As corny as it sounds, my first thought after hearing about “Occupy Wall Street” wasn’t about right or wrong or even really about politics: it was about John Steinbeck and his book The Grapes of Wrath . It’s a book I read long ago in high school, but it was one which left a very deep impression on me. While I can’t even remember the main plot (other than that it dealt with a family of Great Depression and Dust Bowl-afflicted farmers who were forced to flee Oklahoma towards California), what I do remember was a very tragic description of the utter confusion and helplessness that gripped the people of that era (from Chapter 5):

“It’s not us, it’s the bank. A bank isn’t like a man. Or an owner with fifty thousand acres, he isn’t like a man either. That’s the monster.”

“Sure,” cried the tenant men, “but it’s our land. We measured it and broke it up. We were born on it, and we got killed on it, died on it. Even if it’s no good, it’s still ours. That’s what makes it ours—being born on it, working it, dying on it. That makes ownership, not a paper with numbers on it.”

“We’re sorry. It’s not us. It’s the monster. The bank isn’t like a man.”

“Yes, but the bank is only made of men.”

“No, you’re wrong there—quite wrong there. The bank is something else than men. It happens that every man in a bank hates what the bank does, and yet the bank does it. The bank is something more than men, I tell you. It’s the monster. Men made it, but they can’t control it.

And therein lies the best description of the tragedy of the Great Depression, and of every economic crisis that I have ever read. The many un- and under-employed people in the US are clearly under a lot of stress. And, like with the farmers in Steinbeck’s novel, its completely understandable that they want to blame somebody. And, so they are going to point to the most obvious culprits: “the 1%”, the bankers and financiers who work on “Wall Street”.

But, I think Steinbeck understood this is not really about the individuals. Obviously, there was a lot of wrongdoing that happened on the part of the banks which led to our current economic “malaise.” But I think for the most part, the “1%” aren’t interested in seeing their fellow citizen unemployed and on the street. Even if you don’t believe in compassion, their greed alone guarantees that they’d prefer to see the whole economy growing with everyone employed and productive, and their desire to avoid harassment alone guarantees they’d love to find a solution which ends the protests and the finger-pointing. They may not be suffering as much as those in the “99%”, but I’m pretty sure they are just as confused and hopeful that a solution comes about.

The real problem – Steinbeck’s “monster” – is the political and economic system people have created but can’t control. Our lives are driven so much by economic forces and institutions which are intertwined with one another on a global level that people can’t understand why they or their friends and family are unemployed, why food and gas prices are so expensive, why the national debt is so high, etc.

Now, a complicated system that we don’t have control of is not always a bad thing. After all, what is a democracy supposed to be but a political system that nobody can control? What is the point of a strong judiciary but to be a legal authority that legislators/executives cannot overthrow? Furthermore, its important for anyone who wants to change the system for the better to remember that the same global economic system which is causing so much grief today is more responsible than any other force for creating many of the scientific and technological advancements which make our lives better and for lifting (and continuing to lift) millions out of poverty such as those who live in countries like China and India.

But, even keeping that in mind, I — a firm believer in freer markets and globalization — am hard-pressed not to sympathize with the idea that the system has failed on its promise of expanding prosperity for a broad swath of the population. What else am I (or anyone else) supposed to think in a world where corporate profits can go up while unemployment stays stubbornly near 10%, where bankers can get paid bonuses only a short while after their industry was bailed out with taxpayer money, and where the government seems completely unable to do more than bicker about an artificial debt ceiling?

But anyone with even a small understanding of economics knows this is not about a person or even a group of people. To use Steinbeck’s words, the problem is more than a man, it really is a monster. While we may not be able to kill it, letting it rampage is not a viable option either — the “Occupy Wall Street” protests are a testament to that. They may not be generating any policy recommendations which can stop the problem, but their frustration is real and legitimate, and until politicians across both sides of the aisle and individuals across both ends of the income spectrum come together to find a way to “tame the monster’s rampage”, we’re going to see a lot more finger-pointing and anger.

(Image credit – Wikipedia)

This month’s paper from Science is not the usual traditional science fare I’ve tended to blog about. I heard about this on the Science magazine podcast (yes, I subscribe to it). In it, two economists basically find a way to run a randomized clinical trial to see what microfinance does!

For those of you who don’t know what microfinance is, the idea is actually pretty simple. In many developing countries, the banking system is underdeveloped. And, even if a mature banking system were to exist, banks themselves typically do not lend small amounts of money to small businesses/families who don’t have much by the way of credit history. Enter microfinance. The idea is that you can do a lot to help people in developing countries by providing their smallest businesses, especially those run by women who are traditionally excluded from their local economies, with small (or “micro” ) loans. Organizations like Kiva have sprung up to pursue this sort of work, and the 2006 Nobel Peace Prize was even awarded to a man, Muhammad Yunus, because of his role in microfinance.

But, does it work at building communities and improving economies? If you’re a scientist, to answer that question conclusively, you need a controlled experiment. So, the authors of the study worked with a for-profit microfinance organization in the Philippines, First Macro Bank (FMB), to do a double-blinded randomized trial. Using a computer program, they automatically categorized a series of microcredit applicants by their creditworthiness. Obviously credit-worthy and obviously credit-unworthy applicants (combined, 26% of applicants) were taken care of quickly. For the 74% of applicants that the program considered “marginal” (not obviously one way or the other), they were randomly assigned to two groups: a control group that did not receive a microloan, and a treatment group who would receive a microloan. Following the “treatment”, the participants in the experiment were then surveyed by along on a number of economic and lifestyle metrics, and their results compared.

How was this double-blinded? Neither the applicants nor the FMB employees who interfaced with were aware that this was an experiment. The surveyors were not even aware this was an experiment or that FMB was involved.

Why focus on “marginal” applicants? A couple of reasons: first, the most likely changes to microfinance policy will impact these applicants the most, so they are the most relevant group to study. Secondly, you want to try to make apples-to-apples comparisons. Rejecting some obviously credit-worthy (or credit-unworthy) individuals may have raised red flags that some sort of algorithmic flaw or artificial experiment was happening. To really understand the impact of microfinance, you need to start on even footing in a realistic setting (esp. not comparing obviously credit-worthy individuals with so-so- credit-worthy individuals)

So, what did the researchers find? They found a lot of interesting things, actually – many of which will require us to re-think the advantages of microfinance. The data is presented in a lot of boring tables so, unlike most of my science paper posts, I’m not going to cut and paste figures, but I will summarize the statistically significant findings:

1. Receiving microfinance increases amount of borrowing. The “treatment group” had, on average, 9% more loans from institutions (rather than friends/family) than the control group (excluding the microloan itself, of course)
2. Microfinance does not seem to go towards aggressive hiring. The “treatment group” had, on average, 0.273 fewer paid employees than the control group. Whether or not this reflected the original size of the businesses is beyond me, but I am willing to give the researchers the benefit of the doubt for now.
3. Microfinance does not seem to have a major impact on subjective measures of quality of life except elevated stress levels of male microfinance recipients. Most of the subjective quality of life measures showed no statistically significant differences except that one.
4. Receiving microfinance reduces likelihood of getting non-health insurance by 7.9%
5. There don’t appear to be significantly different or larger impacts of microfinance on women vs. men.

So, when’s all said and done, what does it all mean? First, it appears that instead of leading to aggressive business expansion as it is widely believed, microfinance itself actually seems to have a small, but slightly negative impact on employment at those businesses. While I don’t have a perfect explanation, combining all the observations above would suggest that the main impact of microfinance is not business expansion so much as risk management: entrepreneurs who received microloans seemed more willing to consolidate their business activities (i.e., firing “extra” workers who might have been “spare capacity”), avoid buying insurance, and reach out to other banks for more loans — very different than the story that we usually hear from the typical microfinance supporter.

The fundamental unknowns of this well-crafted study, though, are around whether or not these findings are that useful. While the researchers did an admirable job controlling for extraneous factors to reach a certain conclusion for a certain set of people in the Philippines, its not necessarily obvious that the study’s findings hold true in another country/culture. These studies were also conducted a few months after receipt of the microfinance — it is possible that the impacts on businesses and local communities need more time to manifest. Finally, the data collected from the study does almost too good of a job stripping out selection bias. Microfinance organizations today can be fairly selective, picking only the best entrepreneurs or potentially coaching/forcing the entrepreneurs to allocate their resources differently than the mostly hands-off approach that was taken here.

All in all, an interesting paper, and something worth reading and thinking about by anyone who works in/with microfinance organizations.

(Image credit)

Paper: Karlan et al., “Microcredit in Theory and Practice: Using Randomized Clinical Scoring for Impact Evaluation.” Science 332 (Jun 2011) – doi: 10.1126/science.1200138

On the advice of one of the members of the little investment club I am a part of, I picked up David Moss’s book A Concise Guide to Macroeconomics. I wasn’t expecting much, having taken a few introductory economics courses in college and being a casual economics aficionado, but I gave it a shot.

And, I think that the subtitle “What Managers, Executives, and Students Need to Know” is simultaneously very appropriate and a dramatic underselling of the book. Moss’s writing style and his very direct, conclusion-oriented (as opposed to “scholarly”) overview of basic macroeconomics makes the book not only accessible to people who need a working understanding of economics but not the extra academic theory, but also a great reference.

Now, if you’re an economic genius, or have even just taken basic economics, then you’re not going to learn anything earthshattering from the book, but what you may get out of it which could be just as valuable is a different way of thinking through or of explaining macroeconomic concepts.

Case in point: I had never thought of “the job of a pension system is to divide national output between active workers and retirees.” While this is a simple and obviously true statement, Moss uses that underlying “framework” to explain why moving existing Social Security/pension plans to an IRA (stock-based) retirement system is unlikely to fundamentally solve anything:

Although all of us are accustomed to thinking that we can sell our financial assets for cash at a moment’s notice and then use the cash to buy goods and services, this obviously wouldn’t work if everyone tried to do it at once. If a large number of senior citizens liquidated their financial assets at the same time, in order to buy needed goods and services, they would soon find that the proceeds were much smaller than they had expected. Simply giving the elderly more pieces of paper – more stocks and bonds – does not guarantee that there will be more output for them to consume in the future …

The key question from a macroeconomic standpoint, therefore, is not whether the senior citizens of tomorrow have IRAs or traditional Social Security benefits, but whether they (or others) reduced their consumption to prepare for their eventual retirement. Unless savings are increased today, the division of output between active workers and retirees will be no less onerous tomorrow, regardless of whether we have a fully funded pension system based on individual accounts or a traditional pay-as-you-go system based on payroll taxes …

The amount of output a country produces is its ultimate budget constraint, regardless of how many stocks or bonds or Social Security cards may be floating around. Unless its output grows, a country cannot give more to its retirees without giving less to its workers.

Maybe you didn’t hear anything new there – and if so, pat yourself on the back as you are far smarter than I am – but I was blown away by the simplicity of Moss’s explanation of what is a very complicated problem. Mind you, he doesn’t have an answer to out-of-control entitlement programs like the one the US has, but being able to break this down only pages after explaining the different things that make up and affect GDP (national economic output) was impressive to me. And the cool thing is that Moss does this several times, explaining, for instance, why boosting monetary supply (i.e. when the Federal Reserve cuts interest rates) may have a certain effect on the exchange rate in the short-term but a different one in the long-term and how an “unsustainable current account deficit” (i.e. huge trade deficits) might look like a “high degree of investor confidence” at first.

If you’re interested in macroeconomics casually or as a business-person who needs a better grasp of it in his or her job, I’d highly recommend the book.

When I found out that he wrote a piece for the New York Time’s Economix blog on how to stir in economics lessons to childhood fairy tales, I was intrigued:

“If you are an economics-minded parent of young children, like me, then you may also have spent long hours wondering how to teach economics to your toddlers. Luckily, much-loved children stories can be made far more delightful with a healthy dose of supply-and-demand charts. Many such tales already include their own hidden economic messages that only need to be exposed to bring edification and enjoyment to the under-5 set.”

Really?

“The Three Little Pigs,” for example, is more than just a story about the value of better building materials. Like a whole host of fairy tales (“The Ant and the Grasshopper,” or “The Goose with the Golden Egg”), it teaches that sensible investment can yield high returns.”

He gives  few other examples which led me to wonder, why is Glaeser so interested in fairy tales? Apparently, its because his first paper was on Cinderella:

“The first thing I ever published in an academic journal was “The Cinderella Paradox Resolved,” which purported to make sense of the odd fact that Cinderella’s parents invested in only two of their three siblings, despite the fact that standard economics pushes toward more equitable arrangements.

The story itself explains this fact with “The Wicked Stepmother Hypothesis,” a reasonable but excessively straightforward explanation of the decision to ignore Cinderella. I offered a distinctly less plausible explanation. The marriage market in Cinderella’s country was a tournament, where marrying the prince carried high rewards and everyone else was a mouse, pumpkin, etc.

In a first-past-the-post race, it often makes sense to lavish investment on only one or two competitors, which makes the stepmother’s behavior entirely rational. Of course, the stepmother did choose to back the wrong horse, but that just makes her unwise, not wicked.

As I explain this logic to my children, they respond with the glazed and distinctly annoyed looks that conveys to me their inner joy. I am sure that you will get the same reaction.”

So, do I take advice from Glaeser on how to raise my kids? On the one hand, he is an intelligent, wealthy, well-dressed man (always wore 3-piece suits if my memory serves me), who smokes a cigar. On the other hand, he was giving our class a lecture on the Slutsky Equation while his wife was in labor (probably with one of the kids who had to listen to this “re-telling” of Cinderella)…

The Chinese government has begun a concerted campaign of economic threats against the United States, hinting that it may liquidate its vast holding of US Treasury bonds if Washington imposes trade sanctions to force a yuan revaluation.

Two Chinese officials at leading Communist Party bodies have given interviews in recent days warning, for the first time, that Beijing may use its $1,330bn (£658bn) of foreign reserves as a political weapon to counter pressure from the US Congress. Shifts in Chinese policy are often announced through key think tanks and academies.

Barack — or do you prefer Jesus? or Kal-el, last son of Krypton? – let me get this straight. The bill that is sitting before you from Congress has many flaws and many strengths, like all bills. There are economists and policymakers for and against many parts of it.

But, there’s one part of the bill which strikes me, and nearly all economists as utterly ridiculous – the “buy American” provision. Think about the consequences:

1. It forces the federal government to buy potentially more expensive goods, wasting taxpayer dollars which could have gone into creating more jobs or helping to shore up US banks.
2. It poisons the ability for US companies to export their goods overseas, worsening the economic crisis we are in. Do the words, Smooth-Hawley Tariff ring a bell? You know, that massive trade restriction that was passed during the early days of the Great Depression that made everything worse?
3. A very strong sovereign “strategic ally/competitor”, who provides cheap labor and cheap goods to the US, is now threatening to (a) destroy the US dollar and (b) stop buying US debt even though it costs their country immense taxpayer funds which they could have funneled into their own country’s well-being but have instead chosen to give to the US so that the US will continue to buy Chinese goods

Here’s hoping your advanced schooling see’s the obvious choice and talks your party into backing down on that one little clause.

(Image Credit)

I think “it’s called math” and “I feel all savvy” pretty much wrap it up.

For those of you who are wondering how seriously to take this analogy – the logic behind securitization is basically just as Dogbert explained (buy up a lot of bad mortgages/cows and expect at least some of them to make it). The cartoon does leave out one (very dangerous) assumption which, if true, almost makes the whole scheme make sense (but just almost): mainly that the price of cows/homes is always increasing – so much so that even if one sick cow dies, you can still make a fair amount selling the carcass. That this entire scheme depended on being able to sell dead cows (foreclosed homes/re-financed mortgages) for more than they were originally worth is still mindboggling to me.

(Hat tip: Bill, who works for the government, so he technically fits the bill here)

What the blue line above shows is how much banks have borrowed from the Fed (the Fed’s BORROW index). You’ll notice (or maybe you won’t because of the small font size) that this graph goes back to 1910, with the gray bars reflecting when recessions occurred. You’ll also notice how that line basically doesn’t go anywhere through pretty much all of the 20th century, including even during the Great Depression, the economic crises of the 1970s and the early 1980s or the tech collapse in the early 2000s. Then, notice what happens at the right end of that graph – aka today. Yup, banks have so little capital left that they are now borrowing money from the Fed by the truckload.

But, wait. Borrowing from the Fed isn’t necessarily a bad thing. Maybe they’re borrowing it so they can lend it back out! Alas, this next chart shows that the borrowing is exactly what I just suggested – cash to cover the fact that the banks can barely cover what they owe:

Here, the blue line represents how much of a bank’s reserves are non-borrowed – or in other words, how much of its original deposits is a particular bank holding so as to make sure money comes out when you use an ATM – the Fed’s BOGNONBR index (no I’m not kidding on that acronym).

You usually expect this to be a certain percentage of what each bank is obligated to be able to cover (because the bank re-loans out most of the money that it has so that it can make money on interest). What you don’t expect, and never want to see, is when that number becomes negative – because what that means is that the bank’s own holdings can no longer cover its obligations – it has to borrow money just to make sure that money comes out of the ATM.

The combination of the two charts tells something quite horrifying – our banking system has no capacity to cover its own debts, and it is borrowing money like there’s no tomorrow to try to patch this up. If we want to fix the financial crisis, we need some way of helping to patch this horrible horrible gap. And how to do that is the $700 billion (or more) question.

1. There is a “black market” that evolves to sell currency (b/c they don’t trust the fiat or official currency values)
2. That black market is being carried out in the Classified ads of your country’s newspapers

In the classifieds on the web of the daily Iceland newspaper Mbl, you find hard currency for sale (US dollar, Danish kroner, and Euro) ranging from USD 300 to USD 12000. With the breakdown of the official exchange rates, the market has emerged.

The Nation’s Financial Industry Gripped by Fear – Not a pleasant article to come to work first thing in the morning on Monday to read, but a good summary of what happened that weekend — aka the fall of Lehman Brothers and Merrill Lynch, two of the oldest investment banks on Wall Street.

"Things change a lot in this business." – Megan McArdle waxes philosophical about her first post-MBA interviews with investment banks.

A New Beginning – Greg Mankiw on Intro to Economics enrollment: "I would like to thank all my friends on Wall Street for doing so much to spark interest in economic issues. You have gone beyond the call of duty, and your timing could not have been better."

Top Five Lehman Brothers souvenirs to grab on your way out: Funny and irreverent — especially this "must have": "Operating principles cube – A must-have desk accessory with helpful pieces of advice and guidance. Includes top Lehman operating principle: Demonstrating smart risk management"

"Smart investors should buy this stock": Hilarious (that is, unless you actually owned Merrill/Lehman/AIG stock) coverage of very poor investment advice provided by some of the world’s largest and most well-regarded financial magazines.

Ok, Raise Your Hand if you’re completed $&%^$! – Owned

Too Few Regulations? No, Just Ineffective Ones – Tyler Cowen of Marginal Revolutions gives his take on what went wrong. Short answer: no political party is to blame, as the problems started years ago, and rested not in the amount of regulation, but in the type of regulation that took place.

"My Wealth will go on": Sinfest at it’s best

The Financial Crisis, LOLCat edition – Answering the very important question, how would LOLCats explain how the financial crisis went down? "Bank: OH NOES!  WE WERE COUNTIN ON UR PAYIN US"

How Wall Street’s woes will hurt the next President – Megan McArdle points out that the cost of these bailouts means that the next President won’t be able to increase spending or cut taxes as much as they’d like.

Foresight? – "Thanks goodness we bailed out Bear Stearns back in March if we hadn’t we might have lost Fannie Mae and Freddie Mac, Lehman Brothers, Merrill Lynch and who knows what else.  Oh wait…"

The US credit rating under fire? – "Scary to think that two committees of eight or so underpaid analysts at S&P and Moody’s could destroy the world’s economy with a penstroke."

US Treasury yield drops to basically 0 – Translation: putting all of your money under your mattress might start to make sense soon…

Megan McArdle – explains that there is nothing Bush or Clinton or anyone probably could have reasonably done to avert this.

How the two candidates are responding to this crisis: Not very well, e.g.: "JOHN MCCAIN’s message: We’re in this mess because a bunch of Wall Street hot shots got us into it, but they won’t dare to pull that stuff when I’m in the White House, because I survived five years in a POW camp."

Blocking short-selling is stupid – Blocking short-selling is stupid

Where do we go from here? – David Brooks: "It all sounds great, like buying a house with no money down…"

Glass-Steagall’s repeal is not to blame: So, no, you can’t blame the Clinton administration.

The New "Business" Strategy? – Ay caramba

The End of the Independent Investment Bank – Goldman Sachs and Morgan Stanley, the “two last men standing,” ideologically throw in the towel and become fully regulated banks

What should we do? – Calculated Risk makes a calculation on what can/should be done. Their best plan sounds like a long shot to me.

Liquidity trap? – Paul Krugman educates us on what the Fed traditionally does, and why he thinks the Fed is powerless now. Tyler Cowen has a different take.

Guest post on Freakonomics blog explains the whole thing

Image source (S&P500 Financial Sector Index)

A while back I posted about something called “goodwill” — an accounting term which means very little but, by accounting standard practice, shows up on corporate financial statements. If you can’t tell by my tone of voice, I don’t put a lot of stock in the concept of "goodwill".

Much to my dismay, I discover that, in light of the current financial crisis, that regulators are now thinking about letting banks pretend that "goodwill" actually means something (HT: A. Garvin):

Under the proposal issued this week, the regulators would permit buyers of banks and thrifts to count some of the goodwill toward meeting their regulatory capital requirements.

In other words, something which has no material value whatsoever now suddenly counts for something.

Let me give you an analogy for how insane this would be if it goes through. Let’s say I wanted to buy a house and you’re my friendly neighborhood banker who’s helping me take out a mortgage to buy it with:

YOU: So, did you like the place?
ME: This place was awesome!
YOU: So, how much is the place?
ME: $400,000.
YOU: Ok, well, we’ll need a $100,000 down payment…
ME: Sounds good, except for one thing.
YOU: What?
ME: I don’t have that much cash. But don’t worry, I can give you this hug which I think is worth $400,000! Would that be all right?
YOU: Sure!

Now, correct me if I’m wrong, but didn’t the current crisis start because of something tantamount to trading something (houses) for nothing (the promises of subprime borrowers to pay)?

This is a question that very few people ask, even though it is oftentimes taken for granted that the government should indeed engage in anti-trust activity.

The logic behind modern anti-trust efforts goes back to the era of the railroad, steel, and oil trusts of the Gilded Age, when massive and abusive firms engaged in collusion and anti-competitive behavior to fix prices and prevent new entrants from entering into the marketplace. As any economist will be quick to point out, one of the secrets to the success behind a market economy is competition – whether it be workers competing with workers to be more productive or firms competing with firms to deliver better and cheaper products to their customers. When you remove competition, there is no longer any pressing reason to guarantee quality or cost.

So – we should regulate all monopolies, right? Unfortunately, it’s not that simple. The logic that competition is always good is greatly oversimplified, as it glosses over 2 key things:

1. It’s very difficult to determine what is a monopoly and what isn’t.
2. Technology-driven industries oftentimes require large players to deliver value to the customer.

What’s a Monopoly?

While we would all love monopolies to have clear and distinguishable characteristics – maybe an evil looking man dressed in all black laughing sinisterly as his diabolic plans destroy a pre-school? – the fact of the matter is that it is very difficult for an economist/businessperson to really tell what counts as a monopoly and what doesn’t, for four key reasons:

1. Many of the complaints and lawsuits brought against “monopolies” are brought on by competitors. Who is trying to sue Intel? AMD. Who complained loudly about Microsoft’s bundling of Internet Explorer into Windows? Netscape.
2. “Market share” has no meaning. In a sense, there are a lot of monopolies out there. Orson Scott Card has a 100% market share in books pertaining to the Ender’s Game series. McDonald’s has a 100% market share in Big Macs. This may seem like I’m just playing with semantics, but this is actually a fairly serious problem in the business world. I would even venture that a majority of growth strategy consulting projects are due to manager’s being unable to correctly define the relevant market and relevant market share.
3. What’s "monopoly-like" may just be good business. Some have argued that Microsoft and Intel are monopolies in that they are bullies to their customers, aggressively pushing PC manufacturers to only purchase from them. But, what I fail to see, is how this is any different from a company that offers aggressive volume discounts? Or that hires the best-trained negotiators? Or that knows how to produce the best products and demands a high price for them? Sure, Google is probably "forcing" its customers to pay more to advertise on Google, but if Google’s services and reach are the best, what’s wrong with that?
4. "Victims" of monopolies may just be lousy at managing their business. AMD may argue that Intel’s monopoly power is hurting their bottom line, but at the end of the day, Intel isn’t directly to blame for AMD’s product roadmap mishaps, or its disastrous acquisition of ATI. Google isn’t directly to blame for Microsoft’s inability to compete online.

Big can be good?

This may come as a shock, but there are certain cases where large monolithic entities are actually good for the consumer. Most of these lie around technological innovation. Here are a few examples:

• Semiconductors – The digital revolution would not have been possible without the fast, power-efficient, and tiny chips which act as their brains. What is not oftentimes understood, however, is the immense cost and time required to build new chips. It takes massive companies with huge budgets to build tomorrow’s chips. It’s for this reason that most chip companies don’t run their own manufacturing centers and are steadily slowing down their R&D/product roadmaps as it becomes increasingly costly to design and build out chips.
• Pharmaceuticals – Just as with semiconductors, it is very costly, time-consuming, and risky to do drug development. Few of today’s biotech startups can actually even bring a drug to market — oftentimes hoping to stay alive just long enough to partner with or be bought by a larger company with the money and experience to jump through the necessary hoops to take a drug from benchside to bedside.
• Software platforms – Everybody has a bone to pick with Microsoft’s shoddy Windows product line. But what few people recognize is how much the software industry benefited from the role that Microsoft played early on in the computer revolution. By quickly becoming the dominant operating system, Microsoft’s products made it easier for software companies to reach wide audiences. Instead of designing 20 versions of every application/game to run on 20 OS’s, Microsoft made it easy to only have to design one. This, of course, isn’t saying that we need a OS monopoly right now to build a software industry, but it is fair to say that Microsoft’s early "monopoly" was a boon to the technology industry.

The problem with today’s anti-trust rules and regulations is that they are legal rules and regulations, not economic ones. In that way, while they may protect against many of the abuses of the Gilded Age (by preventing firms from getting 64.585% market share and preventing them from monopolistic action 1 through 27), they also unfortunately act as deterrents to innovation and good business practice.

Instead, regulators need to try to take a broader, more holistic view of anti-trust. Instead of market share litmus tests and paying attention to sob stories from the Netscapes of the world, regulators need to really focus on first, determining if the offender in question is acting harmfully anticompetitive at all, and second if there is credible economic value in the institutions they seek to regulate.

Gas prices are going up. Believe me, my wallet is well aware of this as I not only live in the Bay Area, but my weekly commute is over 200 miles. And if I’m feeling the pinch, people around the country probably are as well.

Not surprisingly, there has been a lot of steam generated by politicians about taxing the so-called “windfall profits” of oil companies. While I can’t argue with clauses in the bills advocating the development of alternative energy sources, the entire notion that one can point at Exxon’s $40.6 billion net income and declare that oil companies make “too much money” is to me about as ridiculous as Don Quixote’s battle against windmills (hence the random picture of a guy on a steed charging a windmill, that and windmill sounds like windfall — yes, I’m very creative).

There are three reasons that immediately jump out to me as to why you can’t just point at the amount of money Exxon makes (or for that matter, a pharmaceutical company or a telecommunications company or any company) and immediately jump to the conclusion that profits are too high in a particular industry and hence must be taxed:

1. Large profit doesn’t necessarily mean a high profit margin
2. A high profit margin doesn’t necessarily mean the company is doing well
3. Taxation on profits is not going to reduce prices

The first reason is basically stating the question how much is too much profit? Is $1 million too much? How about $1 billion? Or $10 billion? Or how about Exxon’s $40.6 billion? The reason why this is a trick question with no answer, is because the sheer amount of profit a company makes is no indication of how much it is profiting from every sale. For example, if two poker players end the night having won $50, but the first player started with $10 and the second player started with $100, who would you say is the better poker player? Probably the former, because he had less to work with. On a similar level, you can’t just point at $40.6 billion and immediately say that profits are excessive. They certainly aren’t excessive if Exxon had to sell $1 trillion worth of gas to make that profit, as that would mean Exxon was only making 4 cents on every dollar — and what would be the point of regulating/taxing that?

But, let’s say you’re smarter than the average politician/bear, and you point out that Exxon has a profit margin of 10% (Exxon’s sales in 2007 were $405 billion), and that is simply too high when people around the country are struggling to pay their energy bills. This then takes us to the second reason, which is basically questioning how difficult is it to make that profit margin? Again, an example would probably best illustrate this — let’s say there are two poker players who both started with $100, and both ended the night having won $50 — in this case, both players have the same “profit margin” (50%). However, let’s say one player played at a table full of children who don’t quite know how to play, and the other played at a table full of World Series of Poker champions. Now, given this setup, it should be obvious who the better player is. You are likely to say that the player who made a 50% margin playing the table full of WSOP champions is the better player and that his profit margin was very difficult-to-get and probably not excessive. On the other hand, we would be ashamed of the player who basically stole candy from babies and would think that money was not well-deserved.

Translating this back to the world of windfall profits, the takeaway message is that the profit margin that a business earns is no indication of “windfall” profits because the profit margin does not reflect how “difficult” it was to earn the profit. The pharmaceutical industry is a perfect example of this, and a perennial whipping boy of politicians who seem to not comprehend that it is not only extremely unlikely for a particular investment to make it from the lab to a patient, it takes a very long time and is also extremely expensive to develop. Companies in the oil industry and telecommunications industry are also similar in that significant upfront investments (e.g. Exxon needs to hire workers and buy equipment before it starts drilling, AT&T needs to build out a large network infrastructure before it can issue new services) with no guarantee of success (e.g. what if Exxon drills where there is no oil? what if AT&T’s network service offering is a dud?). Now, to be absolutely clear, this argument doesn’t mean that it’s impossible to earn “windfall profits”, but it does mean that different industries have different standards of profitability to determine how well a company is doing.

And lastly, even if we find an example of a company that is making excessive profits by a legitimate, industry-specific definition, it is highly unlikely that a tax on profits will result in a cut in prices. The reason is pretty basic — there are three levers a company can use to raise profits — it can raise prices, it can try to sell more things, or it can try to lower costs. If we assume that companies usually aim to maximize profits, which is typically a decent assumption, then a tax on profits will simply encourage the company to either:

1. raise prices
2. sell more things
3. lower its cost structure (maybe by firing some workers or outsourcing more stuff)
4. some combination of the above

#1 is especially likely if the item being sold is something which is a necessity to the buyer or something which the buyer would buy the same amount of with little regard for price (which allows the seller to “get away” with charging more). Typical examples of this are things like food, oil, and healthcare — typical targets of movements to tax windfall profits. What this means is even if the tax were 100% efficient (no overhead costs for collecting it and overseeing it, no impact on the quantity of product provided) and it was completely refunded back to the consumer, at best you are saving the consumer a few percent of the original price, as they are forced to bear the brunt of the tax in price hikes.

Of course, hoping the politicians will listen is much the same as telling Don Quixote not to bother attacking windmills.

Image credit

Fact 1: We are facing tough economic times. Fact 2: When people are facing tough economic times they look for other sources of income. Fact 3: Police tips are a source of additional income.

Conclusion: We are probably seeing an increase in police tips right now.

The New York Times has a fascinating article about this (hat tip: Marginal Revolutions):

Cities and towns from Detroit to Omaha to Beaufort County, N.C., all report increases of 25 percent or more in the first quarter, with tipsters telling operators they need the money.

Are we sure it’s not a rise in generosity?

Some coordinators suggest that rising crime rates might be driving up the number of tips. But in Jackson, Tenn., Sgt. Mike Johnson said his call volume had gone from 2-3 a day to 8-9. He theorized that rising crime there was not a factor because the program advertises steadily regardless of trends. “People just need money,” Sergeant Johnson said.

Jim Cogan, director of the Silicon Valley Crime Stoppers program in California, said most of the rewards offered by his program used to go unclaimed. But with large numbers of foreclosures and heavy job losses, Mr. Cogan said, “now we’re seeing rewards get picked up right away and our tipsters being frustrated when tips aren’t available as quickly as they need the money.”

Yeah, pretty sure. Actually, sounds like this could be quite lucrative, doesn’t it?

Some people have made a cottage industry of calling in tips. Although repeat callers do not give their names, operators recognize their voices.

“We have people out there that, realistically, this could be their job,” said Sgt. Zachary Self, who answers Crime Stoppers calls for the Macon Police Department.

“Two or three arrests per week, you could make $700, $750 per week,” Sergeant Self said. “You could make better than a minimum-wage job.”

Which then raises the issue that my consultant mind likes to ponder — could this be a viable business model? Or at least a viable non-profit initiative? This could be the libertarian’s compromise — a private police/investigation group, but not officially deputized and lacking the authority to make arrests or use force that the official police has. This way, the private group becomes like a consultancy — providing advice and tips on solving crimes, helping to gather and share information, etc — and a link between the police and the community.

I haven’t fully thought this through, but this is how I see it working:

1. Retaining an “expert group” of criminologists and sociologists who follow crime and drugs and gang activity to provide analytical horsepower to provide investigation/profiling consulting services
2. Designing a database and IT infrastructure to provide readily accessible information to police departments around the country
3. Becoming an intermediary between police department rewards and the people who report them — the group would need marketing specialists and people who are good at building social networks and community advocacy to reach out and encourage members of communities to phone in tips. In return, the business will handle timely payments, payment schemes (e.g. incentives to improve quality), and the filtering of information to make sure only the most useful information makes it to the police’s desk
4. Retaining a group of “professional” tip-gatherers equipped with better tools and training
5. Implementing policies to make sure that local government officials are involved as oversight to guarantee transparency

The payment scheme could be simple — the company could charge a group of police departments an annual fee for access to the database, a small finder’s fee (1-2%) for each tip that contributes to the solving of a crime, and a fee for any consulting services that the firm is hired to do.

In terms of setting up the business, I see two big hurdles that need to be crossed. The first is establishing trust in the quality of the service. This is something that depends greatly on the caliber of the individuals involved and the database. This would represent a significant upfront investment, but could be justified as I suspect the activities being pursued are fairly profitable (low variable cost, so as long as the service is good, the group can cover its costs) and police departments should be excited to be increasing the quality of their service to the community.

The second is establishing trust in the integrity of the service — one doesn’t want this to be run by the mob or a corrupt agency. This is something that depends highly on the transparency policies involved, and is one reason I think that it would work best if a group of police departments were involved — it’s much more difficult to corrupt an organization with background checks and oversight from 5 or more police departments and citizen/government groups.

Bad boys bad boys — what you gonna do? What you gonna do when a non-official network of informants snitches on you?

The reason for this is that the business models of these financial services firms are highly dependent on something I’m going to call “non-real” assets — instead of converting raw materials and labor into a product (intellectual or physical) to sell, they depend upon price movements in financial markets, on credit risk, and on leverage (borrowing other people’s money). Now this is not an angry tirade that the financial services industry is worthless (somebody must think what they’re doing is worthwhile if they’re paying them so much) but merely my illustrating that the assets and holdings a financial services claims to have are oftentimes illusory by virtue of the fact that these firms make money by watching these assets and holdings change market value.

This distinction between “real” and “non-real” is difficult to make given that “real” companies also have to deal with similar issues (e.g. a steel company’s holdings will be worthless if we all stop using steel), but I believe it’s a useful tool to understand the current credit crisis. In a nutshell, the financial services industry is reeling from broken markets, debtors defaulting like crazy, and creditors calling in loans and being reluctant to make new ones. As a result, the profit engine for the industry has come to a sudden and sputtering stop, orders of magnitude worse than what you would expect just by looking at their financial statements from last year.

This problem — that investors can’t really gauge what a financial service company is doing through official financial documents — is made even worse when you consider that one common tactic banks have used in recent years is to create Structured Investment Vehicles (SIVs), a practice which is tantamount to creating new companies who’s sole purpose is to invest the money of the parent bank but with little public scrutiny. This arrangement lets the bank make risky investments “off balance sheet” — or, in other words, make investments which don’t show up anywhere in official financial reports unless, as has been happening recently, the investments suddenly become worthless.

As Marc Andreessen aptly points out (hat tip: A. Phan), “Remember Enron? Imagine Enron times a hundred.“ 

Given the IMF’s recent estimate that the subprime crisis will destroy $1 trillion of value, that means we are talking about nearly $200 of market value destruction for every single human being on Earth.

The solution? I’m not sure. I have doubt over how much “better” accounting standards can help thwart problems like the current credit crisis. Different accounting standards may help address the issue of off-balance sheet SIV holdings, but they can’t change the underlying fact that financial services firms make money from forces/factors which fundamentally make financial statements less useful. They also can’t prevent swarms of people from knowingly taking large risks. The only guidance from this is to be very wary of what you read — just like you can’t make money off of a tech company that has no product, you also can’t make money off of a financial services company that is holding worthless illiquid assets, no matter how much they claim on their balance sheet.

Suffice to say, Bear Stearns is not a bank to be looking up to right now.

Which makes this article from Reuters (hat tip: A. Phan) titled “Bear Stearns cuts Citigroup, Bank of America 2008 share view” that much more amusing:

“Bear Stearns cut its 2008 earnings estimates for Citigroup Inc and Bank of America Corp to reflect anticipated write-downs and higher credit costs.”

While, I am of the opinion that the Federal Reserve made the right choice (shoring up the financial markets by preventing one disaster from ballooning into a much larger one), that what happened to Bear Stearns is more a product of herd psychology than an underlying problem with Bear Stearns’ fundamentals, and that plenty of smart analysts still work there, I think after the past month, Bear Stearns has no business bad-mouthing other financial companies.

Unless of course, they’re making the “takes one to know one” argument here…

Putting together everything we’ve learned over the past 10 days about high finance in Manhattan, one thing is clear: If Eliot Spitzer had saved all the money he apparently paid “Kristen” and her co-workers at the Emperors Club, he could have bought Bear Stearns.

How can you quantify the “social impact” of a single individual? For instance, how much of an impact does Britney Spears have on “society”? (And, yes, those and other quotes that you see in this post are meant to convey vast depths of sarcasm).

An economist could argue that Britney’s worth to society would be her income. The reasoning behind that is that if she were worth less to society, society would simply not pay her so much. If she was worth more to society, Britney would, because she is clearly a rational utility-maximizing individual, find some way to extract from society her true value in the form of a higher income.

Even if we put aside moral issues with this definition of value to society, any careful observer will notice that Britney does more than just “add value” equal to her income. For example, she was a popstar, meaning her “work” rakes in extra money for the record label. Her face and escapades become the “incomes” of paparazzi and celebrity gossip columnists. Her “image” backs her perfume lines and her appearances in advertisements. These cannot all be directly attributed to her (i.e. she did not set up the record label, she did not write the columns dedicated to “her life”, etc.), so her income doesn’t necessarily reflect these, but it can at least be said that Britney enables a whole world of economic activity which (*drumroll*) Conde Nast’s Portfolio.com estimates to be worth over $110 million. (Hat tip: Freakonomics)

This is how big she is:

A celebrity tabloid with Britney Spears on the cover sells 1.28 million newsstand copies, some 33 percent more than the average. Between January 2006 and July 2007, Britney was a cover subject of People, Us Weekly, In Touch, Life & Style, OK!, or Star a total of 175 times in just 78 weeks. During that period, newsstand sales of issues with her on the cover amounted to a staggering $360 million. She’s also topped the annual Yahoo Search rankings in six of the past seven years, slipping to No. 2 only in 2004, when Paris Hilton briefly stole her crown. Searches for Britney were up 60 percent in 2007, the year of her divorce, shaved head, and car wreck. “If there was no Britney, would all Web traffic stop?” asks Vera Chan, senior editor at Yahoo. “I would hesitate to give her that much power, but it’s hard to argue with the facts.”

And the breakdown of this $110 million?

Estimated annual take (record company, promoters, licensers, and others): $30 million to $40 million

Estimated average annual take (Paparazzi): $4 million

Estimated average annual take (the Media): $75 million

Estimated average annual take (K-Fed): $1 million

Hit me baby one more time? No seriously. Hit me. Because this number can’t be real.

My previous post cited a paper by Michael Greenstone who noted that Iraqi bond prices fell ~40% following the surge, suggesting that the surge wasn’t working.

In recent days, however, those bond prices have gone up (source: Bloomberg’s):

While the war in Iraq has dragged Bush’s approval ratings lower, his policies in Iraq have turned around investor opinion on Iraqi debentures. The addition of 28,000 troops in the first half of the year has reduced terrorist attacks in the country by 55 percent, the U.S. embassy in Iraq said on Nov. 18.

“We’ve had a shift in sentiment,” said Gorky Urquieta, who oversees $14 billion of emerging-market debt at ING Investment Management in The Hague. ING started buying the securities last month, and is now among the biggest holders along with San Mateo, California-based Franklin Templeton Investments and Baltimore- based T. Rowe Price Group Inc., data compiled by Bloomberg show. “There’s optimism the surge is starting to pay off,” he said.

Greater security from the troop surge, a promise by Moqtada al Sadr to cease attacks, and a rise in oil prices seems to all be promising signs for the future of Iraq.

On the other hand, we all need to remember that bond prices aren’t just driven by the ability to pay, but also by the return on other investments — in recent days given the widespread belief that the global economy will enter a recession, its not surprising that investors view Iraq as relatively less unstable — it doesn’t necessarily mean they think its stable.

Now, I personally was under the impression that the uninsured pose a major burden to the healthcare system. After all, we’re talking about a fairly large number of individuals who cannot afford health care (and hence need to be subsidized by the American taxpayer). Much to my surprise, the blog Healthcare Economist quotes from a paper from the Journal of Health Economics that finds that the uninsured in net might not actually be a burden on doctors’ wallets at all (hat tip: A. Phan)

The majority of physicians actually make money, on net on their uninsured patients…12-14% of physicians found their uninsured patients patients more than twice as profitable as their insured patients; that is the net payments from the uninsured were more than twice the expected payments from the insured patients.

The reason? Apparently (although, as a consultant, I shouldn’t be surprised by this), insured patients are able to extract bargain prices for medical equipment/drug suppliers as a result of insurance companies being able to bargain for prices. Uninsured patients, on the other hand, have to pay the full list price, because they lack the scale (or, in other words, the bargaining power) to negotiate lower prices.

But, even more interesting, is that if the higher prices are ignored, the study concluded that

Even our most conservative estimates suggest that uncompensated care amounts to only 0.8% of revenues, or at most $3.2 billion nationally [Ben's note: (a) the report shows that most of this cost comes not from care that doctors hand out for free but by nonpayment and (b) this is TINY compared to total health spending, and even smaller compared to US GDP].

This is interesting, because while it is known that the standard statistics cited about the uninsured also count those who choose to forgo insurance or those who, although unable to pay for large expenses, are able to pay for smaller ones, there’s usually some level of controversy over the ability of uninsured patients to pay. This finding suggests that there is a reasonable capacity to pay amongst the uninsured. This isn’t a blanket statement that can be made, and this is certainly not claiming that individuals without insurance can pay for chemotherapy or heart surgery, but it’s a caution that we don’t necessarily have to jump to a single payor-universal health care form of coverage. We just need to find a way to get more people covered (kind of like my proposal).

Furthermore, this will hopefully shed more doubt on claims by individuals believing that the uninsured are a horrible burden — an insurmountable problem that can’t be solved.