existence gives rise to the potential profits of speculation and investment.  These things do not amount to a deficiency in property rights.  If you are a farmer and the demand for your product falls, it is not a failing of you property rights.  You own the rights to your produce and along with it you own the risk associated with price changes.  When a volcano goes off in Iceland, and you are stuck in Europe, it is not a deficiency of property rights it is the realization of an adverse event that was foreseeable, although unlikely, and you accepted the risk when you went to Europe.  These risks will never bring economic progress to a halt.

The real danger to an economy is when people lose confidence in their ability to predict revenues and costs in the future.  This occurs when the power to seize their property is put in the hands of men (in other words the government).  A volcano going off is an event which is harmful but it is harmful in a predictable way with a predictable probability.  A government that is not constrained by the rule of law could do anything at any time.  Here are some of the main ways they assault your property rights in difficult to predict ways.

Taxes: If you started a tanning salon last year, sorry, you go screwed.  Bet you wish you had done nothing instead.  Same if you started a smoke shop, or a bar in my home state of Washington.  Taxes are the most direct way that the government seizes your property.  They can decide to come after any particular industry, class, or group at any time.  Rush Limbaugh famously fled New York to escape high taxes.  If you are a millionaire industrialist looking to build a factory and you look at our debt and our promises to not raise taxes on the middle class, do you want to be stuck in this country in five years, or would you feel more comfortable building that factory in Singapore?  Is there going to be a VAT tax?  Seems like that would have a big impact on your calculation of revenues and expenses in the future.  There’s gotta be some tax sometime to pay for all this stuff.  Who’s gonna pay for it?  Nobody knows, it depends who is in power and who they like.  The only way to be sure it won’t be you is to not produce, or move out of the country.

Regulation: If you finished medical school last year, sorry, you’re screwed.  Unless you start refusing medicare patients.  But wait, if you do that, the government could just pass a law forcing you to take them.  Or pass a law preventing other insurers from paying more than medicare does.  Don’t you wish you had just joined a construction workers union instead?  If you started a health insurance company you’re also screwed, unless they decide to save you by screwing someone else.  If you started any other kind of company and hired employees you are probably still trying to figure out whether or not you’re screwed.  Somehow that 2000 page bill is going to interact with the millions of pages of existing regulations and the complex laws of economics to have some effect on the economy.  And when it does, they will do something else.  Who knows what the effect will be or what they will do about it?  If you looked at the airline industry and realized it would be more efficient to offer a lower price and charge for carry-on bags, the thing to do in a free market is to go start an airline and cash in on this realization.  But if you do that now, is Chuck Schumer going to pass a law making it illegal?  If you start a supermarket, are they going to force you to unionize?  If you think you can produce a good cheaper than the competition and you do it, will the government come in and put a price floor in place?  If you start a business to make energy-efficient windows, will the government give a grant to your competitor?  Maybe it’s better to just do nothing.

Money: In a free market with real money, the value of money would be determined by natural forces.  You would be able to predict inflation, and you could sign contracts for payments in the future and have a good idea of their value, and at least if it turned out to be wrong, the variation would be beyond the control of the contracting parties.  Because of this, after America abandoned the gold standard people wrote gold clauses into contracts to guard against inflation.  That is, until FDR made this practice illegal.  If you borrow money to start a business or buy a home and deflation happens you get screwed.  If you lend money to start a business or buy a home and inflation happens, you get screwed.  Which is going to happen?  The politicians like to claim that the Fed stabilizes inflation but does that seem to be the case?  Prices and interest rates are determined by expectations about the future.  If the money supply was determined by natural forces, this wouldn’t be much of a problem.  We can get a fairly good idea of how much gold will be mined over the next ten years.  But we gave control of it to a group of men.  Now we have to guess what they are going to do over the next ten years.  And their future actions depend on the way we react to our guesses about those actions.  And if this weren’t enough, the government has a huge stake in the game.  They are the biggest debtor in the world, they stand to gain a lot by unexpected inflation.  And the fed is a bunch of bankers, they are the biggest creditors in the world, they stand to gain by unexpected deflation (although this is somewhat complicated and as such is often overlooked).  You can borrow at a low interest rate but so can everyone else.  If you take current prices and imagine 2% inflation and calculate that the revenues in five years from building a widget factory will be greater than the cost, should you build it?  You don’t know because the interest rate that you factor into the cost isn’t determined by the market it is chosen arbitrarily by men.  So is the inflation rate they tell you to expect.  But if you look at these and it makes building the factory look profitable, you have to take into account that a whole bunch of other people may look at it and come to the same conclusion.  If you all do this, then in five years the market will be flooded with widgets and you will all get screwed.  So are we in an asset bubble?  Is the government going to print money to pay off the debt?  Will the dollar collapse?  Could these things have a potentially large effect on your estimation of revenues and costs in the future?  Maybe it’s better to just fill up your basement with food and gold, and take it easy.

This is the economic environment you create when you let the government do whatever they want whenever they want.  There is no way to predict what they are going to do at any given time.  This is a climate of very weak property rights.  When property rights are weak, it becomes very difficult to predict costs and revenues in the future and this makes economic investment very unattractive.  We don’t need government to do more to fix the economy we need them to promise (in a credible way) to stop doing things.  It’s really not that complicated. But then again, that may be this theory’s major flaw.  It doesn’t give economists an opportunity to show off their mathematical ability, and it doesn’t give politicians a way to justify their existence.  These people both want to believe in a world where the economy is a machine that they control by turning dials.  They are incorrect.

Categories: Politics Tags: ,

That’s the Spirit

April 21, 2010 2 comments

When I see things like this I literally get chills up my spine.   It is sometimes shocking to see how drastically ignorant otherwise intelligent people like Shepard Smith can be about economic principles which I take for granted since it is what I spend every day thinking about.  I was going to write a post explaining why charging for bags is more efficient than not charging for them but this story pretty much sums it up so I will use the space to rant about how this illustrates everything that is wrong with the attitude of our government. 

First consider what would happen here in a free market.  I would fly Spirit Airlines because it is more efficient, and Shepard Smith would fly some other airline because he’s an idiot.  Ok I kid, I don’t know why Shepard Smith doesn’t like the policy and it would be presumptuous of me to claim that I did.  But the beauty of the free market is that there is no reason for me to go around trying to divine other peoples’ motivations for what they do.  I can just ride my airline and he can ride his and we can both be happy and there is no reason for us to care what each other does.  If everyone hates bag fees, then Spirit will go out of business.  If everyone prefers them then other airlines will adopt it or they will go out of business.  You see in a free market there is an incentive to do things more efficiently.  One major factor in the efficiency of a transaction is the structure of the contract, and in a free market there is an incentive for people to come up with creative contracts to make transactions as efficient as possible.  So what is Chuck Schumer afraid of?

There is a deep dark secret that progressives don’t want you to realize.  The secret is that thoughtful people can solve pretty much any problem that government can solve through careful contracting.  If we understood that, we wouldn’t need Chuck Schumer.  The way they keep us from noticing that is by restricting the contracts we are allowed to enter into for ridiculous reasons.   Recall that this is exactly what they did with health insurance.  They had to tie the hands of insurers in order to create a “crisis.”  If they had been left alone, they would have been able to deal with it themselves and we wouldn’t need the government to get involved. 

The ridiculous reason is always some sort of unspecified moral objection to a voluntary trade.  Notice that Shepard Smith never mentions any well thought-out reason why Spirit Airlines and I shouldn’t be able to enter into the type of contract in question.  He just takes for granted that it is morally objectionable and goes on laying into the guy for offering it to me.  They expect us to not question whether this moral code makes any sense and just take for granted that they are looking out for us and the person they are attacking is trying to screw us somehow by tricking us into entering into a voluntary agreement. 

If you were to ask Chuck Schumer why we should be afraid of this, he would probably say something like that.  The big bad airlines are preying on uninformed consumers.  But when they say things like this, they are calling you an idiot.  This is saying that you are too stupid to understand the difference between a $100 ticket with no bag fee and a $50 ticket with a $40 bag fee.  Don’t you think you could navigate that intellectual minefield on your own without the help of Chuck Schumer?  But this isn’t the really insidious part. 

The real damage is not done when they treat us like idiots.  It is done when they say “you’re an idiot, but it’s ok I will take care of you.”  Because then there is no incentive to stop being an idiot.  How many times are you going to get “tricked” by hidden bag fees?  Unless you’re really dim, it’s either 1 or 0.  I got tricked once.  I don’t fly much.  The second to last time I flew, there was no fee for a checked bag.  The last time I flew (which was years later) I checked a bag and they charged me $25.  Then while I was waiting to board, they announced over the intercom that if anyone had a large carry on they would check it for free.   So when I flew back I carried my check bag up to the gate and gave it to the flight attendant who checked it for free.  I lost $25 but I got smarter.  My behavior adapts to the structure of the contract.  When I do this, the contract should adjust to my behavior.  If they want to achieve the efficient amount of baggage through fees on checked bags, people will adjust by carrying on more luggage.  The natural reaction to this is to charge for carry-on luggage.  This process is becoming more efficient not less.

Next time I fly, I will think about these things in advance.  When everyone learns to think about these things in advance, the process becomes more efficient.  When the government restricts contracts to what we are used to because we are scared of change, they are halting the progress toward efficiency.  When we learn that we don’t have to think about it in advance and if anything we don’t like happens, Chuck Schumer will come to the rescue, they go in the other direction.  The more it goes in the other direction, the more we run to government to fix it.  In the end the only one who benefits from this is Chuck Schumer.

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First They Came for the Salt

April 20, 2010 1 comment

Here is what an obscure but insightful blogger said about healthcare six weeks ago. 

Once this happens there will be a massive moral hazard problem.  Currently we have to wear seatbelts because if we get injured in a car crash, the emergency room will have to treat us.  This makes our private reckless behavior a public concern.   Once we all have government-run healthcare, everything we do will be a public concern.  They will have a legitimate justification to keep us from smoking, drinking, eating junk food, going skydiving, riding motorcycles, anything that has an adverse effect on our health. 

When I explained this to my students during a lesson on moral hazard they rolled their eyes and said “oh come on, they won’t do that” just because they weren’t telling us that they were going to do it at the time.  But look at what happens when we turn over powers to the government on the assumption that they won’t use them.  Notice the justification by “US researchers.”

…working with the food industry to cut salt intake by nearly 10 percent could prevent hundreds of thousands of heart attacks and strokes over several decades and save the U.S. government $32 billion in healthcare costs.

It’s a public problem.  We’re all socialists now… So ask yourself how much support there would be for a law that limited salt in food.  Why don’t presidential candidates ever run on a platform of protecting you from too much salt?  A hundred years ago, they would have had to pass a constitutional amendment to do something like this.  Now they don’t even pass a law in congress.  Why not?  Because then congressmen would have to answer for it.  They would have to stand up at a debate and be accused of taking the salt from people’s french fries.  If you want to pass laws that most people don’t want, you have to pass a seemingly unrelated law that gives the power to make that law to a nameless faceless regulator.  Then when they do it, the people will have no recourse against them and the politicians can just stand up and say “I have no control over what they do.”  The only way to stop the insanity is to realize when they are grabbing these powers in the first place and say no thanks.

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