What I am Reading

1. Michael Shermer, The Moral Arc. I am only a few pages in, and he already has cited Bill Dickens and Bryan Caplan, among others.

2. Jeffrey Friedman and Wladimir Kraus, Engineering the Financial Crisis. This is a re-read for me. They share with me the view that risk-based capital rules contributed heavily to the crisis. They make a very subtle point, though. They do not believe that bankers went all-out to maximize the effective leverage of their banks. Thus, the authors reject the moral hazard arguments of deposit insurance and too-big-to-fail.

The way I would put their argument is this. Suppose that bank managers were, for whatever reason, actually quite concerned about risk exposure. They thought, even if incorrectly, that the value of keeping their franchises intact and avoiding trouble was very important. Even so, with the risk weights that regulators placed on different assets, the effective rate of return on mortgage securities was much higher than that on other asset classes, including low-risk mortgage loans. Thus, the risk-based capital rules, along with the lenient ratings by rating agencies of mortgage securities, served to steer capital into high-risk mortgage loans and thereby into feeding the housing bubble.

In making their argument that the crisis was in my terminology a cognitive failure rather than a moral failure, the authors point out that if bankers had merely wanted to maximize their exploitation of implicit and explicit guarantees, they could have acted differently. They could have held higher-risk, higher-return tranches of mortgage securities. They could have held less capital (before the crisis, major banks tended to have leverage ratios well below regulatory limits).

Apparently, Gregory Clark is Not Most Economists

Gillian B. White writes,

According to the Fed study, about 60 percent of black children whose parents had income that fell into the top 50 percent of the distribution saw their own income fall into the bottom half during adulthood. This type of downward slide was common for only 36 percent of white children.

…Still, most economists lack a clear, definitive explanation for why, after reaching the middle class, many black American families quickly lose that status as their children fall behind.

Pointer from Mark Thoma.

Obviously, she did not read my review of Gregory Clark’s latest book.

Clark suggests that this may reflect that the underlying mean for these ethnic groups may differ, and the higher propensity of middle-income blacks and Hispanics to have their children’s income fall to the bottom third might be due to regression toward a lower mean.

Suppose that you have two populations of men with different height-producing genetic characteristics. The mean height in group A is 5 feet, 9 inches, and the mean height in group B is 5 feet, 7 inches. There is substantial variation within each group.

Now, out of the current generation of men, you select men from each group who happen to be 5 feet, 8 inches. Track the height of their sons. It seems reasonable to predict that, starting with men who are 5 feet 8 inches, the sons of men from group A are likely to be taller than the sons of men from group B. This does not result from social prejudice against men from group B. It is the result of laws of probability.

The Tea Party, McBoehner, and ObamaCare

Tyler Cowen has referred a couple of times to a book by Philip Klein on Republican politics and health care reform. I am not a political analyst, but here is my impression:

1. The most important Republican divide is between the Tea Party and McBoehner. The Tea Party wants policies to change, and McBoehner want most of all to be Senate Majority Leader and House Speaker, respectively.

2. The Tea Party wants to overturn Obama’s policies on immigration and health care. McBoehner wants to loosen environmental regulations and tweak Dodd-Frank, because that is what their friends in business are telling them are priority issues.

3. I think that a conservative consensus on health care reform is there to be formed, but McBoehner are not the ones to form it. I think that the Tea Party is likely to be shafted both on immigration and on health care reform. That might make them a bit ornery during primary season in 2016.

Pete Boettke on Ideology and Economics

He writes,

Market fundamentalism is far from the mainstream of economic thought. The mainstream folks consider their work non-ideological and merely technical because they all share the same tacit presuppositions of political economy. It would be healthy if they looked through a different window, and spent some time reading those Nobel economists I mentioned above, or the Nobel worthy economists I mentioned as well.

Read the whole thing. I had a hard time choosing an excerpt. It also could use more fleshing out, in my view.

What Boettke is wrestling with is an asymmetry between mainstream economics and those of us with a free market bent.

Here is how I would describe the asymmetry. I think that the free-market types understand the main arguments of mainstream economists, but I think that mainstream economists only seem to deal with a straw-man version of free-market economics. Keep in mind, however, the Law of Asymmetric Insight: when two people disagree, each one tends to think that he understands his opponent better than the opponent understands himself.

I think that we on the free-market side understand behavioral economics. We understand asymmetric information. We understand market failure. Thus, we differ from the straw-man version of us that mainstream economists dismiss.

On the other hand, mainstream economists appear to me not to appreciate the two most important arguments that we have. One is the socialist calculation argument. My sense is that mainstream economists either do not believe that the socialist calculation problem is real, or they believe that it only applies to socialist dictatorships. In fact, any government program to spend, tax, or regulate will encounter the socialist calculation problem. That is, government planners face a fundamental information problem themselves. Knowledge is dispersed. What planners do not know is important, and indeed it can be more important than what they claim to know about market failure.

The second argument is the public choice argument. This is often over-simplified as “government officials act based on self-interest.” The deeper issue, which Boettke mentions in his post, is that markets and government should be looked at in parallel as institutions. The market process has certain strengths and weaknesses. Government has other strengths and weaknesses. The mainstream approach simply assumes away all weaknesses of the political process. Once an economist identifies a market failure and a policy to treat it, the next step if to play fantasy despot and recommend the policy.

Finally, I have to say that this is not mere abstract philosophy. The socialist calculation problem is real. It affects financial regulators, who in the period leading up to the financial crisis used crude “risk buckets” to alter the incentives of banks. That approach was woefully information-poor, and it created huge incentives for banks to do exactly what they did with risky mortgages. See Not What They Had in Mind. The socialist calculation problem affects every agency of the government, from the FCC to the FDA to the panel of experts who is supposed to determine which medical procedures to allow.

The institutional weaknesses of government are real. Read Peter Schuck’s book. You can get the flavor of it from his talk and my comments.

Now is a Great Time to Subsidize the Housing Market!

From the WaPo.

The White House announced Wednesday that the Federal Housing Administration will significantly lower the fees it charges borrowers, a move designed to save individual home buyers hundreds of dollars annually and help jump-start the housing market.

It’s always a great time to buy a home–just ask a Realtor™. Similarly, it is always good public policy to jump-start the housing market–just ask anyone in the housing lobby.

One of the best times to jump-start the housing market was the early 2000s. If you need to be reminded of that, attend this event featuring Peter Wallison. Recently, I reviewed his latest book.

My Review of Colander and Kupers

I write,

the authors seek to dethrone neoclassical economics. In terms of a metaphor that Colander articulated at a conference, neoclassical economics represents a high mountain peak in terms of insights into social phenomena. However, there is a higher peak to be found, and to reach that summit economists must first climb down from neoclassical economics and scale the peak of complexity economics.

My review attacks the authors for “their failure to stick to a single concept of government.”

The Great Depression as a Coordination Failure

In Fear Itself, Ira Katznelson shows how many intellectuals yearned for a planned economy, but without the ugly police-state repression of Fascist Italy or Communist Russia. As you know, I sense that Katznelson himself seems to still yearn for government oversight of the economy. In fact, Katznelson quote explicitly expresses disappointment that planning was superceded by what he called the “fiscal policy” approach (meaning Keynesian economics). Of course, I think that central planning is not the answer.

Katznelson disparages the Keynesians (and the monetarists) who came up with the aggregate-demand theory of the Depression. He clearly prefers the pre-Keynesian theory that the Depression was a breakdown of the capitalist system.

Here’s the thing. I agree with Katznelson.

The PSST story would look at the Depression as a coordination failure. The market price system, which is supposed to serve as a decentralized planning apparatus, screwed up. Old patterns of specialization and trade became unsustainable, and for a long time the market could not figure out new, sustainable ones.

The modern macroeconomic view is that the Depression was caused by a shortfall in aggregate demand, as opposed to a breakdown of the capitalist system. Instead, I prefer the pre-Keynesian diagnosis, although I do not believe that government officials could have done better by taking over more of the planning. To the extent that they attempted central planning through the NRA and various other New Deal initiatives, the results were certainly not good.

Hormones and Financial Intermediation

A recent post reminded me that Jason Collins really liked The Hour Between Dog and Wolf: Risk Taking, Gut Feelings and the Biology of Boom and Bust, by John Coates. Coates looks at how hormones are activated in traders. My guess is that I will get as much from Jason’s review as I would from the book. Jason writes,

In a bull market, testosterone surges through the population of traders. Each takes larger and larger risks, pushing markets to new highs and triggering further cascades of testosterone. Irrational exuberance has a chemical base.

Read the whole review. I would like to see the link between an individual short-term hormonal response and broad, long-term market trends established.

I do believe that there are cycles of financial intermediation. Remember how I think of financial intermediation. Households and businesses want to hold riskless, short-term assets while issuing risky, long-term liabilities. Financial intermediaries accommodate this by doing the opposite. When there is too little financial intermediation, opportunities to take reasonable risks are foregone. When there is too much financial intermediation, there is excessive risk-taking.

To a first approximation, I am not sure that simple trading of financial assets should boost testosterone on net, because financial trading is not positive sum. It’s not like “you want meat and I want shoes, so I’ll trade you meat for shoes.” Financial trading is closer to zero sum, which is why when you win you get high. The guy who sold you that stock that went up 5 points right after you bought it probably feels badly. So why should a bull market make more people feel high? Perhaps because as share prices increase, net financial intermediation is going up overall. That is, there are more short-term, low-risk liabilities being backed by more long-term, high-risk assets. Maybe that increased financial intermediation is accompanied by and reinforced by a hormonal response. Perhaps that is plausible, but it seems to me to require more of a stretch and, above all, more of a story of how markets react in the aggregate, or how System 2 and System 1 interact over long periods of time and across an entire array of market individuals and institutional relationships.

Jason Collins on Colander and Kupers

He writes,

Overall, Complexity and the Art of Public Policy is a good book. However, the last third of the book did not convince me that complexity theory arms us with many new policy tools. A complexity frame punches holes in many of our methods of analysis and the policy options we put on the table using standard economic frameworks. But the very nature of complex systems makes it a challenge to propose options that we can claim with any confidence to have positive effect. Roland and Kupers have ventured into that area – which I am grateful for. I was glad to read a complexity book with an attempt to give some policy relevance without yet another description of the El Farol Bar problem. But the particular examples they provided leave me of the view that the strongest contribution of complexity theory will be to tell us when our standard economic policy tools will work, and when they won’t. That’s no small accomplishment, but in a world where we need to “do something”, it’s not an easy sell.

I called it the best book of 2014, and I think hardly anyone agrees with me. However, I found myself often frustrated by its flaws, and Collins shares my frustration. I strongly recommend reading Collins’ entire piece. I agree with every sentence in it.

Ira Katznelson is this respected?

I just finished Fear Itself, his book on the Roosevelt-Truman years. My final reaction was, “Well written, interesting perspective, looks at political economy with about as much sophistication as Occupy Wall Street.” I looked him up to see if he had any connection to the Occupy movement, figuring he might be the sort of fringe professor who would get into it.

Boy, was I off. He is a major force in the academic world. Past President of the American Political Science Association. Current head of the Social Science Research Council. Fear Itself was recently awarded the Bancroft Prize.

I keep forgetting that it is people whose views of political economy resemble mine who are on the fringe in academia.

As for my disagreements with Katznelson, I barely know where to start. He acknowledges the consensus that Roosevelt’s National Recovery Act was a failure, but he has no idea why. He seems to think that it would have worked had it been better executed.

The view of most economists is that the last thing the American economy needed in the Depression was government-organized industry cartels, which is what the NRA was all about. In Randall Parker’s book interviewing economists on the Great Depression, even James Tobin said that Roosevelt was “lucky” that the Supreme Court invalidated the NRA. Of course, Tobin is a Keynesian, and Keynes is too far to the right for Katznelson, who is very sorry that “fiscal policy” took the place of “planning” as the main tool of government for managing the economy.

I found the book valuable. Actually better than any of the flawed books of 2014 (it was published in 2013). I plan to write a longer review, which will focus on Katznelson’s analysis of the politics of the period.

But right now I am sitting here dumbfounded that someone can attain such lofty professional status and be so clearly ignorant of Public Choice theory or the Knowledge Problem.

One possibility is that everyone is intellectually isolated nowadays. Everybody stays within their own bubble. But I doubt that. Conservatives and libertarians did not ignore Rawls. They did not ignore Piketty.

Instead, I think this reflects the ease with which someone on the left can obtain high status in academia, and the corresponding difficulty for those on the right. If you’re on the right, you have to demonstrate awareness of important left-wing academic ideas, or you will be will be widely denounced as an ignoramus. But the converse is not true. I would bet that I am the first person to dare to suggest that Katznelson suffers from ignorance.