Economist's Notebook: Prediction Markets

Economists LOVE prediction markets.  And why not?  Economists love markets and prediction markets have a pretty good track record.  But I am an economist and I find little to love about these markets when it comes to politics. Above you see the current price for an Obama victory on Tuesday at Intrade.  Currently, Intrade is pricing about a 84% chance of an Obama victory.  That seems to make sense given what the polls and pundits are saying today, but wait, what is this less than 50% chance in the middle of September?  Oh right, this is the post-convention bounce for McCain.  But if prediction markets are somehow "wiser" than individual polls or pundits (or even a collection of polls and pundits) why has this mirrored them so closely?  Shouldn't these wise 'crowds' have figured in the temporary bounce?    

The reason for my view is simple: these markets are incomplete due to a lack of information and so while on average the mass participation should bring the variance down, individual markets are not telling us much that we don't already know.  Investors in these markets are not privy to special information, they are guessing what other people will do.  A recent look at the roller coaster that has been the Dow Jones Average this month should show you how good markets are at figuring that out.  

All this is to say that while I see why prediction markets can do better on average than individual polls, I don't put a lot of faith in any one market.  I think the 84% for Obama simply reflects the chatter as filtered by people who have money riding on it.  Or probably reflects more the abandoning of hope that McCain will win.  I think 84%, by any account, is far too high - reflects far too much certainty - for the first African American with a serious chance to win the white house.  

If I have made Obama supporters nervous, here is some comforting news: look at the spike in Merkley's price (below), he is now at 73!  That's pretty astounding for a race that is generally considered a toss-up.

One last thought, a friend and colleague at Dartmouth who - by right of living in New Hampshire - considers himself an expert on all things electoral, told me in June 2006 that there was no way Hillary would not be the Democratic nominee and his main piece of evidence was Intrade which had her at the time way up.  [For the record, I predicted Obama and denounced Intrade]  It is people like he that move the Intrade markets with little more wisdom than some obscure economics professor in Oregon who claimed to have a read of the zeitgeist of the this time in the US.

So, if I were a betting man (and I am not), I'd take the chance on McCain - you can buy him at less than 17!   

Beeronomics: Complements or Substitutes?

Over at Beervana, Jeff poses a question about the effect on craft brew sales if Budweiser's American Ale (which he proclaims is not half-bad) is a hit. Could it, he wonders, actually help sales of craft beers by bringing in new customers that would previously not look past macro-brews? Does this theory make sense economically? Well, yes.

Maureen Ogle points out that this idea is not new to the business of, shall we say, 'sophisticated foods.' That Starbucks appears to help nearby coffee shops instead of hurt them.

First the economics. It is pretty obvious to everyone that there are two competing forces at work here - the expansion of overall demand and the capturing of that demand by particular brands. In cases where the niche demand is a small part of the overall demand for the basic category (beer or coffee in our two examples) one might expect that the increase in overall demand to outpace the capturing of the market, especially at first. In economics terms, is American Ale a complement to craft brews or a substitute? Here are some thoughts:

One wonders is what the end game is. Budweiser has huge advantages in scale, supply chain, distribution and marketing: once the demand for taste in beer hits its zenith, what next, do brewers start competing heavily on cost. If so, this is where Bud wins. However, if the entire demand expansion is based on the idea that beers are distinctive and diverse, it will be hard to dominate with a single beer.

I think that while Bud AA might lead to a vast increase in overall demand for craft brewed ales, it will probably have a bigger impact on beers that have gone for the mainstream, like Fat Tire, with which AA compares favorably, according to Jeff. It is their part of the demand curve that is most contestable by a large brewer.

If American Ale is not an immediate hit for Bud, and I am guessing it will not be, will the marketing types and bean counters at AB have patience and allow it to gain traction, or will the profit motive be so strong that they will abandon it quickly? I give it 50-50 odds.

In the current economic climate, it is a hard time to turn Bud drinkers on to a more expensive beer, will Bud keep prices low to allow it to sell?

Finally, a large part of the craft brew demand is from folks who relish being 'in the know' and cherishing the latest iconoclastic small brewer, will this scuttle Buds attempt to crash the party?

Time will tell...

Apropos of nothing: I picked up a bottle of Elysian's Immortal IPA the other day and noticed, when I cracked it that it was contract brewed by New Belgium. Thus it has the curious distinction of being both the best beer New Belgium brews, and a terrible purchase for a Northwesterner concerned with the carbon footprint of his purchases.

Election 08: Measure 65

If you are like me, this measure is the one that has delayed me sending in my ballot. I just can't decide how I feel about this and as an economist, there is not a whole lot in economic theory that seems to help. But here is my best attempt. Comment away.

The basic premise of the species homo-economicus is that we are essentially rational utility maximizers. This creates a problem if we think about the marginal impact of a single vote (basically zero) versus the cost of voting (not zero). But if we expand our understanding of the typical voter's utility function, it is not hard to believe that a sense of civic duty, a desire to play a part no matter how small, etc. creates benefits beyond just the ability to determine the outcome of elections. So the basic theory is pretty simple - the voters that determine elections are the ones in the middle and the politician that can appeal to the greater fraction of these middle voters will win.

This makes a lot of sense if you take as given that most people will vote or at least that the proportion of people that will vote is relatively constant throughout the political spectrum. But this assumption is not valid. So economic theory has to incorporate the fact that there are particular issues that will motivate particularly non-centrist voters and will change the proportion of populations that actually vote throughout the political spectrum. This assumption appears empirically valid. The success of Rovian political theory seems to show that voters can become more motivated through political appeals to the things that they care deeply about.

To this I'll add the somewhat controversial claim that we are, to ever increasing degrees, self-segregating along political lines. Take Oregon; the increasing proportion of registered Democrats in the state and the overwhelmingly democratic Willamette valley seem to suggest that Oregon is destined to become heavily democratic.

So what would an open primary look like in such a state? Well in an open primary, standard political economic theory would seem to suggest that the fighting would be over who could be the most popular center-left candidate. But with more than one of these battling over, say 60% of the votes, one could easily imagine one or two center-right candidates finding a relatively easy path to the final. A more modern theory might predict a number of hot-button issue candidates trying the mobilization strategy which, if successful could leave the center behind in a general election.

I have seen arguments that we shouldn't worry because in the state of Washington every single open primary they have had has led to a Democrat v. Republican general election. Is this good news? If it is then we should not change things because the current system delivers basically the same thing. Is it bad news? Well imagine a general election with two democrats. What would be the optimal strategy: pander to the base and mobilize, or try and capture the most right-leaning votes you can. I can imagine both could be winning strategies. Also, the fact that Washington has yet to have a same party general election may simply be the artifact of a two party system that is one, well-financed, and two, deeply ingrained in the psyches of voters.

So here is the rub - does this make our political process more fringe driven or less and does it matter? I think the answer to the first question depends on the marginal impact of mobilizing the base relative to the marginal impact of capturing the middle. I worry that as we become more self-segregated the marginal impact of mobilizing the fringe will begin to dominate. I think the answer to the last question is yes, it does matter. The health of a representative democracy, I believe, depends directly on how effectively the interests of the entire society are represented. And I guess I am as yet unconvinced that our two party system, for all of its obvious faults, is not the best way to ensure this happens. I know that this is an academic's response, but I think I'll wait for more evidence before I vote for a change.

But ask me again tomorrow.... any thoughts that could help me out?

Round up of the Bad and the Worse in Economic News

Where to begin? How about with Portland housing:

The Case Shiller numbers for August:



So, we are still not Las Vegas and still a little better than the national average, but the number for August was 171.93 which is a considerable drop from the 174.21 the month before. To put it in perspective, on average, Portland homes have shed all of the value gains they amassed since March 2006. So, as always, we are not immune, but are in better shape now because we were late to the party. And again, the usual caveat of remembering that averages conceal lots of neighborhood-level variation. Overall, though, the US is not doing well by this particular metric.

Is there hope that we shall soon see appreciation again. Well, the mortgage market, which was one of the few bright spots in the credit freeze after the Fannie and Freddie rescue, is still pretty good, but no longer below 6% for a 30 year fixed. So that's not as good as it was.



What of other credit markets? Well, after some improvement following the world's government and central bank interventions, the progress has stalled. Here is the TED Spread:

It dropped a lot but is now hovering just below 3 percent which is very high historically.

Other bad news? Well the consumer confidence is the worst on record. GM and Chrysler want billions so they can tie their two sinking ships together to stay afloat (come again?). Iceland is sinking.

So now we wait for the Fed to announce new rate cuts, but they are getting close to the zero bound - the point at which spooked would-be investors actually pay for the safety of Treasuries (think Japan).

Isn't there any good news? Well the Trail Blazers begin their season tonight and their future looks very bright.

Go Blazers.

Why You Should Never Marry an Economist

A phone conversation this week...

Wife: [Our son] was impossible this morning, I had to threaten to take away [his favorite toy].

Me: Did it work?

Wife: Well, yes but...

Me: See, it's all about the incentives...

Wife: It is NOT all about the incentives, it's terrible, I hate having to resort to threats!

Me: You can't get frustrated, its human nature to respond to incentives, you have to embrace incentives, INCENTIVES BABY!

Wife: Arggh!

(This is the moment where I usually try and change the subject)

Me: What a beautiful day, eh?

...I can never quite figure out why there are so many two-economist couples, I think I would find being married to me insufferable. 

Election 08: Measures 57 and 61

Economics has a lot to do with crime, and economists have long believed (and research has repeatedly shown) that incentives matter even to criminals. Both Measures 57 and 61 include mandatory sentencing requirements that stiffen the penalties for certain crimes while Measure 57 also includes treatment for addicts that commit certain crimes. As an economist, I have no doubt that increased sentencing will have some marginal effect on crime rates, partly through the effect of increased marginal cost of committing crimes and partly through the incapacitation effect: the keeping the criminals locked up effect. I am not, however, intimately familiar with the economics of crime literature, so I went poking around to see what the latest research says about it all.

In a classic study of the precipitous fall in US crime rates in the 1990s in the Journal of Economic Perspectives (2004), Steve Levitt (of Freakonomics fame) found that increased numbers of police and a rising prison population were two of the four main causes of the fall. He found that for every 1% increase in police the crime rate dropped about 0.5% He also found that for every 1% increase in the number of persons incarcerated, there was somewhere between a 0.1% to 0.4% drop in crime rates (depending on the type of crime). It is worth noting that here, as in most other studies of incarceration and crime, it is impossible to distinguish how much of that drop is due to the deterrence effect of incarceration (people not in prison who choose not to commit crimes for fear of being put in jail) and how much is due to incapacitation (criminals unable to commit crimes because they are behind bars). Nevertheless, Levitt concludes:

"...a Dollar spent on prisons yields as estimated crime reduction that is 20% less than a dollar spent on police."

So, if we are looking for good public policy to address crime, the evidence strongly suggests that police, not prisons are a more effective investment. Note that both increasing sentences and more police increase the expected cost of crime. Increased sentences increase the cost of crime conditional on being caught, and increased police increase the likelihood of being caught.

The other two main drivers of the reduction in crime were, by the way, the waning crack epidemic and the legalization of abortion (which I am not going to touch).

Levitt also studies juvenile crime in a paper in 1998 that was published in Journal of Political Economy and found one very interesting result: being punitive (very harsh punishments) on crime early in life, does not translate into lower crime later. This is a pretty strong statement: jail time, it appears does not 'scare off' or 'scare straight' criminals. However, Levitt cites anecdotal evidence that many juvenile offenders stop offending at the age of majority due to the increased punishments attached to crimes committed by adults. So, once again, incentives do matter.

What about treatment for drug addicts? Well here the economic literature is of little help so let me turn to the Kentucky Treatment Outcome Study, which appears to be a very well designed study of addicts in Kentucky that received treatment for alcohol and drug addiction. They found a 48.2% drop in arrests in the 12 months following treatment. Make of this figure what you will - it is still relatively short term, does not contain the counter-factual, etc. - it is a pretty powerful result in my opinion.

Finally, let me leave you with this last bit of research: Lochner and Moretti, in a 2004 article in the American Economic Review, found that a 1% increase in US male high school graduation rates save about $2,100 per male high school graduate in costs associated with crime. In other words, if we do a better job keeping kids in school, we should see big improvements in crime rates. Oregon, right now, is on the wrong track in this regard.

My conclusion from all of this is simple: wasting state money on incarceration is an inefficient way to address crime. Treatment is good, focusing on kids and education is better.

From the notes of a January OUS meeting citing OUS Chancellor George Pernsteiner:

[Oregon is] one of the few states in the U.S. with the following profile: in the 60’s we had one of the highest education levels in America, and America had the highest in the world. In every decade since, we have dropped; so that the 55 year olds are now better educated than the 45 year olds, the 35 year olds are now better educated than the 25-year olds. In a world that requires a higher level of educational attainment, we are not going in the right direction. There have been many reasons cited, one of which is funding. There will be data released later this week that shows we will slip from 45th to 47th for per student funding in America.

This is disgusting and unacceptable. What are we doing spending more money on prisons?

Beeronomics: Distributors and Double Marginalization

From the Beervana blog, Jeff Alworth points us to an interesting article in Reason magazine. Forgetting the political angle, the article does a good job of describing a quirk in the market for beer - laws requiring a distributor in order for a bottling brewery to sell beer in retail outlets. I have blogged about distributors before, arguing that there may be an efficiency argument for them. Today, I simply want to describe the economics behind this statement:

"For decades wholesalers have quietly added 18-25 percent to every bottle of beer, glass of wine, and shot of liquor you pour down your gullet."

This makes intuitive sense undoubtedly, but what are the economics of it all? It turns out this is a classic case of "double marginalization." Double marginalization occurs when you have two imperfectly competitive firms in a 'vertical' relationship. Vertical refers to the producer/retailer relationship generally, and in this case it is the producer/distributor relationship. Clearly beer producers are not perfect competitors, they do not sell a homogenized product for one, and neither are distributors that have exclusive rights to sell to retailers particular beers. [Note that if they were perfectly competitive, then there would be no problem as price would always equal the marginal cost of providing the beer for sale]

So what happens? Well the basic story is that both firms want to extract their profits and in so doing end up creating a retail price that is significantly higher, and a quantity that is significantly lower, than it would be if they merged (or if breweries could distribute themselves). Here is (I know you were hoping for one!) the graph:

In this picture the demand curve for the downstream firm, or distributor, (denoted d) is given in blue. [In this case we make the simplifying assumption that both firms are simple monopolists - but any market power is enough for the analysis to follow] This is the demand for beer from retail establishments which (since they are highly competitive) closely resembles the demand for beer in the market. Since the distributor is a monopolist they make their price and quantity decision where their marginal revenue (denoted MRd) equals their marginal cost (denoted MCd). Their marginal cost is the price they have to pay the brewer. From this quantity (qu = qd ) they would charge their margin which is the difference between MCd and Pd. Thus the distributor gets a profit equal to the dark red shaded area.

So where does MCd come from? Well, note that depending on what the brewer (the upstream firm = u) charges, the quantity demanded will be read off of the downstream firm's MR curve. Thus the downstream firm's MR curve is the same as the upstream firm's demand curve, creating an upstream firm MR curve. The brewer's MC curve comes from the cost of making the beer and so they set MRu=MCu and lo and behold, the quantity demanded from the brewer is the same as a the quantity sold by the distributor, qu = qd. The brewer's profits are given by the light red shaded area. So consumers would pay pd (assuming competitive retailers) and consume qu = qd beer.

Now let's consider what would happen if the brewery distributed itself (getting rid of the middle person). They would now face the blue demand curve, set quantity at q* and the price would be at p* = pu. The brewer's profits would now be both the light red and the blue shaded areas. So consumers would pay less (p* instead of pd), consume more and brewers would earn more profits.

Interestingly, I once had the owner of an Oregon brewery tell me that he/she likes distributors and thinks that they should remain in place. The owner said that the distributors were their advocates in retail establishments far and wide that they otherwise would not have access to. Perhaps then distributors provide a service not accounted for by this analysis. But if this is efficient, then doing away with laws requiring distributors should leave them in place.

I, for one, would love to see that experiment.

NB: "Marginal" refers to the extra cost or extra revenue from making and selling one more bottle of beer. Marginal revenue is below demand because for a monopolist, making and selling one more bottle means that you have to charge just a little less to get the last person to buy it. But this means that you charge that slightly lower price on all your beer, which dampens total revenue. So the effect on marginal revenue is amplified and thus MR is below D.

Credit Markets Thawing?

It appears so.  The TED Spread is now under 3, still quite high (in a healthy market it would be around 1), but much lower than the 4+ we were seeing in the height of the panic.  Also, the yield on 3 month treasuries (part of the TED) is up above 1 after plunging to 0.02 on September 17th and hovering around 0.2 recently.  

What do these mean?  Well the yield on T-Bills rising means that demand for them has softened suggesting that not all potential lenders are preferring to huddle around the safe warmth of Treasuries.  The TED Spread is going down because of this and because the LIBOR is also coming down meaning the supply of funds being made available for bank to bank lending is rising.  Remember that the LIBOR is a measure of the rate banks charge each other when they lend to each other. The TED Spread is the difference between the LIBOR and the rate on Treasuries and its being high means that all bank's extra cash is being put into Treasuries and not lent to other banks.  

This is good news and suggests that the efforts of the Fed, the other European central banks and the Treasury are finally showing some traction.  This will not correct the recession, but is a fundamental first step on the road to recovery. 

Beeronomics: Fresh Hop Ales

I spent yesterday evening at the Pilsner Room with my personal guide through all things beer, Jeff Alworth, sampling a variety of fresh hop beers, starting with John Hariss' Lupulins. Last year John (seen here) created a masterpiece using Amarillo hops. Those hops are unavailable this year and so he used the same recipe and made three different beers, one hopped with Mt. Ranier, one with the ubiquitous (and delightful) Cascades, and one with Nuggets. [This is a great way to experience how hops can dramatically change the character of the beer - and even the color I learned]  Jeff and I both were super high on the Nugget variety as we felt the typical Cascade floral notes were quite subdued in that one. We also had Deschutes fantastic Hop Trip, Double Mountian's excellent offering, Killer Green and, for a change in style, Hopworks' Octoberfest which is also excellent. What a great night. I have to say, I liked the Deschutes fresh hop ale the best, followed closely by John's Nugget variety and Double Mountain's Killer Green. However, that said, the best beer I had yesterday was a pint of John's sublime Prodigal Sun IPA that was being served on cask. Yum.

Speaking of Amarillo hops, John, who stopped by our table for a chat (his brewery is on the other side of the glass wall and there was some sort of Full Sail thingy going on because I spied Irene Firmat and Jamie Emmerson - he apparently doesn't realize one m is enough - and general noshing at a shrimp cocktail spread) told us that the reason there are no Amarillo hops available is that it is a proprietary hop and there is not that much in cultivation.  Apparently it started as a wild variant that was discovered on a hop farm and cultivated.   

Anyway, this is supposed to be beeronomics and as much as my gastronomic adventures are surely fascinating to all of my devoted readers, let's try and turn my drinking into field research so I can write-off my tab.

So what's the deal with all of these fresh hop beers?  Perhaps it is just a way to keep brewers from getting too bored, but I think there is more.  In many markets, limited editions, special varieties, alternate versions are thought of as a way to increase demand.  The idea is roughly this: for customers that have a strong demand for a product may regularly consume, say, one six-pack of Full Sail beer a week.  They may switch from pale to amber and so on, but their demand does not change from week to week.  You may be able to increase demand for these consumers from time to time by a special variety that will not last.  (It may also be the case that they will just forgo the regular six-pack for the special variety and no new demand will be created).  Creating buzz with new products is also useful to get the uninitiated to try a company's beers, to create or solidify a reputation for quality and creativity, and create another opportunity to get people to try 'bigger' beers and thus create more demand.

By the way, in economics the private incentive for firms that have products of multiple varieties is to produce too much relative to the socially optimal amount.  Why?  Well, the closer you get your product to the idea variety of a consumer, the more you can charge a consumer for that product.  But variety is expensive for producers, so overall the costs (and thus prices) overall will rise due to this variety.

John had an interesting insight when I mentioned the recession proof-ness (s0 far) of craft beer.  He observed that it may be the bottling breweries that are the recession proof part of the craft brew scene for the supermarket six-pack is not seen as that much of an extravagance, while brewpubs are more vulnerable because a night out in a brewpub where you pay $5 for a pint is probably much more of a splurge for many people.  We, I am afraid, will have a long and deep recession in which to test this theory. 

So hurry to the Pilsner Room to get your Lupulins before the recession really sets in...

Economist's Notebook: A Night in the Pilsner Room

What does an economist think about when he is enjoying some of the world's best beers in the company of good friends and the Red Sox on TV?  Here is a sample:

The server waiting on our table nearly left us mid-order to rush over to a table of businessmen who had just sat down.  Incentives matter: the likelihood that their tab would be substantially larger than ours was very high and it is therefore clear to me where she should expend the most effort.  Though Jeff and I hypothesized that we would tip a higher percentage - this based on our experience from running a espresso cart in the cafeteria of Good Sam hospital where it was the nurses who always tipped well while the doctors did not.

This led to my second observation about one of the great paradoxes in economics: why do people tip after they have finished a meal in a restaurant they do not frequent?  Economics struggles to explain such behavior.  It does not seem rationally self-interested.  Economists are forced to try and explain in the uncomfortable territory (for some) of social norms, psychic costs, etc.  But we know that in experimental situations the rational, purely self-interested behavior often fails to materialize.  Does this invalidate the very core of economic theory?  No, it just means that we haven't properly characterized the utility function correctly.  The danger, of course, is that by invoking such other motivations, we get uncomfortably close to tautology.  But it is only tautological if we resort to saying: people do whatever makes them happy.  It is not a tautology to say people care about other people's utility in their own.  This is refutable and testable.

On this note, I consider myself a well-trained economist, so what then to make of my reaction to the realization that the Pilsner Room has a 1/2 pound cheeseburger with fries on the happy hour menu for $1.95 (which must be the best deal in Portland)?  I wasn't particularly hungry, I try not to indulge too much in food that is terrible for me and, until I noticed the burger, was going to do the hummus plate for $1.95.  Now sure, the consumer surplus available to me from paying $1.95 for a 1/2 lb. cheeseburger was quite large.  But I wasn't hungry and yet the very idea that I could get a burger for such a low price not only made me want it more, but also reduced the pleasure I would have received from the hummus plate.  It all goes to show either that, one, I am not as good an economist as I think; or two, that relative comparisons matter.  This is an old idea in economics, that new Honda might make you giddy with delight until the neighbor comes home with an Acura, and suddenly your are not quite as giddy.

I had the burger.  It was great.

And now I think I understand why I don't get many dinner invitations...

Election 08: Measure 60

Ballot measure 60 proposes to mandate that public school teacher pay and job security be based solely on classroom performance and not on seniority.

Teachers are one of the most visible examples of an age old problem in economics: what we call the principal-agent problem. The crux is this: how do you write a contract that aligns the incentives of the agent (the employee in workplace situations) with the incentive of the principal (the employer). Another visible example of this (and the most studied in economics) is the CEO of a public corporation. The principles are the shareholders who generally care about dividends and long-term performance of the value of the shares. The agent is the CEO who cares primarily about his/her own compensation. These are often in conflict. For example, the CEO might want an extra $100 million in salary, but this would cut into firm profits and lower dividends and restrain share performance as well. At the same time, the firm needs a talented leader so paying nothing is equally bad.

How do you overcome this? Perhaps there is a way to write a contract such that the agent is rewarded for maximizing shareholder returns and thus the incentives of the principals and the agent are aligned. It was for this very reason that paying CEOs in stocks and stock-options became so popular. But it was imperfect: CEOs had a new incentive to run up stick prices by compromising the long-term health of the firm for short-term performance gains which would run up the share price and allow them to cash in on a huge payday. One example of how they did this is by cutting R&D to lower costs and raise profits. Good for now, but without R&D the future is less bright. Think of the current state of the US auto industry. This is the problem with these situations, it is often impossible to write contracts that perfectly align incentives and so we are forced to do as best as we can.

Now back to measure 60. Taxpayers and especially parents, as principals would like to be sure that the agents (school districts and teachers) have incentives to perform in the way we would like - to increase the amount of learning and development that our kids. This would be simple if measuring such learning and development were straightforward. Measuring the retention of facts and tools is easier - tests on history and math, say, can do an adequate job. Harder is measuring analytical ability, socialization, artistic ability and appreciation, personal growth, etc., etc. As a parent, were I only concerned that my son could recite the preamble to the constitution, then such tying such measures as standardized tests would be a good solution. But I am much less worried about his ability to memorize by rote then I am about his analytical and social development and I can think of no easy way to measure this.

As an economist, if there is one thing I believe in as virtually universal truth it is that incentives matter. So you might think that this measure would appeal. But 'incentives matter' cuts both ways, creating the wrong incentives will make things worse not better. Until good metrics are developed, tying teacher pay to 'classroom performance' is dangerous. Let's not turn our schools into General Motors.

Finally, in the absence of such metrics, what do I, as a parent, think is a good way to address the principle-agent problem? Well, in economics, one way to overcome it is through monitoring. I trust that with the amount of parent involvement in the classroom, oversight from the principal and parent-observed progress of their own children - problems in the classroom will be adequately addressed. Also, one of the natural incentives built into any job is that the better you are at it, the easier and more personally rewarding it is. Thus I assume that through self-selection and natural attrition, it is the more talented teachers who disproportionately populate our schools. I also believe that experience matters a lot. It can cut both ways, but I believe that there is a very strong correlation between experience and performance and so to cut the incentive to retain talented teachers by rewarding them for their tenure is also dangerous.

Election 08: Ballot Measure 63

So I shall finally take a breather from the national and international economics news of the day (it's bad) and at long last get to my economic analysis of the measures that shall grace our ballots this fall. Where to start? Well, I'll just piggyback on the main editorial in today's Oregonian and talk about measure 63. This measure proposes to exempt from the permitting process any home construction project with a total value that does not exceed $35,000.

I shall frame the question thusly: does government regulation of residential home improvement through building permits make good economic sense? The simple answer is yes: there are externalities involved making the cost of improper construction not strictly private and potentially quite significant.

Perhaps the best way to begin is to set something straight at the outset: free markets work their magic when the costs and benefits of the activity the market is involved in is purely private and accrue to only the participants in the market. Such a market probably doesn't exist and so the relevant questions are: what is the nature of the market failures; and, are they significant enough to intervene in a market, which almost assuredly guarantees a second-best outcome (compared to the ideal)? It is pretty clear from recent events, for example, that credit markets have significant spill-overs and the inefficiency that would result from increased regulation and oversight is probably worth it.

One could argue that the externailites associated with poor construction are minimal compared to the bureaucratic drag on investment that comes from building permits. For instance, the likelihood that if my house catches on fire thanks to an improperly installed gas stove and then catches your house on fire is pretty small. But the fact that there is a higher probability of houses catching on fire in an environment where there is no oversight does impose a cost on me through increased insurance premiums, increased cost of fire prevention and suppression, increased burden on public health for those whose house burned down with them in it, etc., etc. There are also the ancillary costs of lost home equity due to the fact that my neighbor's house is now a heap of charred remains. This is all part of the the public good aspect of home ownership: while houses are private property they do have external costs and benefits that accrue to the community in which they reside.

So the idea that there is enough private incentive to make sure work is done right is not accurate. The true cost of improper construction is quite a bit higher than the personal cost, and thus there is a clear incentive to cut corners. This is especially true for 'flippers' who, once the house is sold, have little fiduciary responsibility to the buyers. The incentive to cut corners would be that much greater.

This gets to another problem that arises in the resale market: asymmetric information. While it is true that there can be plenty of construction that happens illegally, the permitting process is a way to reduce the information asymmetries between buyers and sellers of houses. This asymmetry can be quite damaging to the efficiency of the market and, ironically, hurts the people who don't cut corners the most.

What about the cost of the bureaucratic intervention? Well, for starters, the building permitting process for all other projects will remain in place so the marginal cost savings are likely to be low in terms of the size of the bureaucracy. What about lost investment in building projects? This is impossible to say for sure, and I have no doubt that there is lost investment, but I can't imagine that it is anywhere near the magnitude of the social cost of unregulated construction. I stand ready to be corrected however.

People often mistake economics as being about free markets (and a lot of other things). Not at all. Economics makes clear both the efficiencies of the outcomes of free and complete markets, but more importantly economics studies the implications of imperfect markets and helps figure out appropriate policy responses. This one is a no-brainer.

Beeronomics: Is Beer a Recession Proof Industry?

I blogged a lot about hops shortages and barley prices creating a perfect storm for craft brewers and now the economy has turned south at precisely the time that craft brewers are forced to raise prices. Big trouble right? Apparently not. And from here I outsource and refer you to a great article from the Wall Street Journal on the eve of the Great American Brewer's Festival which is held annually in Denver.

Here are the meat and potatoes:

Despite rising prices and a shortage in hops, craft beer -- beer made by small, independent and traditional breweries -- has grown 6.5% in volume and 11% in sales in the first half of 2008, roughly the same amount as the same period last year, Mr. Gatza says. According to the Brewers Association, in 2006 and 2007, 47 of the top 50 craft brewing companies grew in production to keep up with demand. So far this year about 42 of the top 50 are growing to keep up with demand, Mr. Gatza said.

One of the reasons for this continued growth despite the economic downturn is that craft beer is still one of cheaper luxury items people can buy, with most six packs cost less than $10, says Mr. Norgrove of Bear Republic Brewery. Bear Republic has seen business grow by more than 50% in 2006 and 2007, and is seeing healthy profits gain this year, he says. "We are in one of those industries that is really doing well. I don't want to say it's recession proof, but we are seeing steady growth."

Wow, sales are up 11%! One could possibly infer from this that craft beer, like macrobrews, are an inferior good (in the economics sense, not in the real sense). This means that as incomes fall, you actually consume more. The classic example of this are the potatoes in the aforementioned meat and potatoes meal. As incomes get tight the plate becomes more potatoes and less meat (and vice versa when people are flush). Perhaps craft brew becomes a substitute for fine wine, scotch and the like. Of course it is more likely that demand just continues to rise as more and more people wake up to the fact that beer doesn't have to taste like crap (pardon me - that is an economic term of art for "Bud"). Oh and what about those macros? Sales are flat, just like the keg the day after the frat party.* Anyway, read the WSJ article, as it addresses how brewers are coping with hops shortages and increasing input prices. Beeronomics indeed...

Oh and one more note about the GABF: Kudos to my old buddy and Ithaca Beer founder Dan Mitchell for coming home with two silver medals. Truth be told, the beer wasn't that great at the beginning, but it is good stuff now.

*I know that at Oregon State Frats the kegs are more likely to be Rogue. ;-)

Why Do We Need Financial Intermediaries in the Age of the Internet?

This is something I have been meaning to blog about for a while, and of course, waiting has meant that others have beat me to it. The internet has spawned a number of Peer-to-Peer (P2P) lending sites. These sites borrow a page from the microfinance organizations in developing countries that have moved onto the internet. For example, sites like Kiva where individuals can lend to fund small entrepreneurial projects by individuals in developing countries. Savers can act directly as lenders without any financial intermediary. This is a hard thing to do in general, because it is hard to find people and projects to lend to. There are also problems of asymmetric information (borrowers know more about their probability of default than do lenders) and moral hazard (borrowers have an incentive to be more risky when it is someone else's money). Financial intermediaries (like banks) can overcome these problems through access to lots of borrowers through retail outlets and the like, numerous resources to get information about the borrowers (credit scores, work history, etc.) and through the diversification of risk so that the money they accept on deposit is almost completely safe (and definitely so with FDIC insurance).

But now there is another way for savers to earn interest on their money and a way that while involving more risk, earn higher returns as well. P2P tries to get around the problems by being on the internet for one, which is a remarkable tool to reach millions of people, requiring information about borrowers, and keeping track of repayment histories. There is a serious problem of adverse selection however. The people who go to P2P lending sites are probably disproportionately people who cannot get access to mainstream credit and many of these are people who cannot due to poor credit scores from a history of repayment issues. So though they try to tackle the problems, their ability to do so is limited. The loans are also generally small personal ones, insufficient for businesses and big personal needs like home loans.

Thus, though P2P is another great market that has sprung up due to a unfulfilled need, I don't think it will supplant mainstream banks anytime soon.

News and Notes: October 14

Oregon's Economy: Heavy job losses in September. This is why I had a hard time with the "burn baby burn" crowd that opposed government action in the face of a financial crisis. The truth about all economic crises (both in high and low income countries) is that it is always the most vulnerable - the poor and the working class - that are the hardest hit. No matter how bad it gets on Wall Street, the CEO of Merrill Lynch is going to do just fine, thank you very much. We can let it burn but those that will suffer most are the poor, children and the elderly.

Credit Crisis: so far so good for coordinated intervention, but don't take the rally on the world's markets as a sign that we will escape recession. We are most certainly in it now and it will be quite a while before we return to robust growth.

Commodities Prices: And now the good news/bad news. The good news for consumers and the Fed is that the possible bubble in commodities prices has burst, suddenly that insatiable demand doesn't look so insatiable to commodities traders now that the world is in recession and so prices are falling precipitously. This means cheaper prices at the grocery store and at the gas pump. The bade news is the ag and resource extraction-based industries are seeing a free-fall in prices and profits which will certainly lead to a painful contraction. Here in Oregon, the wood products industry, already hit by the housing slump looks like it is in for a even bumpier ride. Also ban, in my opinion, is the retreat in gas prices. Yes, I know that I just said the the poor and working class are most vulnerable to downturns and they are also most vulnerable to gas price spikes, but this is one area where pain=gain. High gas prices have led to a plummeting market for big cars, a boom market for hybrid and fuel efficient vehicles and have brought about a huge change in behaviors that are all good for the future sustainability of our economy and our climate. For example the 90% rise in Tri-Met ridership.

Global Panics Call for Global Response

What is clear this morning is that the coordinated (and quite dramatic) action of both US and European governments have potentially turned the tide on the global banking panic.  Individual actions were not enough, the finance sectors of each individual economy are so intimately intertwined that confidence can only be restored by coordinated action.  Of course the rally in the worlds exchanges could be short lived and there will still be blood spilled in the banking sector, but for now the outlook is positive.  

This all begs the question (once again): are the world financial markets so enmeshed that a global system of regulation and oversight is needed?

By the way, I am often asked about the strategy of buying equity rather than buying the toxic assets as in the Paulson Plan.  I am generally in favor of this for three reasons: one, the toxic assets are so complicated that figuring out what to pay is very hard - buying equity is simple and can be done quickly; two, buying equity is a direct capital injection that gives the government something tangible in return for its investment; and three, I think it restores confidence more forcefully than the buying of toxic assets.  But I also have hesitations: one, the government, finding itself part owner of failing banks, have a new incentive to prevent them from failing - even when they should; and two, if one is worried about rewarding the fat cats for bad decisions, this does that more directly.  On balance I am tilted pretty far toward the direct equity approach, especially after the terrible response by the market for the Paulson plan.

Krugman Wins Nobel

I am often asked by my non-economist friends (yes, I do have some) what I think about New York Times columnist Paul Krugman.  They know him only as a sometimes acerbic left-of-center political commentator that occasionally veers off into partisan rants. [Though he would defend himself by saying that stuff that he was accused of engaging in hyperbole about early on in the Bush administration has proven to be essentially correct] Usually they want to know what kind of economist he is - especially since his column is now only occasionally about economics.

What I have always said is that Krugman is a lock to win a Nobel Prize - he is that good an economist.  I did think it was going to be another decade or two before he won it, the Nobel is not awarded posthumously so they tend to try and make sure that the old folks get it before they perish (but they are now catching up and the winners are getting younger).  As a trade theorist, Krugman made perhaps the most significant contributions of the second half of the 20th century.  He showed how increasing returns to scale could provide a rationale for trade and helped explain the trade patterns seen in the real world.  The simple example is this: old style trade theory (Ricardo and Heckscher-Ohlin) shows how comparative advantage (through either natural productivity advantage - Ricardo - or through differences in natural endowments - HO) can cause some goods to flow from country A to country B and other goods to flow from county B to country A.  This is all correct and immensely powerful - it still provides the basic rationale for trade, that everyone can benefit through efficient allocation of production.  But these theories fail to explain why we see cars from Germany shipped to the US and US cars shipped to Germany, for example, nor do they explain why so much production occurs in so few countries.  Krugman, by applying insights from industrial organization (or essentially, the study of firm behavior) developed theories that explained these patterns of trade.  Economies of scale and product differentiation when applied to trade go a long way to explain these patterns. Krugman made the first major contributions to this theory and figured out how to do it in a tractable way theoretically.  

What is especially beautiful about his work, and what has echoes in his popular writing, is how simple and elegant his models are - something I strive for in my work.  In the modern era, where a lot of credit is given for elaborate mathematical tricks in models (economics training is highly mathematical these days) it is rare to see such elegance.  And herein lies the essence of Paul Krugman - a man with extraordinary economic insight that is able to translate that insight simply and plainly.  I think this is a prize that is richly deserved and I am delighted to see him win it.  This has nothing to do with Krugman the political commentator and one always wonders how much politics comes into play with the Nobel committee's decisions.  Krugman was going to win the Nobel anyway, but I thought he would win it with others and in another ten years.  On the eve of the US election, is it coincidence that one of the highest profile leftist commentators in America gets the Nobel?  I wonder....

Econ 101: Confidence and Money

All of this talk about a lack of confidence in the credit markets causing all of this turmoil makes me think of one of the most basic economic mechanisms that exists - fiat money. Fiat money is essentially money that is backed by the full faith an confidence of the government (and, by fiat, must be accepted as a means of exchange) but not backed by any real commodity, like gold. We take the solidity of the Dollar for granted in the United States. In fact, I am reasonably confident that I can take a wad of dollars almost any place on earth and it will be accepted for exchange (and usually much more happily accepted than the local currency) - far out of the reach of the US government. How on earth can a simple piece of printed paper be so valuable? Well, because we believe it is.

What I believe, and what most people in the world believe, is that I will always be able to exchange Dollars for stuff: goods, services, interest, etc. And the reason I believe it is because everyone else believes it too - the fact that others believe it is what makes them willing to exchange stuff for my dollars. This is what gives the Dollars its value. It is a confidence game.

The Dollar is still the international currency of choice, thanks in large part to the dominance and stability of the US economy and government. What would happen if this crisis shakes world confidence in the US so much that the Dollar and US Treasuries are no longer seen as safe harbors (in other words, what happens if people start to believe that the US could possibly default)? The Dollar could suddenly become essentially worthless for international transactions. I am not predicting this, in fact I predict that the Dollar will remain the currency of choice and perhaps even more so now that the world is watching Europe struggle to come up with a coordinated response to the crisis lowering slightly their confidence in the Euro.

What if I started worrying about the US government and the monetary system, I might prefer to take payment in kind for my services. If a lot of people felt this way pretty soon that piece of paper with George Washington's face on it, is just a nice memento. Again, I am not suggesting this is where we are headed, rather I wanted to use this amazing demonstration of a crisis in confidence to point out how something as fundamental as currency relies on confidence.

It is pretty amazing when you think of it. A bunch of carefully printed pieces of paper in my wallet allow me access to an amazing array of goods and services - simply because we all believe in them. So it is not "In God We Trust" it is really in each other that we trust.

Beeronomics: The Oregon Business Magazine

A little while ago I was contacted by Ben Jacklet of the Oregon Business Magazine who had heard about my pedagogical interest in the Oregon beer industry. Though not directly relevant to his article, I had a very interesting chat with Ben about this great article on the craft beer industry in Oregon. Especially interesting, in my opinion, is the stuff about the Widmer brothers and the reaction of their partnership with AB in the beer community (much more so among consumers than fellow brewers, I have found).

Anyway, since I haven't had time to do much beeronomics blogging, this will have to suffice for now.

What Does the Credit Crisis Mean to Oregon?

I have spent a fair amount of time blogging about the credit crisis and now I would like to try, as best I can, to trace these effects to our fair state. In general the local effects of the global financial crisis are pretty similar to all states.  The most immediate impact is probably the drying up of the bond market.  This means that municipalities and states that are trying to raise money by selling bonds are not finding any buyers at anything close to reasonable rates.  California recently alerted the federal government that without the ability to raise case, it may run out of money - and soon.  Luckily, apparently Salem has been quite prudent and is weathering this crisis relatively well at the moment, thanks in part to the skillful leadership of Randall Edwards - so pay close attention to the state treasurer race and vote prudently.  

Anyway, without access to bond revenue, state and local governments may not be able to proceed with planned projects (this is also true for other institutions like colleges and universities, I wonder if the U of O has already sold the bonds for the arena project...).  And of course this all filters down, postponing or canceling planned projects further hurts the construction industry.  

Oregon businesses face troubles without access to credit as well, temporary cash needs may go unfulfilled leading to layoffs, etc. In the medium and long term, lack of credit can postpone or scuttle planned investments, hurting future productivity and business growth.  This also filters down - lower employment and lower wages.  A global economic downturn might also depress one of the few bright lights - exports - in the Oregon economy these days.  

Finally, Oregon households are having a hard time now accessing credit and may soon have a harder time finding jobs, getting raises, etc.  

Now for the latest in bad news: The Dow closed lower than 9,000 today, showing just how big is the crisis of confidence on Wall Street. The TED Spread soared to another all time high today showing just how much banks are still worried about each other. And the Treasury is starting to think seriously about buying equity in the banking sector.  This last one is a good thing in my opinion.

The good news?  Is there any?  Well, yes, the mortgage market is looking great.  So go buy a house!

Now Let's Try Rate Cuts!

And why not? Positives - Wall Street loves them and since the panic/crisis seems to be fueled by the plunge in the Dow, perhaps it is a good idea to lower rates in the effort to restore a sense of confidence. Negatives - this really does very little to help out the seized credit markets since the federal funds rate and the rates that are currently important (the LIBOR and the commercial paper markets) have become untethered to the fed funds rate. This is the essence of the crisis.

On balance then, I am skeptical, but since inflation pressures have eased tremendously, I suppose it is worth a try. It is very good to see some coordinated action with Europe. As I mentioned last time, this is the first true global crisis of international financial market and calls for global action.

Note: I had planned to be knee deep in ballot measure analysis at this point - hopefully I can get to that soon.

Commercial Paper...

...is the financial term de jour. This has been one of the big worry spots of the Fed and Treasury - in fact it may be the key reason for the unleashing of the Paulson Plan. This is how businesses raise short-term capital: secured and unsecured short-term loans. In a healthy market, raising such money (to cover temporary cash flow issues like payroll, new equipment purchases, etc.) was very easy. Sometimes you had to offer sweeter deals, but generally there was a buyer at not too extreme a price. This market was good for both sides - businesses that needed to smooth out expenditures (hiring and firing employees is a much more expensive alternative after all) and businesses and banks that have transitory extra cash that can be put to a productive (and interest earning) use.

But the market has essentially seized. Nobody wants commercial paper (just like no banks want to lend to each other). Everyone is so freaked out that they all want to hold cash or Treasuries and want to take on absolutely no risk. It is already clear that $700 billion promised to buy toxic assets was not enough to reassure people (as I has worried it might not) to get off their duffs and start lending out their cash, so today the Fed has stepped in with a plan to buy commercial paper and directly inject liquidity into that market.

The running theme of the week so far is how bad news and jittery investors in Europe has counteracted the effect of the $700 billion bailout. We are all interconnected now. And here, as evidence, I will simply steal from Paul Krugman:

The chart above shows rest-of-world assets in the United States (red) and US assets abroad (blue) as a percentage of non-US GDP; while we talk a lot about the US as a debtor nation, what’s really striking is the surge on both sides of the balance sheet. This has made the global financial system a lot more tightly linked, so that big economies are now experiencing the kind of contagion previously associated with emerging markets caught up in the 1997-1998 crisis. We’re all Brazilians now.

What this shows is that we are trying to deal with a problem domestically that has spill-overs internationally. This begs the obvious question (which has been asked by development economists for a long time): are the integrated international financial markets so big and so integrated that there needs to be international cooperation in their oversight?

Uh oh...

The TED Spread is up, the Dow is down, Europe is in turmoil, and there is evidence that the money markets are totally frozen. Not what I had hoped to see the Monday morning after the financial rescue plan was passed. Evidence that the plan is not enough to save the banking industry from a lot of pain. But some pain is good and the retrenching that is going to happen is probably healthy in the long run. It's the short run that is still worrying me. Evidence that the recue is not going as hoped: the Fed this morning has had to announce a huge increase in the TAF. There seems to be two possible reasons for all this bad news. One, the Troubled Asset Relief Plan (TARP - or Paulson's Plan) has been judged by Wall Street and banks as terrible insufficient for the existing crisis. Two, a cascade of bad news from Europe has caused a new wave of panic. My opinion is that it is mostly the second reason at the moment (causing essentially the first reason with 'existing' now including Europe). Of course, we know about troubles in Europe already, why this response is the obvious question, to which I can only reply - that is the nature of a 'panic.'

Still, banks can't stay huddled in a corner holding cash for too much longer, they are going to need to start lending soon...aren't they?

I think we need to wait until the end of the week before we start declaring all of these moves insufficient (or misguided). Until then, keep a paper bag handy to breathe into as you monitor the situation...

Oregon Self-Service Gas Poll Open Again

I have reopened the poll, why?: lots of new readers, election coming up, because I want to...

See here for discussion if the issue.

Portland Housing Prices: The Monthly Case-Shiller Update

Too much going on to spend too much time on this, so I'll cheat and steal a graph from Calculated Risk which shows the overall price decline from peak prices for all 20 of the Case-Shiller markets.  So are you a glass half-empty or half-full type of person?  Overall, I think the story for Portland is that it has held its value remarkably well during these troubles housing times.  But all bets are off for the moment about the near future...

So What is the Bailout (oops, 'Buy In,' sorry Nancy) Supposed to Do?

Last time I blogged about why credit matters to the economy, today I will try and explain in as simple terms as possible what Paulson's original idea is all about.

The background is now familiar. Investment banks and securities firms, eager to provide outlets for a huge pile of global money, started bundling together more and more suspect mortgages, sliced them up and created Mortgage Backed Securities (MBS) (see my old posts on the credit crisis). The huge demand for these securities caused even more suspect mortgage lending. This all fueled the housing bubble which finally popped. When the value of houses started crashing the performance of the MBS tanked. They tanked so badly that it soon become apparent that no one could really figure out how to value them. When that happened, the market for these securities basically disappeared. [It is worth noting that though MBS are not the only culprit, they are the main one] Suddenly a major part of the asset side of these banks (both investment and commercial - the difference is not that significant anymore) balance sheets lost all of their value both because of the drop in housing values on which they are based, but also because of they worry about valuing them appropriately made no one interested in buying them. Banks suddenly faced a solvency crisis and needed to raise liquidity. Normally you can do this by selling assets but as I just explained, there is no market for them. Alternatively you can borrow money and lend it out or invest it to try and raise new capital through profits, but now no banks want to lend to each other because they are all worried about default (and rightly so, look at Lehman Brothers, WaMu, etc.) So with banks facing insolvency and the usual channels to overcome this blocked we find ourselves teetering on the brink of total meltdown in the banking sector.

What the Treasury proposes to do is to try and address the second part of the asset pricing problem for the MBS. Namely, that no one wants to buy them because no one can figure out what they are worth (and their worth depends in large part on the future performance of the housing sector). The Treasury claims that they are not worthless (as the current market price suggests) but that 'hysteria' [my word] in the credit market is causing the current price to be much too low. Basically this is a problem of asymmetric information (not knowing the true worth) and coordination failure (not knowing what will happen to housing values which depends on the freeing of credit, which, in turn, depends on confidence returning to the banking sector). Treasury thinks that it can figure out the true worth of these MBS assets and pay that today. Doing so, they believe, will calm the hysteria and free up credit because essentially banks will take the Treasury money and put it right back into T-Bills which will shore up the balance sheet, return them to solvency and make the eligible to borrow and lend again -- which will eventually trickle down to the housing market. Once the hysteria is gone and housing markets have stabilized, the true value of the MBS will become clear and the Treasury can start selling them back - hopefully for as much or even more than they paid.

You can see the risk: if the hysteria about the MBS does not calm down (no one wants to touch them ever again) or if the injection of liquidity does not free up enough credit to turn the housing market around, the Treasury could be stuck with a huge amount of worthless MBS and will end up loosing $700 billion with nothing to show for it. This is why some economists claim is it better to buy equity in the banks because then if it doesn't work you at least have some tangible assets you can sell (like, e.g., WaMu's retail branches that apparently Chase coveted). [The rejoinder to this is that the government may find itself heavily invested in banking, will have a huge amount of complicated real and paper assets to deal with, and will go to even greater lengths to prevent failure.]

So the real cost of the plan, will depend on the sales price of the MBS in the future (and how far that future date is). It's a big risk, but meltdown is a risk an order of magnitude larger.

NB: Later I will try and comment on the DeFazio plan.

The Bailout Plan: Two Perspectives

Tonight, just in time for tomorrow's dramatics The Oregon Economics Blog presents two perspectives.  Fred Thompson chimes in on the plan itself and I try a different tack: trying to explain why you should care if you are not the CEO of a major bank.  I hope it is interesting and helpful.