Economics/Finance

Gareth Wilson brings something up in comments to this post. What do the parents among you say when your children ask you if your family is rich? I say, yes, we’re rich. Living in Asia as we do, our family has lots of chances to see really poor people in Indonesia, the Philippines and Thailand. We see these people because we’re going on family vacations to stay in villas in Bali. There doesn’t seem to be much to say about that except, being rich sure is great, eh? I tend to say, well, that doesn’t mean we can buy just anything we want, and we’ll often see other people we know having great things we can’t afford, but on the whole, we’re rich. This is ideally meant to inspire charitable thoughts rather than mercenary self-satisfaction. Am I going to deprive my children of their God-given American right to insist they are middle-class? And when is Richie Rich Euros going to come out and serve as the grave monument for the mighty US dollar?

This NYT article, The Decline of the $20 Wage”, on the vanishing blue-collar worker with a middle-class income is both depressing and…confusing. Adjusting the numbers for inflation is at least alluded to initially:

Leaving aside for a moment those who have lost their jobs, what of those who still have them? Once upon a time, a large number earned at least $20 an hour, or its inflation-adjusted equivalent, and now so many of them don’t.

However, from this point on the article seems to talk about wages which were $20-an-hour or above in the past–even as far back as the 70s–and are now less than $20 in nominal terms.

The $20 hourly wage, introduced on a huge scale in the middle of the last century, allowed masses of Americans with no more than a high school education to rise to the middle class. It was a marker, of sorts. And it is on its way to extinction….

Hourly workers had come a long way from the days when employers and unions negotiated a way for them to earn the prizes of the middle class — houses, cars, college educations for their children, comfortable retirements. Even now a residual of that golden age remains, notably in the auto industry. But here, too, wages are falling below the $20-an-hour threshold — $41,600 annually — that many experts consider the minimum income necessary to put a family of four into the middle class….

Since [the 1970s] the percentage of people earning at least $20 an hour has eroded in every sector of the economy, falling last year to 18 percent of all hourly workers from 23 percent in 1979 — a gradual unwinding of the post-World War II gains.

The decline is greatest in manufacturing, where only 1.9 million hourly workers still earn that much. That’s down nearly 60 percent since 1979, the Bureau of Labor Statistics reports.

The shrinkage is sometimes quite open. The Big Three automakers are currently buying out more than 25,000 employees who earn above $20 an hour, replacing many with new hires tied to a “second tier” wage scale that never quite reaches $20. A similar buyout last year removed 80,000 auto workers. Many were not replaced, but many were, with the new hires paid today at the non-middle-class scale, and with fewer benefits.

Surely $20 an hour in the 70s would be $60 or so an hour now, adjusted for inflation? It makes a big difference to this article and the author has totally failed to explain the issue. ‘Fewer people of this class make even 1/3 as much per hour as they did 30 years ago’ is a very different message from ‘fewer people of this class make this inflation-adjusted wage.’ It seems clear the article implies the former but muddies the waters with the nominal wage, ironically further masking the dramatic decline of the blue-collar middle class.

The big increase in food prices over the last six months or so raises lots of issues, of which I’ll try to cover a few.
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Jeremy Waldron has a great piece in the latest LRB reviewing a recent book by Cass Sunstein. He has a nice discussion of the Cheney doctrine that even a one-percent probability of a catastrophic event should be treated as a certainty for policy purposes, where the class of catastrophic events is limited to those with a military, security or terrorist dimension. Reasoning like this interacts neatly with “ticking-bomb” scenarios: now a 1 per cent chance that the there’s a ticking bomb the terrorist knows about is sufficient in to justify waterboarding or worse. Of course other potentially catastrophic developments — such as climate change — haven’t generated a “treat as if certain” policy response from the US government, even thought even the most determined denialists must evaluate the probability that anthropogenic global warming is happening at greater than one in a hundred.

Waldron is also pretty acid about Sunstein’s treatment of global warming and distributive justice, noting some of the shortcomings of the idea that poor people’s lives should be valued according to what they’re prepared to pay to avoid the risk of death. But read the whole thing, as they say.

Buried within the U.S. Treasury Department’s just-released blueprint for a new financial regulatory structure is a “proposal”:http://www.treas.gov/press/releases/reports/Blueprint.pdf for a new approach to regulation. The report calls the regulatory status quo an “institutionally based functional system,” and as a long-term goal seeks to replace this with “objectives-based regulation.” In fact, OBR is celebrated in the document as the optimal regulatory structure. Strong words indeed. I’ll resist the temptation to dismiss this as recycling “management-by-objectives” for the public sector. Instead, it is useful to regard OBR as one of a new set of approaches to economic regulation, all of which stem from criticism of “old-fashioned” command-and-control regulation. These new approaches include “principles-based” regulation and “performance-based” regulation.

Whatever their faddish qualities, the problem they respond to is real. When regulation is done by promulgating detailed rules (that explain what the regulated shall and shall not do, and how), and then enforcing compliance with those rules, two problems arise. First, the regulated activity or industry typically evolves faster than the governing rules, and so the latter become increasingly irrelevant. In fact, escaping the grasp of static regulations becomes a big incentive to innovate. Regulators trying to keep up will usually add more rules, spelled out in excruciatingly greater detail, until the ungainly corpus of rules looks like, like, well, … the IRS code. Second, compliance increasingly becomes formal compliance with the strict letter of the law, even when such compliance violates the spirit of the law. It encourages a “check list” mentality that focuses solely on the literal meaning of the rules. OBR, and the other alternatives, try to avoid such difficulties by recasting regulation so that it focuses on a desired outcome or objective, and then grants a measure of flexibility to the regulator to steer towards that goal in whatever way seems best. Flexible regulations make sense if the behavior, market or industry that is to be regulated is dynamic, innovative, or highly variable.

Is OBR truly optimal? Who knows? Evidently the Australians have some experience with it, and the British know something about its close cousin “principles-based” regulation. But OBR certainly isn’t a failsafe measure, for the flexibility that makes OBR adaptable can also be used to render it ineffective or even toothless. The discretion that it necessarily entails means that both the regulators and the regulations matter. Thus, people who fear regulatory capture get even more worried about the possibility that the captured regulators possess lots of authority that they can legally exercise under the rubric of broad rules.

In the greatest sea battle of World War I, British Admiral David Beatty watched with uncomprehending dismay as his battlecruisers got blown out of the water, and famously remarked that: “… there seems to be something wrong with our bloody ships today.” Ninety years after Jutland, there seems to be something wrong with our bloody financial system. A big reputable investment bank like Bear, Stearns wasn’t supposed to get into such trouble that it had to be bailed out by the Federal Reserve before it blew up. One of the legacies of the last systemic American financial crisis, in the 1930s, was a regulatory system intended to ensure greater transparency for investors, some measure of confidence for bank depositors, and prudential requirements for financial institutions. Recent events suggest that this system is no longer adequate to the task. The savings-and-loan crisis of the 1980s could have slowed down the push to deregulate, but in the 1990s the Asian Financial Crisis provided a moment for self-congratulatory triumphalism about the superiority of Anglo-Saxon finance and the perils of crony capitalism. With rigorous accounting standards, regulatory oversight, and a quantitatively-based credit culture that kept lenders honest, surely the U.S. wouldn’t be vulnerable to the real estate bubbles that plagued Indonesian, Thai and South Korean banks. Or so we fervently hoped. Thus, financial deregulation and innovation proceeded apace. Today’s sub-prime mortgage crisis wasn’t supposed to happen, and now investors are haunted by the fear that financial portfolios are filled with near-worthless paper. And the baleful effects of the credit crunch are now felt widely by both individuals and firms.
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It’s just been announced that JP Morgan will buy Bear Stearns for $2 a share, implying a value of about $250 million. Given that the company headquarters is said to be worth about $1.2 billion, that gives the BS banking business a value of negative $1 billion. And that’s only after the Fed agreed to take on $30 billion worth of toxic waste from the BS portfolio, politely described as “less-liquid assets.”

Clearly, under any normal circumstances, a company like this would have been left to go bankrupt. The problem is that this would jam up the entire credit market because BS is a counterparty in a vast range of transactions with other banks. (We debated this issue a month ago with a number of commentators arguing that the problem of counterparty risk was not such a big deal).

Some light relief is provided by the announcement by Standard & Poors, the day before Bear imploded, that the worst was over. This will go down with Irving Fisher’s comment in late 1929, that the stock market had reached “what looks like a permanently high plateau”. But at least Fisher wasn’t being paid to judge the stock market. Surely it’s now time to kill off the quasi-official role of the ratings agencies, as Justin Fox has just argued in Time

Looking ahead, the limits of the white knight strategy employed in this case must be approaching. JPM will take a while digesting this mess, and Bank of America has already done its bit when it agreed to rescue Countrywide. The other big banks have their own problems. Any future maidens in distress will have to look directly to Uncle Sam for a rescue.

Update Readers used to the natural order of things might be concerned by the implication that with such a giveaway price, the top brass at BS might be forced to bear the financial consequences of events that were obviously beyond their control. Never fear. According to this Reuters report in the Guardian, while most employees up to junior executive levels will lose both their jobs and the shares they were encouraged to buy, with no “golden parachutes:

JPMorgan Chief Financial Officer Mike Cavanagh late Sunday said taking over Bear would generate about $6 billion in merger-related costs.
JPMorgan has not broken down those figures, but much of that will be earmarked for severance pay and potential exit packages for top executives like Schwartz.
A person familiar with the transaction told Reuters that roughly $1 billion of those costs would be earmarked for severance and retention.

The Fed’s bailout of Wall Street investment bank Bear Stearns has, unsurprisingly, been discussed in terms of the domino theory. A more appropriate metaphor is The Wonderful One-Hoss Shay . This was a carriage constructed on the theory that a system always fails at its weakest spot.

he way t’ fix it, uz I maintain, Is only jest T’ make that place uz strong uz the rest”.

On the Fed’s current approach, the system is unbreakable, provided that “too big to fail” protection is extended to every significant firm in the system. The result of this protection is that the kind of crisis where the failure of one firm leads to a cascade of failures elsewhere is prevented. But then

First a shiver, and then a thrill, Then something decidedly like a spill,– And the parson was sitting upon a rock, At half-past nine by the meet’n’-house clock,– Just the hour of the Earthquake shock!

–What do you think the parson found, When he got up and stared around? The poor old chaise in a heap or mound, As if it had been to the mill and ground! You see, of course, if you ‘re not a dunce, How it went to pieces all at once,– All at once, and nothing first,– Just as bubbles do when they burst.

Since I’ve already been giving grief to prominent economists today, I might as well annoy one of our regular commenters (whom I actually quite like) still further, by linking to this “Harvard Crimson article”:http://www.thecrimson.com/article.aspx?ref=522288 on the political economy of the textbook market (many thanks to the correspondent who sent it to me).

Since N. Gregory Mankiw returned to Harvard to teach the College’s introductory economics class, 2,278 students have filled his weekly lectures, many picking up the former Bush advisor’s best-selling textbook, “Principle of Economics” along the way. So, what has professor of economics Mankiw done with those profits? “I don’t talk about personal finances,” Mankiw said, adding that he has never considered giving the proceeds to charity. … With textbook prices sky high, some professors feel an obligation to donate the proceeds they receive by assigning their own textbooks for their classes. Kenneth A. Shepsle, the professor of government who teaches Social Analysis 46: “Thinking About Politics,” allows students to e-mail suggestions for where the charity money should go. … Similarly, the professor who introduces thousands of Harvard undergraduates to what is just finds it unjust to profit from textbook sales.

… Like many introductory textbooks, Mankiw’s book has seen frequent republication. Retailing for $175 on Amazon.com, “Principles of Economics” has come out in four editions since its first publication in 1998. Economics chair James K. Stock is known for complaining in class about this practice, although not about “Principles of Economics” in particular. “New editions are to a considerable extent simply another tool used by publishers and textbook authors to maintain their revenue stream, that is, to keep up prices,” Stock wrote in an e-mailed statement. He said that while he requires his own book for his class, he encourages students to buy older editions and international copies, and said one student bought a Korean copy for 15 percent of the domestic list price. “Some new editions really do make substantial intellectual improvements, but I would suggest that is the exception not the rule,” Stock said. … Mankiw asserts that “Principles of Economics” has been the bible of Harvard economics concentrators since before he took over “Economics 10.” … “The textbook chose the professor, the professor didn’t choose the textbook,” Mankiw said.

If he’s being quoted accurately, Mankiw seems unduly defensive. If I were him, I’d take a much more pro-active stance. I’d claim that I was teaching my students a valuable practical lesson in economics, by illustrating how regulatory power (the power to assign mandatory textbooks for a required credit class, and to smother secondary markets by frequently printing and requiring new editions) can lead to rent-seeking and the creation of effective monopolies. Indeed, I would use graphs and basic math in both book and classroom to illustrate this, so that students would be left in no doubt whatsoever about what was happening. This would really bring the arguments of public choice home to them in a forceful and direct way, teaching them a lesson that they would remember for a very long time.

The alternative – that a benevolent and all-seeing regulator named Gregory Mankiw has chosen the _very best_ textbook available for the students, and that any rents flowing from the $175 cover price were completely irrelevant to his decision making process – seems to be closer to Mankiw’s preferred explanation, and I see no reason whatsoever to doubt his sincerity (really – I’m not being sarcastic here, even if, like Stock, I generally consider the frequently updated textbook game to be a very fishy business). But it’s a claim that’s surely rather hard to reconcile with the usual political lessons we’re expected to draw from econ 10, econ 101 and their cousins.

Some of the things that are most interesting to international political economy scholars such as meself are notoriously difficult to measure. To take one example, there’s a lot of muttering in the US and elsewhere about international trade, whether multilateral and bilateral trade deals are good or bad for the US economy, and so on (these debates also have close equivalents in Europe and elsewhere). But how to cut through the hype to figure out whether or not there is a real likelihood of change in the current regime or not? The usual approach is to look for an indicator variable of some variety that will allow you to track underlying processes that you can’t directly measure. I think I’ve found one – and it’s _at least_ as good as the Economist’s famous Big Mac index for figuring out shifts in PPP. My claim is that the degree of rhetorical overkill in Jagdish Bhagwati’s op-ed fulminations on trade is a very good indicator of what the free trade establishment actually thinks about the underlying risks or threats to the existing regime, and (to the extent that this establishment is politically plugged in) a plausible leading indicator of what’s likely to happen in the future. I’ll endeavour to test this hypothesis by keeping track of the Bhagwati Blood Pressure Index (or BBPI) over a period of time, and testing whether it maps well onto the expected outcomes.

Bhagwati’s piece in today’s “FT”:http://www.ft.com/cms/s/0/f24fa1c4-e92b-11dc-8365-0000779fd2ac.html is a good place to start. Those unfamiliar with his writing style might think that language such as “faintly ludicrous,” “denigration of freer trade,” “witless fear of trade,” and “disturbingly protectionist” indicates a BBPI that is alarmingly high, both for free trade and for Professor Bhagwati. Comparative analysis with previous op-eds and writings would suggest, however, that these criticisms are almost genial by historical standards; at worst they’re love taps. By my reading, the BBPI has dropped quite significantly since mid 2007 or so, suggesting that the free trade establishment believes that the current fervor over free trade is froth that will mostly disappear after the primary season. On the evidence of this article, we may expect the BBPI to drop still further if Barack Obama is elected President (one presumes that Bhagwati believes Austan Goolsbee’s representations to the Canadian government), but to rise substantially in the unlikely event that Hillary Clinton snatches the crown. Also of interest is the evidence that the article provides on the mental modelling processes that underlie these empirical predictions:

whereas Mr Obama’s economist is Austan Goolsbee, a brilliant Massachusetts Institute of Technology PhD at Chicago Business School and a valuable source of free-trade advice over almost a decade, Mrs Clinton’s campaign boasts of no professional economist of high repute. Instead, her trade advisers are reputed to be largely from the pro-union, anti-globalisation Economic Policy Institute and the AFL-CIO union federation.

Clearly then, your soundness on trade depends on the extent to which your campaign employs economists whom Professor Bhagwati approves of. I suspect that Hillary’s campaign is doubly damned because it’s supported by Paul Krugman (whom professor Bhagwati condescendingly refers to as an apostate ‘former student’). Nor had I hitherto realized that the economists of the ‘pro-union, anti-globalisation Economic Policy Institute’ were unprofessional economists of little repute; silly me.

Update: “Megan McArdle”:http://meganmcardle.theatlantic.com/archives/2008/03/a_fair_trade_index.php suggests that a basket of pundits would be preferable.

Daniel’s post on Stiglitz and the cost of the Iraq war reminded me to get going on one I’ve had planned for some time, as a follow-up to this one where I pointed out that the $50 billion in aid given to Africa over the past fifty years or so is not, as is usually implied, a very large sum, but rather a pitifully small one, when considered in relation to the number of people involved, and the time over which the aggregate is taken.

What are the sums of money worth paying attention to in terms of economic magnitude. I’d say the relevant order of magnitude is around 1 per cent of national income[1], say from 0.5 per cent to 5 per cent. Smaller amounts are important if you’re directly concerned with the issue at hand, but are impossible detect amid the general background noise of fluctuations in income and expenditure. Anything larger than 5 per cent will force itself on our attention, whether we will it or not.

To get an idea of the amounts we’re talking about, US national income is currently about 12 trillion a year, so 1 per cent is $120 billion a year. A permanent flow of $120 billion a year can service around $6 trillion in debt at an interest rate of 4 per cent, so a permanent 1 per cent loss in income is equivalent to a reduction in wealth by $6 trillion.

For the world as a whole, income is around $50 trillion, so the corresponding figures are $500 billion and $25 trillion.

What kinds of policies and events fit into this scale?

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Well, _I_ thought it was worth passing on ….

Megan McArdle “responds”:http://meganmcardle.theatlantic.com/archives/2008/02/tax_me_more.php to my earlier “post”:https://crookedtimber.org/2008/02/16/revealed-preferences/ on taxes and revealed preferences and really makes a bit of a mess of things. More detailed discussion below the fold. [click to continue…]

Via Wicked Anomie. Imagine Sifl and Olly with less slacking and more social theory.