Friday, February 04, 2011

Risk-Takers and (the Lack of) Social Progress

-- Posted by Neil H. Buchanan

In my post last Friday, I offered some thoughts on the relative efficacy of tax cuts aimed at the non-rich versus the rich. The broad point of the post was to discuss in some detail how it is possible that rich people can have so much money without being an important source of the spending that could end recessions.

On the comments board for that post, there was a brief discussion among some readers regarding a parallel argument about tax policy. Even though tax cuts for the rich would not be spent in a way that would help to end a recession, is it not possible that such tax cuts would help any economy (in recession or otherwise), by putting money in the hands of people who would use it to fund innovations and breakthroughs that will ultimately benefit everyone?

I have long been skeptical of such arguments. They are, after all, little more than trickle-down economics sprinkled with some appealing modernist rhetoric. Crude trickle-down economics simply says that rich people will spend their money as they wish, with that money ending up in the hands of those whom the rich employ (butlers, stable-boys, caterers, and so on), who will thus be better off than if they had not been hired by a rich person. (A version of this argument was the recent statement by one of the right-wing radio talkers that he had never been hired by a poor person.)

By contrast, the more appealing version of trickle-down economics says that high-end tax cuts result not in more butlers being hired, but rather in an expansion of entrepreneurial activity. And what could be more forward-looking and confidence-inspiring than an entrepreneur -- especially if the alternative is to put money in the hands of the dreaded government and its stultifying bureaucrats? (Who cares if the internet was created by government-funded projects, staffed by smart guys who were not seeking profit?)

Ah, the entrepreneur! Is there a word in the modern vocabulary that has a more positive connotation combined with such vague denotation? If you do not support entrepreneurs, you must hate America.

Other commenters on last Friday's post made two points in response to the "put the money in the hands of the entrepreneurs" suggestion. First, entrepreneurs need customers; so money in the hands of the non-rich will still stoke entrepreneurial activity. Second, people engaged in high-risk/high-payoff activities are seeking something so big that marginal tax rates almost surely are irrelevant to their calculations. "Hmmm, I might be able to invent cold fusion, thus revolutionizing the way all of modern society is powered. But I just found out that I'd pay an average tax rate of 45% instead of 35% on my resulting billions. Nah. Let's just forget it."

As it turns out, this past Sunday's New York Times Business Section offered some related thoughts on this issue from the conservative economist Tyler Cowen. (Cowen is one of the two rightie essayists who rotates with two left-centerie essayists on Sundays.) In "Innovation Is Doing Little for Incomes," Cowen looks at the enormous effect that technological innovations had on living standards from the Industrial Revolution through the 1970's, compared to the seemingly non-existent effects that more modern innovations have had.

The sentence that jumped out at me from Cowen's essay was this one: "Today, no huge improvement for the automobile or airplane is in sight, and the major struggle is to limit their pollution, not to vastly improve their capabilities." During my recent travels, as I sat through 13-hour flights between California and the East Coast of Australia, I had been miserably pondering this very phenomenon. Why, I wondered, have we apparently hit a plateau in aircraft technology that makes it impossible to imagine shorter flying times? Is 600-mph a barrier that we will never surpass?

I am just old enough to remember the excitement and controversy surrounding the Supersonic Transport, the breakthrough jet that cut the flying time between New York and London down by several hours. The SST was ultimately grounded because of severe noise problems, along with high fuel consumption during the Energy Crises of the 70's. My casual reading of the news regarding aircraft technology tells me that no new SST is anywhere in the production pipeline. Boeing continues to suffer public-relations embarrassments from production delays in its super-jumbo jet, suggesting that even the innovations on the drawing boards these days are not proceeding smoothly.

In any event, Cowen uses that example to make a broader point. Whereas innovation used to change society in ways that could arguably support the heroic vision of business embodied in the word "entrepreneur," it no longer does. The example of the moment is, of course, Mark Zuckerberg's Facebook. While I never understood the appeal of Facebook, I can readily concede that it is wildly popular. It might even be making people better off in some sense that could be captured in the word "utility." What is has not done, Cowen points out, is make anyone but Mr. Z wealthy. Ford, Packard, Olds, and all the other lions of the auto industry spawned the Great American Middle Class. Zuckerberg made it possible to know whether the hottie down the hall is in a committed relationship.

This, of course, does not mean that we should simply give up on the idea of innovation as a driver of social progress. We have, however, for the last three-plus decades been shoveling more and more money to the people whom we hope against hope will respond with a burst of entrepreneurial zeal; and we have increasingly refused to transfer any of the resulting bounty back to the public treasury. It is difficult to make even a minimal prima facie case that taxing high incomes (and accumulated wealth) at rates even double those currently being debated in the U.S. has ever harmed innovation. And the innovations during the low-tax era simply have not trickled down on the rest of us. I love America. I wish it would stop worshiping false heroes.

47 comments:

Michael C. Dorf said...

Neil,

I think you and Cowen are taking a rather short-sighted view of technology. Why doesn't Skype video count as an improvement of the airplane in that it makes a good deal of air travel unnecessary? Or at least it and related technologies hold out the promise of doing so. I realize that we've had reliable long-range telephone capacity for many decades during which face-to-face meetings were still thought necessary. But when the video-conferencing really gets good enough, a lot of the travel could be eliminated. Etc.

Paul Scott said...

As a technophile, I have to second Mike's comments. Technological advancements in the last several decades are what allow me to do almost all of my work from my home office. If it were not for advancements that have resulted in personal computing power being miniaturized (in size) and magnified (in power) as well as most paper technologies being replaced, I would require a lab and an office (and a car to take me to them each morning). If it were not for craig's list (something fairly similar to facebook), my ability to find urine and blood collectors globally would be severely impaired. Directly parroting Mike, Just last week I testified in a case in Lausanne using video conferencing instead of flying there. My ability (which certainly some view as a curse) to work, and work effectively, no matter where I am or the time or day is a direct result of my phone being powerful enough to act as a home computer - if less efficiently - for many tasks.

There is no question in my mind that technological enhancements over that last 30 years have been significant and done a lot more for us than keep track of the hotties down the hall.

George H said...

Even if all Facebook has done is let us keep track of hotties, it's unfair to credit Ford et al with the Great Middle Class while looking only at Facebook's direct contributions. Just like Ford did, Facebook provides well paying jobs for 2000 or so people directly and many more employees of internet bandwidth providers, computer hardware manufacturers, sysadmins, programmers, database administrators... If Ford's good paying jobs get credit, why doesn't Facebook?

That said, the argument that entrepreneurs will hire more if they get a tax cut on profits is not something obvious to me. Employee salaries and most of the operating costs associated with having another employee are already deductible from income, so any effect of tax rates on this is second order at best, and while it's plausible to me that there's some incentive effect, I wouldn't be surprised if there isn't. There may even be a small negative effect, because tax law tends to shelter various savings vehicles from income tax to varying degrees, so reducing the marginal rate on income consumed may actually decrease savings incentives.

michael a. livingston said...

Today I was held up for 40 minutes driving by useless work projects supported by the "stimulus" bill. If I have to take my chances on an innovative private sector, or more money for make-work projects, it's a pretty easy choice. If Neil's philosophy is motivating the Obama Administration, it's no wonder our economy is in trouble.

Neil H. Buchanan said...

I will respond to the (excellent) comments from Michael C. Dorf, Paul Scott, and George H in a new post in the very near future.

Eric said...

Sowell has refuted many of these points before:

http://www.capitalismmagazine.com/economics/1115-The-Trickle-Down-Economics-Straw-Man.html

http://www.capitalismmagazine.com/index.php?news=4183

"There has never been any school of economists who believed in a trickle down theory. No such theory can be found in even the most voluminous and learned books on the history of economics. It is a straw man...

...Those who imagine that profits first benefit business owners -- and that benefits only belatedly trickle down to workers -- have the sequence completely backward. When an investment is made, whether to build a railroad or to open a new restaurant, the first money is spent hiring people to do the work. Without that, nothing happens.

Money goes out first to pay expenses first and then comes back as profits later -- if at all. The high rate of failure of new businesses makes painfully clear that there is nothing inevitable about the money coming back...

...The real effect of a reduction in the capital gains tax rate is that it opens the prospect -- only the prospect -- of greater future net profits. But that is enough to provide incentives for making current investments. Reductions in the capital gains tax rate tend to draw money out of tax shelters like municipal bonds and into creating jobs and productive capacity. That's the point!

As with all taxes, a distinction must be made between tax rates and tax revenues. Tax revenues went up while tax rates went down in the 1980s. Similarly in the 1960s and the 1920s. That is because incomes rose more than tax rates fell. But still it will be claimed that we cannot 'afford' to cut tax rates because it would create deficits. Spending creates deficits -- and it is big spenders who fight hardest against cutting tax rates..."

egarber said...

Two points:

1. I don't really see the exercise as a zero-sum dynamic -- where innovation occurs *either* because of public-sector investment *or* private risk tasking. The truth is that both have to be in place for anything sustainable to take hold.

Basic R&D has led to more breakthroughs in technology, medicine, etc. than can be listed. And it's the result of research for learning's sake, something way beyond the ability or desire of profit-seeking companies to undertake at any meaningful level.

However, without private investors and entrepreneurs, very little of that breakthrough can be converted into innovative expression. An immediate example is the technology used for remote collaboration (as Mike mentions). It wouldn't have come into existence without both of these platforms (public and private investment) in place. Think about how racing to the moon stimulated private industry in subsequent years, as another example.

[As a related topic, we need address the disconnect between basic and applied R&D, which creates an environment where American researchers make big discoveries, only to see others (Taiwan, et al) leverage them into application. There must be some way to direct more of that domestically -- maybe through domestic license discounts for patents.]

2. As to the notion that it's always better to cut taxes at the top and hope for the best, that's just folly in my view -- a religious adherence to one side of the Laffer curve. We're better off first and foremost building lower-level stability; financially secure families drive demand, which creates investment opportunities in the aggregate.

Over the Bush years, we saw real median incomes decrease, and there is little to no evidence that the tax cuts created Facebook or Cisco's video-conferencing products. The only innovation that was empirically visible was that in the financial products industry. Billions upon billions were pumped into exotic securities that ultimately obliterated the job market.

This goes back to a core point I made somewhere else: generally the wealthy will spend tax cuts creating paper wealth, whereas the lower classes will pump those dollars directly into the economy, creating the very demand -- and growth -- that gives innovation a chance.

egarber said...

>>As a related topic, we need address the disconnect between basic and applied R&D, which

I mean, "we need to address..."

Eric said...

1. The problem with government R&D is that there are no ways to evaluate if they have a positive economic impact or not. Anecdotal “success” stories do not demonstrate how much waste and crowding out was involved. Siphoning hundreds of trillions of dollars from the private sector to send someone to Mars is not necessarily a success simply by the fact that someone went to Mars. In reality, government R&D is questionable at best. In their book, TECHNOLOGY PORK BAREL, professors Cohen and Noll conclude that “that the goal of economic efficiency — to cure market failures in privately sponsored commercial innovation — is so severely constrained by political forces that an effective, coherent national commercial r&d program has never been put in place” and “American political institutions introduce predictable, systematic biases into R&D programs so that, on balance, government projects will be susceptible to performance underruns and cost overruns.”

2. Tax policy should be simple, predictable, and not based on envy based class rhetoric. Also, Keynesian remedies emphasizing demand at the expense of saving should be avoided. As economist Steven Horwitz has said, “we only have the power to consume if we have produced and sold something in order to acquire the means to engage in consumption. Starting the analysis with consumption assumes one has already acquired means. Contrary to that analysis, wealth is created through acts of production that rearrange resources in ways people value more than alternative arrangements. These acts are financed with savings that come from households refraining from consumption.”

3. We’re in agreement that crony capitalism including bubble inducing housing policy, low interest rates, & risk without consequences (“Greenspan put” & bailouts), etc., will result in financial collapse.

egarber said...

Hi Eric. Good stuff. Some replies below…

>>The problem with government R&D is that there are no ways to evaluate if they have a positive economic impact or not.

Says who? It wouldn’t be hard – and I’m sure it’s been done somewhere – to trace big product launches to R&D origins. In fact, in a lot cases with technology, public universities hold the patents. So I disagree; there are plenty of ways to evaluate it. As further proof, you’ll find very few investors who think public R&D should go away.

What’s *not* falsifiable is the notion that the same long-term breakthroughs would have occurred solely with private investment. I’m more comfortable concluding that short-term profit motive is a limiter in this area, not an enabler.

>>.Anecdotal “success” stories do not demonstrate how much waste and crowding out was involved.

This comes across as an ideological characterization. Please demonstrate for me empirically how public investment is “wasteful.” Given my explanation above, I think it’s the exact opposite.

>>Siphoning hundreds of trillions of dollars from the private sector to send someone to Mars is not necessarily a success simply by the fact that someone went to Mars.

My moon race example was to point out that even when applied research isn’t the goal, there is tremendous incidental benefit associated with certain public investments. We obviously didn’t go to the moon to stimulate the economy, but it had that effect nonetheless. When growth and innovation are the direct goals of investment, that impact is greater.

>> Tax policy should be simple, predictable, and not based on envy based class rhetoric.

I agree. That’s why to me, the progressive code is about efficiency, not class warfare. In fact, given that in a graduated framework everybody is taxed the same amount on the same dollar earned, the class warfare charge is misplaced, imo. Higher *ranges* of income are taxed more because that’s the most efficient model – i.e., people at the bottom spend more of their income on basic needs, so it’s logical their rates are lower. And it’s much more stimulative that way as well.

>>Keynesian remedies emphasizing demand at the expense of saving should be avoided.

Lay out for me what would have happened had the government gone into austerity mode when the stimulus package was passed. Individuals were starting to save, sapping the economy of its aggregate demand. If the government had likewise pulled back, we would have spiraled into a deflationary downturn, creating (potentially) multiple lost decades.

>>Contrary to that analysis, wealth is created through acts of production that rearrange resources in ways people value more than alternative arrangements. These acts are financed with savings that come from households refraining from consumption.”

There certainly is some truth to this statement, but the absolute form of it is treacherous, especially in a downturn. Japan’s high savings / low consumption culture created a prolonged deflationary environment. To me, long term sustained demand from the bottom up – fueled by efforts to create financial stability for hard-working families – is the real catalyst for growth and innovation.

Eric said...

Oh, and thanks for the polite exchange. Often, these types of discussions degenerate into partisan name calling.

Eric said...

"process can along prolong" = "process can ONLY prolong"

Eric said...

Dorf has decided to delete my response, so farewell.

Michael C. Dorf said...

Eric,

I certainly did not delete your reply. There appears to be some Blogger glitch. I received the comment to which you refer by email but I see that it's not on the blog. But rest assured that I didn't delete it. (I never delete comments that disagree with me, another blogger, or a commenter. I only delete extremely personal attacks, and even then, only sporadically.) And only I have Administrator privileges, so it had to have been a computer issue. In the next comment, I'll re-post your comment from the email I received.

Michael C. Dorf said...

Here's the comment from Eric that disappeared mysteriously:

1. The waste stems for the basic economic principle that money is managed more carefully in the hands of original owners than through third parties who have received funds through coercive transfers. At its most basic level, the idea is that you’re likely to spend your money more wisely than if I spent money that you were compelled to give me. Who is correct if I think it's best that you spend your money on transportation but you want to spend it on food? On a national level, is the money better spent by taxpayer’s or by political means subject to rent seeking and interest group dynamics? The answer should be obvious and explains why “waste, fraud, and abuse” is characteristic of government spending and R&D is no exception. The proposition that a government breakthrough is good because it is a government breakthrough is circular reasoning and entirely subjective. The fact that I think it's better to spend your money on a car compared to your choice of preferring housing or food does not make it right.


2. The progressive tax code is a compliance monstrosity full of loopholes that the wealthy know how to navigate. Drastically simplify to get better compliance and higher revenues.

3. Government stimulus further distorts markets that are trying to reach a healthy equilibrium. Preventing this process can along prolong unemployment and the ability of markets to function properly. For empirical evidence for stimulus failures see John Taylor’s piece in the WSJ that says “The bottom-line is the federal government borrowed funds from the public, transferred these funds to state and local governments, who then used the funds mainly to reduce borrowing from the public. The net impact on aggregate economic activity is zero, regardless of the magnitude of the government purchases multiplier.”

4. Interest rates determine what the ideal proportion of saving and spending should occur. Price fixing by the Federal Reserve leads to distortions and malinvestments. See this piece regarding Japan that should sound earily familiar (but hopefully not prophetic):


http://www.econlib.org/library/Enc/Japan.html

"The policy remedies that Japan’s government has tried have all focused on increasing aggregate demand. The real problem with the Japanese economy, however, is a mismatch between the structure of production and consumers’ specific demands. The structure of production was distorted away from consumer preferences when the post–Plaza Accord monetary expansion artificially depressed interest rates, thus signaling investors to undertake capital-intensive and long-time-horizon projects. When the monetary expansion stopped in the early 1990s, the boom collapsed. The Japanese government’s interventions in the economy have hampered the market’s correction process by maintaining the existing structure of production against consumer wishes, thus delaying economic recovery."

egarber said...

>> Oh, and thanks for the polite exchange. Often, these types of discussions degenerate into partisan name calling.

Of course. No worries. This blog is about substance -- to the creator's credit.


>> The waste stems for the basic economic principle that money is managed more carefully in the hands of original owners than through third parties who have received funds through coercive transfers.

But are there no needs that are purely public in nature, and thus more efficiently handled in that sphere? Are you saying police protection would be managed more efficiently if each American family contracted its security needs with private providers? Should we dismantle public education? Should each American family test its own food for safety? Should public universities and the National Institutes of Health be eliminated?

Where is the proof that your “basic economic principle” (money is better managed by original owners) would create better results in these long-horizon areas? How do private players, following their narrow interests, do all the long-term things necessary to carry out the *public* interest, where the return on investment is at the aggregate level?

According to your theory, it seems the credit default swap implosion should have never occurred – after all, investors were just “handling their money without coercion.” But alas, investors' individual interests – following the herd for profits – left no room to prevent the entire operation from collapsing.

Having said all that, I’m with you when it comes to bringing products to market, because the government has no proper role to play there. But other areas – R&D, affordable healthcare, physical and social infrastructure – are uniquely public in their character, and thus beyond the skill set, perspective and motivation of purely private players.

Even Hayek acknowledged as much, when he wrote in the Road to Serfdom that a national system of social insurance is perfectly compatible with free market principles. He said that such investment supplements the wider market economy – it doesn’t compete with it. Obviously, his scope is narrower than mine, but the core idea is the same: there are times government will be more uniquely suited to play a critical role.

Charles T. Wolverton said...

Some elaboration on item 2 in egerber's comment (which I consider to be "excellent").

Attributing motivation for job-creating, high-tech entrepreneurship to lower marginal tax rates on income seems naive. As far as I know, the founders of such companies typically don't need to worry much about personal tax rates. Their wealth comes mainly from capitalization, so that in principle they need pay little or no taxes: eg, sell stock to obtain cash as needed, pay taxes at (what should be called) the "realized capital gains rate". Presumably one reason why Buffett can say that he pays taxes at a lower rate than his secretary.

Also, describing that kind of entrepreneurship as "risk-taking" ignores how such enterprises are typically financed and the likely future prospects of even those whose companies fail. (And as anyone familiar with high-tech start-ups knows, "fail" isn't necessarily equivalent to "unprofitable for the founders and early employees".)

In addition to the "astute" observation (sneer quotes only because it should be obvious to anyone) that tax rates can be on either slope of the (painfully simplistic) Laffer curve, it's worth addressing another mantra popular with the "government=bad" crowd: "Small businesses account for the majority of new jobs." A half-truth: they apparently also account for most job losses, so that the significant statistic - net job creation - is less impressive. There are also considerations of relative job security, wages, et al. Bumper sticker slogans usually ignore significant details. (A version of another popular piece of bumper sticker wisdom is describing self-interested concern about the stability of one's society due to rising economic disparity as "envy-based class rhetoric" - not only mindless but insulting. One can have such concerns despite needing to envy no one.)

Amazingly, many (most?) among the privileged elite seem largely incapable of recognizing (or at least acknowledging) that their prosperity isn't an indication of general economic health. Worrying about relative multipliers, disincentive effects, Laffer curves, etc, is a luxury only available to those who are neither jobless, assetless, nor hopeless. The cancers eating away at the US economy seem likely to need not the bandaids of the past but major surgery. Unfortunately, many already affluent surgeons seem to be on strike for even higher incomes - seemingly unaware that, as egerber observes, if in the meantime the patient dies their services will no longer be required.

michael a. livingston said...

If the debate here is about the best way to encourage innovation--whether through private sector tax breaks or direct public investment--that is an interesting discussion. If the suggestion is that the age of innovation is somehow past, or innovation is somehow overrated, that is a political argument with little basis in economic fact. Again, if public policy is being made on the basis of views like the latter, it is hard to see how things will get very much better.

egarber said...

>>“The bottom-line is the federal government borrowed funds from the public, transferred these funds to state and local governments, who then used the funds mainly to reduce borrowing from the public. The net impact on aggregate economic activity is zero, regardless of the magnitude of the government purchases multiplier.”

This isn’t accurate, in my view. The bottom line is that the government borrowed money from the global bond market, and invested in jobs domestically, staving off a further downturn. There clearly is a net impact on aggregate economic activity, because those borrowed funds would have otherwise languished within financial institutions here and across the globe. As Neil often says, the real question is whether the return surpasses (and justifies) the cost.

Eric said...

Thanks Michael & sorry I jumped to conclusions.

Eric said...

“But are there no needs that are purely public in nature, and thus more efficiently handled in that sphere? Are you saying police protection would be managed more efficiently if each American family contracted its security needs with private providers? Should we dismantle public education? Should each American family test its own food for safety? Should public universities and the National Institutes of Health be eliminated?”

I find public goods theory dubious at best. Absent revealed preferences in the marketplace, there is no way to determine how much of a particular good or service is to be supplied. Huge inefficiencies in the public sphere (Public schools, Post Office, courts, Medicare/Medicaid, etc.) are caused by a lack of a price system where profit and loss exits to determine what is and isn’t economically justified.

Florida State Professor economist, Bruce Benson, has done some important work in the area of police services and notes "If we look to history, we find that rather than the emphasis on government inputs to and dominance over crime control that we see today, the norm is completely or nearly completely private production of policing, prosecution, and punishment. Public police forces did not develop until the middle of the nineteenth century in the US and Great Britain, and crime victims served as prosecutors in England until almost the turn of the century. Publicly financed and operate prisons are also a relatively recent development, arising in England near the end of the eighteenth century and in the US even later."

Consider Ronald Coase’s answer to a question about the benefits of regulation:

Coase: This When I was editor of The Journal of Law and Economics, we published a whole series of studies of regulation and its effects. Almost all the studies--perhaps all the studies--suggested that the results of regulation had been bad, that the prices were higher, that the product was worse adapted to the needs of consumers, than it otherwise would have been…

Q: What's an example of bad regulation?

Coase: I can't remember one that's good. Regulation of transport, regulation of agriculture-- agriculture is a, zoning is z. You know, you go from a to z, they are all bad. There were so many studies, and the result was quite universal: The effects were bad.


Was this merely a coincidence of when Coase was editor or perhaps indicative of something more systemic concerning government intervention?


“Where is the proof that your “basic economic principle” (money is better managed by original owners) would create better results in these long-horizon areas? How do private players, following their narrow interests, do all the long-term things necessary to carry out the *public* interest, where the return on investment is at the aggregate level?”

In short, firms are in the business of making money and not going bankrupt. Short term plunder and narrow interests are characteristics of the political arena where participants are shielded from the threat of bankruptcy and in which responsible use of taxpayer money is a secondary concern at best.

Eric said...

“According to your theory, it seems the credit default swap implosion should have never occurred – after all, investors were just “handling their money without coercion.” But alas, investors' individual interests – following the herd for profits – left no room to prevent the entire operation from collapsing. “

The implosion was a symptom rather then the cause of the collapse (very low default rate prior to the collapse). What you seem to be implying is that greed caused the financial crisis, but since greed is a constant, it fails to explain why things changed for the worse the way they did. Some variables that did change include Federal Reserve action fueling the housing bubble, Fannie and Freddie policy, and capital regulations (Basel Accords). According to economist Jeffrey Friedman,

“The FDIC, the Fed, the Comptroller of the Currency, and the Office of Thrift Supervision issued an amendment to Basel I, the Recourse Rule, that extended the accord's risk differentiations to asset-backed securities (ABS): bonds backed by credit card debt, or car loans — or mortgages — required a mere 2 percent capital cushion, as long as these bonds were rated AA or AAA or were issued by a government-sponsored enterprise (GSE), such as Fannie or Freddie. Thus, where a well-capitalized commercial bank needed to devote $10 of capital to $100 worth of commercial loans or corporate bonds, or $5 to $100 worth of mortgages, it needed to spend only $2 of capital on a mortgage-backed security (MBS) worth $100. A bank interested in reducing its capital cushion — also known as ‘leveraging up’ — would gain a 60 percent benefit from trading its mortgages for MBSs and an 80 percent benefit for trading its commercial loans and corporate securities for MBSs. Astute readers will smell a connection between the Recourse Rule and the financial crisis. By 2008 approximately 81 percent of all the rated MBSs held by American commercial banks were rated AAA, and 93 percent of all the MBSs that the banks held were either triple-A rated or were issued by a GSE, thus complying with the Recourse Rule…

…By steering banks' leverage into mortgage-backed securities, Basel I, the Recourse Rule, and Basel II encouraged banks to overinvest in housing at a time when an unprecedented nationwide housing bubble was getting underway, due in part to the Recourse Rule itself — which took effect on January 1, 2002: not coincidentally, just at the start of the housing boom. The Rule created a huge artificial demand for mortgage-backed bonds, each of which required thousands of mortgages as collateral. Commercial banks duly met this demand by lowering their lending standards. When many of the same banks traded their mortgages for mortgage-backed bonds to gain "capital relief," they thought they were offloading the riskiest mortgages by buying only triple-A-rated slices of the resulting mortgage pools. The bankers appear to have been ignorant of yet another obscure regulation: a 1975 amendment to the SEC's Net Capital Rule, which turned the three existing rating companies — S&P, Moody's, and Fitch — into a legally protected oligopoly. The bankers' ignorance is suggested by e-mails unearthed during the recent trial of Ralph Cioffi and Matthew Tannin, who ran the two Bear Stearns hedge funds that invested heavily in highly rated subprime mortgage-backed bonds. The e-mails show that Tannin was a true believer in the soundness of those ratings; he and his partner were exonerated by the jury on the grounds that the two men were as surprised by the catastrophe as everyone else was. Like everyone else, they trusted S&P, Moody's, and Fitch.”

Eric said...

“Having said all that, I’m with you when it comes to bringing products to market, because the government has no proper role to play there. But other areas – R&D, affordable healthcare, physical and social infrastructure – are uniquely public in their character, and thus beyond the skill set, perspective and motivation of purely private players.”

Government has been involved with these for years with predictable consequences such as exploding costs, deterioration & neglect, fraud, etc. In fact, government healthcare threatens to take down the entire economy if serious cost controls aren’t implemented. Government does have skill set but it’s not one of efficiency and cost control. :-)

P.S. Apologize for the long post. Lots of ground to cover.

egarber said...

Eric,

It looks like we have many areas where we’ll need to agree to disagree.

One final thought though:

With regard to the financial implosion, the notion that Fannie / Freddie were somehow behind the run up has been proven false. By their charters, FF weren’t allowed to take on toxic debt; they only acquired some of the nastier stuff later on, when the damage was already done.

The subprime securitization run-up was almost exclusively carried out by private underwriters. New innovations led to increasingly complex CDO structures –- and private ratings agencies gave high marks to even the most toxic tranches. From there, the bond insurers got involved, creating and trading credit default swaps that became a time bomb on the books of AIG and others. Once the magnitude of counterparty risk become apparent, the country’s credit system locked up.

Another claim floating around is that the CRA forced banks to issue subprime loans. This has also been debunked. None of the subprime lenders at the heart of the mess were even subject to the law, which in any case called for quality standards when loans were issued in poor areas.

The secondary markets on Wall Street were hungry for securities, and lenders were only too willing to feed them; since those front-line banks quickly resold loans (taking them off their books), they had little incentive to ensure creditworthiness when handing out money. This is all a perfect case study in the agency problem: nobody had enough skin in the game to own the risk.

So the implosion was the result of private financial innovation, all taking place in a weak regulatory environment. I therefore think it is indeed a good example of how the “invisible hand” only extends so far. In this case, it failed to prevent private players from destroying their own livelihood.

Eric said...

"With regard to the financial implosion, the notion that Fannie / Freddie were somehow behind the run up has been proven false. By their charters, FF weren’t allowed to take on toxic debt; they only acquired some of the nastier stuff later on, when the damage was already done. The subprime securitization run-up was almost exclusively carried out by private underwriters."

I’m not sure this is entirely accurate:

http://www.cato-at-liberty.org/krugmans-fannie-mae-fantasyland/

“What evidence he does (Krugman) offer is to show that during the boom, the percent of the market that was securitized by Fannie/Freddie fell, while the percent securitized by the private-label market increased. Krugman has that fact correct, yet he misses a critical point. That increase in private-label securities was being funded/purchased by Fannie and Freddie. As my chart illustrates, the more involved were Fannie and Freddie in purchasing subprime MBS, the more the subprime market grew. During the bubble years, Fannie and Freddie were the largest single source of liquidity for the subprime market. And the chart doesn't even take into account all the subprime whole loans being purchased by the GSEs.”

“Another claim floating around is that the CRA forced banks to issue subprime loans. This has also been debunked. None of the subprime lenders at the heart of the mess were even subject to the law, which in any case called for quality standards when loans were issued in poor areas.”

Calabria again:

“First, he (Krugman) argues that the bad lending was done not by banks covered by CRA, but by non-banks that were exempt from CRA. Now in Krugman's defense, there is a grain of truth to this. For instance, up until its purchase of a thrift, Countrywide, the largest subprime player, was not covered by CRA. However, comparing Countrywide to say Bank of America, which was covered by CRA, misses a crucial point: these non-CRA lenders were selling their loans to Fannie and Freddie, who were getting housing goal credit for those loans. For instance, 25% of Fannie's whole loan purchases were from Countrywide. So rather than, as Paul claims that CRA didn't matter, what the comparison shows is that the GSE housing goals were more damaging than CRA...

…We have little hope of avoiding a future financial crisis if we do not undo all the perverse government incentives for irresponsible lending. Krugman's presentation of selective and misleading data only makes true and meaningful reform all the more difficult.”

Eric said...

"Attributing motivation for job-creating, high-tech entrepreneurship to lower marginal tax rates on income seems naive."

Recommended reading:

http://www.econlib.org/library/Enc/MarginalTaxRates.html

“Economic Growth' by Robert J. Barro and Xavier Sala-i-Martin (MIT Press, 2004, p. 514) lists among the world’s twenty fastest-growing economies Taiwan, Singapore, South Korea, Hong Kong, Botswana, Thailand, Ireland, Malayasia, Portugal, Mauritius, and Indonesia. As Table 1 shows, all these countries either had low marginal tax rates to begin with (Hong Kong) or cut their highest marginal tax rates in half between 1979 and 2002 (Botswana, Mauritius, Singapore, Portugal, etc.). This might be dismissed as a remarkable coincidence were it not for a plethora of economic studies demonstrating several ways in which high marginal tax rates can adversely affect economic performance.

Numerous studies, ably surveyed by Karabegovic et. al. (2004), have found that high marginal tax rates reduce people’s willingness to work up to their potential, to take entrepreneurial risks, and to create and expand a new business: “The evidence from economic research indicates that ... high and increasing marginal taxes have serious negative consequences on economic growth, labor supply, and capital formation” (p. 15). Federal Reserve Bank of Minneapolis senior adviser EDWARD PRESCOTT, corecipient of the 2004 Nobel Prize in economics, found that the “low labor supplies in Germany, France, and Italy are due to high [marginal] tax rates” (Prescott 2004, p. 7).

… People react to tax incentives for the same reason they react to price incentives. Supply (of effort and investment) and demand (for government transfer payments) respond to marginal incentives. To increase income, people may have to study more, accept added risks and responsibilities, relocate, work late or take work home, tackle the dangers of starting a new business or investing in one, and so on. People earn more by producing more. Because it is easier to earn less than to earn more, marginal incentives matter.

To the extent to which a country’s tax system punishes added income with high marginal tax rates, it must also punish added output—that is, economic growth."

egarber said...

I never cited PK as a source. The FF claims have been much more widely vetted than that. In their primary role, FF don't buy securities; they buy mortgages directly from lenders and create guaranteed (high quality) securities out of them. Like I said, they bought some of the nasty stuff for their books later on, but this is a sideshow. In the main, Wall Street investors and financial institutions bought up the trash in the secondary markets -- that's why the big banks needed the bailout. And it's why the Fed opened discount windows for banks (not FF), who could offer toxics as collateral. Further, none of this even touches on the CDS disaster.

Likewise, look broader on the CRA in your research. My sources are varied -- including Businessweek and Forbes.

Eric said...

But as Friedman says above, "By 2008 approximately 81 percent of all the rated MBSs held by American commercial banks were rated AAA, and 93 percent of all the MBSs that the banks held were either triple-A rated or were issued by a GSE, thus complying with the Recourse Rule."

This is hardly an example of reckless trash purchasing.

egarber said...

>>That increase in private-label securities was being funded/purchased by Fannie and Freddie.

From everything I've seen, this statement is patently false. Wall Street fueled that boom, just as FF's share of overall underwriting fell to the floor. Private underwriters and secondary market purchasers dominated the subprime run-up.

egarber said...

>>By 2008 approximately 81 percent of all the rated MBSs held by American commercial banks were rated AAA,

yes, and like I said -- private ratings agencies were a big part of the problem. They failed in their area of expertise: risk assessment. Of course, they are paid by the very issuers they rate, so conflict of interest concerns pervade all of this.

I never said investors knowingly lost money at the time. Nobody would do that. I'm arguing that the private system failed, a clear indication that there's a unique place for public policy and care (back to why we started talking about the implosion in the first place).

Been fun. I'll try to stay quiet now. :)

Eric said...

Well, I found another passage where Friedman states, "Bankers who were indifferent to risk because they were seeking higher return, hence higher bonuses, should have bought the lower-rated tranches universally, but they did so only 19 percent of the time. And most of those purchases were of double-A rather than A, BBB, or lower-rated, more-lucrative tranches."

Feel free to provide another source.

Eric said...

"private ratings agencies" = SEC created oligopolies.

Charles T. Wolverton said...

eric -

If you provide a cite, there's no need to copy the content thereof. We all know how to click on a hotlink - which I always do, especially with those who argue via random quotes.

As I think was clear, my point was that for a certain class of entrepreneurs, marginal tax rates on income seem unlikely to be the prime motivator. If their companies thrive, they will become wealthy owing to capitalization of their ownership shares, not careful husbanding of their pretax incomes.

Hence, the cite about lowering marginal rates tells me nothing. What could possibly be the relevance to my point of the fact that starting in 1979 a bunch of minor countries lowered their marginal income tax rates from extremely high levels (50-89%)? The US realized capital gains rate has been relatively low for as long as I can remember, and that's the rate relevant to my point. In any event, it seems quite unsurprising that a reduction from near-confiscatory marginal income tax rates might well reap a variety of desirable results. But that's the point about the Laffer curve (after all these years I just now noticed the perfectly appropriate homophone) - ignoring any other defects in the concept, in assessing the supposed effects of lowering rates it's rather important where one is on the curve.

The author continues by pointing out that effective marginal tax rates on the very poor can rise to very high levels because of offsets due to benefit reductions, thereby disincentivizing marginal income increases. Again, what could possibly be the relevance to the behavior of high tech entrepreneurs?

The author concludes by offering a potpourri of seemingly disconnected observations about incentives and disincentives, finishing off with a few gems like: "People earn more by producing more." Trite, but not necessarily true.

On another issue, like egArber (sorry for the previous misspelling) I've read refutations of the claims against the CRA from several sources - as well as the claims themselves from several sources. I have no special insights into the issue, so can't referee the dispute. But someone not from an ideological org like CATO making the claims in some mode other than Krugman-bashing would be more credible.

Michael C. Dorf said...

Wow! What a great set of comments. I'm just popping back to tell Eric, no problem. Blogger is very easy to use, but it's sometimes hard to figure out how it works on the back end--at least for me!

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