A New World Order?

It is hard not to see the astonishing success of the Democratic Party in Tuesday’s election, at a time when the world is reeling from a massive and sudden economic downturn, as a watershed moment in an economic revolution that started some thirty years ago. Though voters have many motives and it would be wrong to ascribe all of the democratic success to the failing economy, clearly there is a strong sense of dissatisfaction with the failures of unregulated credit markets and unfettered markets in general. After years of success in which people saw the type of efficiency and growth free markets can bring, it is now becoming clearer that there are limits to the extent to which markets can answer all of society’s problems. It is quite possible, then, that we are about to enter a new era – an era in which the government takes a more active and interventionist role in the design and functioning of markets.

The world underwent a transformation of similar magnitude in the eighties after the economic malaise of the late seventies left citizens of the United States and Western Europe feeling that the weight of heavy government intervention in the economy was largely to blame. The seventies were characterized by heavy regulation in the United States and Europe and government ownership or control of major industries in many European and developing countries. The eighties saw a remarkable shift toward free markets and private ownership, not just in practice, but in public sentiment. And the market delivered. By the nineties, the freeing of markets, restraining of regulation and emphasizing private ownership became a pathway to heretofore unheard of level of growth and prosperity in the world. Many developing nations, most notably China and India, pursued these market based polices and saw astonishing growth. After decades of very little progress in the developing world, economists finally saw real results from market-based reforms. The so-called neo-liberal (in the economic sense) revolution had taken hold and its spread across the globe was akin to wildfire. The debate appeared to be over: free-market based capitalism was the superior form of economic organization. And in this new era of intertwined neo-liberal economies, we may have not always liked the consequences, but we became accustomed to live in a world of globalization.

To economists, that providing more freedom to markets, emphasizing private ownership and opening up to world trade should create efficiencies and growth was not surprising. One of the first lessons a student of economics learns is the efficiency of free and complete markets. But economists should not be surprised at the failures of markets. Failure to self-regulate, to provide equitable distribution of the proceeds of growth, and to provide public goods and deal with the challenges of global climate change are limitations of markets are well known in economics (though underemphasized in most curricula).

At this moment of renewed distrust in markets, we should not be too quick to dismiss the enormous progress humanity has made in the last decades of neo-liberal reforms. Millions of people have escaped abject poverty thanks to the growth experience of the developing world under such policies. The United States, for almost two decades, experienced unprecedented growth and prosperity – low unemployment, and low inflation, once though to be in fundamental conflict, have become the norm. But we should also not be naïve and believe that the current economic crisis is an aberration. The inability of markets to achieve efficient outcomes in the face of uncertainty, incomplete information and externalities is not a surprise, nor is the inability of markets to ensure equity.

What is called for at this moment and time is a careful re-evaluation of our markets and our polices, not based on either faith in, or fundamental distrust of, markets - but on economics. Despite the public perception, modern economics has made enormous strides in understanding the functioning of markets, and this understanding can guide us through a period of careful adjustments to the way that we create and regulate markets. To withdraw inside a protectionist and regulatory shell is not a viable way forward. Neo-liberalism is not dead, but is in need of a serious tune-up. Governments need to harness the power of markets to address the challenges of growing inequality, climate change and social upheaval. Economic growth is not the problem, but the only serious solution to the global challenges of poverty, inequality and climate change. We do not need to return to the seventies, but to move forward to a new era of market-led, but government directed economic growth.

Now What?

Now that the Obama and Merkley have won, the reality of the enormous challenge of the current economic catastrophe is sobering. With respect to John McCain, the fundamentals of the economy are not strong and Oregon, along withthe rest of the country, is facing the real prospect of a deep and long resession that will bring with it large scale unemployment and crashing state revenues. [And by the way, to reference an earlier debate on tax structure, consumer spending declines and job losses are happening concurrently, so it is not clear that sales taxes would help that much] We are well along in the process of economic meltdown, and pretty far along in attacking the issue at the forefront of the problem: the credit crisis.  Progress has been slow, but it is happening: the LIBOR is down, the TED Spread is down, the A2P2 spread is down (a measure of the health of the commercial paper market), but Treasuries are still too low (indicating a lingering flight to safety urge).  However, there are still a lot of serious problems with the financial health of major banks and corporations, and consumer confidence has completely fallen off a cliff.

So what is the federal government to do?  A number of prominent economists are now urging ramping up fiscal spending on domestic projects (think WPA and CCC).   Some suggest that this should be done through transefers to states for infrastructure projects to help stabilize state budgets.  The basic idea behind such spending (besides the direct benefit of helping out unemployed families and the like) is that by getting money into the hands of consumers you provide a boost to spending, allowing revenues to flow to firms who can invest and create new jobs, etc. Essentially it is to stop the downward spiral we are currently in of a contraction in spending, thus a contraction in jobs, thus a further contraction in spending in spending...

I think that the idea is essentially correct, though I am cautious about the scale of such an enterprise. But I think it can also be done with the goal of improving the future economy in mind. Investments in renewable energy projects, mass transit, education - especially through support for university tuition - could yield not only a quicker and more robust recovery, but could also create an asset that yields dividends long into the future.

I think it is also necessary to resist the appeals to populism that could negatively impact future growth in Oregon and in the US. Jeff Merkley's increasingly populist protectionist rhetoric makes me worried that democrats will use their newfound power to reverse some of the progress we have made. We need more intelligent trade policy for sure, but we do not need less trade.

This will be a trying couple of years for the democrats as they try to steer the US out of the economic doldrums, they can do so two ways - they can use this period of adjustment to make fundamental changes in the economy that will ensure a brighter future, or they can return to the failed policies of the past that will leave us more isolated and further behind. Let's hope they get it right.

VOTE

As an economist, I can't offer you much of a rationale to vote in terms of your marginal impact; but as a citizen, the utility I get from voting comes from the responsibility I feel about participating in our democracy. A true democracy represents the interests of all citizens, not just the mobilized fringes. So, though Oregon has a mail-in ballot system, it is not too late to vote: you can drop-off your ballot by 8pm Tuesday night. Here is a list of drop-off locations throughout Oregon.

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?

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?

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.