Category Archives: Economics

Understanding Money

For a long time I’ve been convinced that we mostly don’t understand how money really works.  It’s way to easy to think that the government must operate just like a household, and ensure that it doesn’t overspend – thus many of the current calls for austerity.  And obviously there are limits – we all know about 1920s Germany and Zimbabwe and many other examples of runaway inflation.  But typically there are additional circumstances driving such situations (such as reparation payments and crazy dictators)!

I found this column “Not Enough Money” from the National Review’s Ramesh Ponnuru interesting, because he believes many of the folks warning of impending hyper-inflation are probably fighting “the last war” instead of truly understanding the current situation.  Here’s a taste:

In warning about inflation, conservatives are crying “fire” in, if not Noah’s flood, at least a torrential rain. It may be that they are stuck not so much in the 1930s as in the 1970s — the time when conservatism forged much of its current outlook on economics, and a time when monetary restraint was badly needed. Conservatives also tend to think that loosening monetary policy is a kind of intervention in free markets, and therefore to be suspicious of it. But this is an error.

Conservative States / Liberal States

This posting over at Richard Florida’s Creative Class blog caught my eye: The Conservative States of America.  There he shows a number of statistical view of the 50 states, and some of the general trends that are evident.  Here’s an excerpt:

Conservatism, at least at the state level, appears to be growing stronger. Ironically, this trend is most pronounced in America’s least well-off, least educated, most blue collar, most economically hard-hit states. Conservativism, more and more, is the ideology of the economically left behind.  The current economic crisis only appears to have deepened conservatism’s hold on America’s states. This trend stands in sharp contrast to the Great Depression, when America embraced FDR and the New Deal.

Liberalism, which is stronger in richer, better-educated, more-diverse, and, especially, more prosperous places, is shrinking across the board and has fallen behind conservatism even in its biggest strongholds. This obviously poses big challenges for liberals, the Obama admiration and the Democratic Party moving forward.

But, the much bigger long-term danger is economic rather than political. This ideological state of affairs advantages the policy preferences of poorer, less innovative states over wealthier, more innovative, open and productive ones. American politics is increasingly disconnected from its economic engine.  And this deepening political divide has become perhaps the biggest bottleneck on the road to long-run prosperity.

In many ways I think this raises more questions than anything else:  is conservatism a reaction or a cause? how truly ‘conservative’ are conservatives, especially around programs like Social Security and Medicare?  But it’s all certainly worth thinking about!

Climatopolis – Matthew Kahn (2010)

Climatopolis is a recent book by Matthew Kahn, an economist and ‘green’ thinker, focusing on the effects of climate change on cities (subtitle = How our cities will thrive in the hotter future).  It’s a fairly short and easy read, and has some interesting findings and ideas, taking some level of climate change as a given and suggesting that market forces will provide mechanisms of adaptation as city amenities (like weather and flood risk) change over time – leading people to move around as they see fit.

I find various passages in the book to be annoyingly glib however.  Too often Kahn simply parrots free-market ideas without much consideration or subtlety.  Here are a couple examples.  Page 27, he says that high taxes “encourages people to work less and take more leisure” – well, perhaps, for some portion of the ‘people’ who find that the marginal work effort is not worth the marginal gain, but most people have pretty fixed expenses and will probably work just as much if not more.  Page 45, at the end of a chapter on a variety of responses to city disasters, he writes “One theme that emerges from this chapter is that government policies can significantly increase the degree of climate -related risks that a population faces” – yet one of the sections in the chapter talks about the use of better building codes to increase the quality of buildings and reduce potential damages…  so obviously bad policies can make things worse and good policies can make things better – it’s not a one way street!

As noted on Matthew Yglesias’s blog, there is also a rather casual treatment of past instances of mass violence and death, citing statistics that show that both the A-bombed cities of Japan and Vietnam got back fairly quickly to their longer-term growth rates.  Not much comfort for those in the midst of the onslaught.  And likewise for those caught in climate-change disasters, it’s not going to make the going any easier to realize that probably all will be back to normal in 15-20 years (assuming that’s true).

Kahn includes in the book some closer looks at issue that Los Angeles, New York and the new Chinese cities will be facing, and it is worth a read just to stir one’s thoughts on the future (with a critical eye open).

Here’s Matthew Kahn’s blog on Environmental and Urban Economics.

Unfolding Trends from Vaclav Smil

Here’s a passage I found worthy of consideration – from Vaclav Smil’s Global Catastrophes and Trends – The Next Fifty Years (2008):

The aging of the U.S. population, although far less pronounced than in Europe or Japan, and a multitude of social ills will only accelerate the inevitable transformation of the country.  The aging of the population will have similar effects on health budgets, pensions, and the labor market as in Europe or Japan, but given much more widespread stock ownership, its principal undesirable effect may be on the value of long-term investments. There will be too few well-off people in the considerably smaller post-boomer generations to buy the stocks (and real estate) of the aging baby boomers at levels anywhere near peak valuations. That is why Siegel (2006) expects that stock prices in rich countries could fall by up to 50% during the coming decades, unless newly rich investors from Asia, the Middle East, and Latin America step in. But that intervention would have to be on a truly massive scale. Siegels calculations indicate that for rich countries’ stocks to perform at their long-run historic rate, most multinational corporations would have to be owned by non-Western investors by 2050.  (p. 151)

While I haven’t studied the details, it strikes me that there has to be some truth to this story.  The reference is to the book The Future For Investors by Jeremy Siegel.

Ideas to consider…

I’m reading The Rational Optimist by Matt Ridley, subtitled ‘How Prosperity Evolves’.  On page 109 I came across a few lines that describe what I also find to be an interesting paradox:

Politically, as Brink Lindsay has diagnosed, the coincidence of wealth with toleration has led to the bizarre paradox of a conservative movement that embraces economic change but hates its social consequences and a liberal movement that loves the social consequences but hates the economic source from which they came. ‘One side denounce capitalism but gobbled up its fruits; the other side cursed the fruits while defending the system that bore them.’

The reference is to Brink Lindsay’s 2007 book The Age of Abundance: How Prosperity Transformed America’s Politics and Culture.

Ridley is in essence trying to convince both sides to see the bright side.

The Big Short – Michael Lewis (2010)

I first read Michael Lewis back in the 80s with Liar’s Poker, where he covered the initial bond trading explosion.  His new book, The Big Short, is back in the same territory, covering the subprime mortgage blowup in 2006-2008, and it’s a very readable story centering on a handful of traders who got the idea early that they should start betting against this market.  If only to have a quick reference for later, I want to jot down a few notes on the various trading vehicles.

First off, note that any cash stream can essentially be thought of like a bond.  A mortgage is a cash stream from the borrower to the lender.  The risk on a particular mortgage is that the borrowers won’t be able to re-pay, but since the penalty for not paying will be to lose the house, most borrowers with some skin in the game will try hard to re-pay.  Back in the 80s they came up with the idea of bundling mortgages together, and making bonds out of them, called collateralized debt obligation (CDO).  That worked OK for awhile, but in the 2000’s real estate boom, in part to keep the party going, we saw the massive increase of subprime loans (where there was little to no downpayment, and perhaps no income verification either).

But it wasn’t until about 2005 that some smart traders decided they needed a vehicle to bet against mortgage bonds, and in particular mortgage bonds on subprime mortgages.  Now it’s apparently very hard to short a bond, but bankers were able to come up with the next best thing, which was called the credit default swap (CDS).  The CDS is like an insurance policy on a mortgage bond – to hold a CDS you pay a yearly insurance premium (usually a percent or two of the amount of the bond) to the issuer, and if the underlying mortgage bond defaults (because individual loans in the bond are not being repaid), then the issuer pays out to cover the losses.  Note that the issuer of the CDS is potentially on the hook for the entire value of the underlying bond.

Now we can see that in fact one can look at the CDS as a cash stream of insurance premium payments, and since the chance of a pay out is the same as the chance that the underlying bond will default, it means that you can create a CDO made out of CDS policies (called a synthetic CDO). And if your assumption was that the underlying mortgages would always be repaid since real estate always goes up, then you’d be presumably happy to buy synthetic CDOs as well as regular CDOs, seeing them as equally risk-free.

The other important factor here is that as long as you can find an issuer, anyone can buy a CDS.  Thus the volume of trading of these things was not limited to the number of home loans being made!  For awhile AIG was a big issuer of CDS’s, but after awhile they saw they might run into trouble with them, and others stepped in. Also note that most purchases of these things were brokered by the big banks, and they liked the fact that there was not a transparent market – i.e. they could charge a nice profit for being the middleman.  They also, of course, had some of their own money in these holdings.

So, The Big Short tells the story of some investors who bought CDS’s, and what happened next.  Funny enough, while they were convinced that the underlying mortgage bonds would go bad, several of them were very worried that they would not be paid off, because they could see that the issuers would be losing a lot of money.  Thus typically they did not hold the CDS’s until the end, but sold them at a big profit to desperate buyers who had the underlying bonds and saw that they were in big trouble.

This books gives me some idea of why the banks are so opposed to regulations, but that doesn’t mean the rest of us need to listen to them!


From John Mauldin’s last newsletter, in a section titled “So Where’s the Inflation?”:

The actual amount of bank loans is falling each and every quarter, with no signs of a bottom. Consumers are reducing their debt and leverage. Bank loans are being written off at staggering rates. Over 700 banks (I think that is the figure I saw) are officially on watch by the FDIC, with more banks being closed each week.

There is at least $300-400 billion in losses on commercial real estate waiting to be written down. Housing foreclosures are rising and hundreds of billions have yet to be written off. As more families fall into unemployment or underemployment, there will be more writedowns. Is it any wonder that banks are having to shore up their balance sheets and make fewer loans?

With capacity utilization just off all-time lows, why should we expect businesses to borrow to increase capacity? Inventory levels are much lower than two years ago. Businesses no longer need to finance as much inventory. They simply need less.

Dennis Gartman writes:

“Effectively the Fed had become a cash machine rather than a monetary expansion machine. At the end of last year, the multiplier had actually fallen to less than 1.0 and the trend remains downward. If anyone had told us five years ago that the money multiplier would be down to 1.0 we would have laughed. The laugh, however, would have been upon us, for it is there and it is still falling. Hard it shall be to sponsor strong economic growth when no one really wants to take a loan or when few banks want to make a loan. The ‘game’ of banking has been turned upon its head, and the strength of the economy suffers while inflationary pressures (at least for now) remain virtually non-existent.”

Bottom line is that there’s plenty of evidence that we’ve already had a lot of the inflation everyone’s worried about (it was just called a Housing Bubble, or rising tuition, or rising medical costs, not inflation).  Right now money is disappearing (loans being paid off or written off), and I think the Treasury and Fed are trying desperately to keep outright deflation from taking over.

This NYT article “Preparing for the next bubble” also had this interesting bit at the end:

So rather than trying to predict the number and type of bubbles, it may make more sense to look inward when trying to predict the future. Bob Goldman, a financial planner in Sausalito, Calif., said that clients often looked at him blankly when he asked them what it was they imagined for themselves in the future. Sometimes, they need to go home and figure out what sort of life it is that they’re saving for — and how much (or little) it might cost.

“People come in and talk about how we all know that inflation is going to explode next year,” Mr. Goldman said. “Well, we don’t all know that. We don’t know anything. But we can know something about our own lives, and there is a person we can talk to about that. A person in the mirror.”

It does strike me as strange that so many people seem to have such certainty about the economic future, when in fact no one really knows!  But it is indeed fascinating to ponder…

I Sold Andy Warhol (too soon) – Richard Polsky (2009)

“I Sold Andy Warhol (too soon)” is a follow up to Richard Polsky’s 2003 book “I Bought Andy Warhol” and it continues his stories of the pop art market through the 2006-2008 period of sky-high prices.  It’s a quick, fun read, starting with the sale of his Warhol “Fright Wig” piece, and following several other ongoing stories, such as another collector’s quest to buy one of those same pieces soon afterwards, as prices continued to soar.  Polsky turns himself into an ‘art financial advisor’ and he discusses some of the unlikely twists and turns of art collecting, such as the story of Leon Kraushar, who began filling his suburban Long Island home in the mid-sixties with now astronomical pop art work from the likes of Warhol, Lichtenstein and Rosenquist. While a few folks get lucky, just as with stocks, by buying low and selling high, it’s generally very hard to truly treat art as an investment.

An excerpt from the book can be found here at artnet.

'From Poverty to Prosperity' by Kling & Schulz (2009)

‘From Poverty to Prosperity’ by Arnold Kling and Nick Schulz is subtitled ‘Intangible Assets, Hidden Liabilities and the Lasting Triumph over Scarcity’, and it’s an attempt to plot out the direction of what the authors call Economics 2.0.  They describe Econ 1.0 as “about scarcity” whereas 2.0 is “about abundance, which arises from technical progress”  (p. 4).  Another way they describe the difference is by saying that 1.0 is about the hardware – physical materials, their handling and transport, while the new economics pays more attention to the software – the innovation of techniques and recipes, which are not subject to the same laws of scarcity that physical goods are, since recipes can be shared and used simultaneously by many.  Traditional economics has not focused in on where technical innovation comes from, treating it instead as something that just appears.

A line I liked: “Maybe there is no free lunch, as the saying goes; but we do not have to work nearly as hard to put food on the table as we used to” (p. 4).  Economists do seem fond of claiming that ‘there’s no free lunch,’ implying the necessity of tradeoffs, and yet what can come closer to free than a new idea which, for instance, increases the productivity of group of workers (perhaps through a different divisiion of labor), so that the same input effort produces more output?  Kling and Schulz make the case that innovation and new technology are what has brought us to a level of prosperity that make everyday life in the developed countries close to what only the wealthiest could enjoy not so long ago.

The book consists of chapters by the authors and interviews with a variety of noted economists which shed light on the interesting topics.  The initial section uses a number of statistics to show how the developed countries have increased health and lifespan, while the mix of jobs and skills has transitioned over the last century to greatly emphasize thinking and people skills over manual labor.  I am in general agreement with their notion that we in the developed countries have benefited greatly from the many innovations that have revolutionized so many areas of production.  I would argue however that there are some tangential factors that go along with the technical recipes, such as the important role of cheap energy in the form of oil (though the cheap days seem to be ending), and the role of culture and values.

There are many intriguing issues raised in the book, such as the reminder from Paul Romer that “everyone wants growth but nobody wants change,” (p. 104) but they come together.  If indeed the speed of innovation will continue to increase, that seems to imply ever more change, and while technology can change quickly, people and skills can have a hard time keeping up.

The big lurking dilemna, which the book touches on, is why, given all the advances in our recipes, there still exist so many areas of the world that still suffer great poverty.  A chapter in the middle describes the so-called ‘bugs’ in the software, which they name as tribalism, insecure property rights, corruption, unearned income curse (from, for instance, oil), and the lack of knowledge and skills.  And these problems are certainly part of the problem to be overcome in the developing world.  But there are hints of a deeper issue.

A couple times the authors raise the idea that in principle the developing countries could simply adopt the techniques of the developed countries, without any new innovation, and they would reap huge gains.  But in general we don’t see this happen.  Economist Paul Romer says to get development going, you need establish what he calls the “institutions of the market”;  “Get property rights, the basic institutions of security, personal security, a legal system that supports property rights, get those in place and things will be fine” (p. 90), and he then adds that you also need institutions of science.  This seems very much easier said than done.

I found Joel Mokyr’s answer to be more realistic.  When asked about his confidence that institutions can be developed where they don’t exist today, he says “I am hugely skeptical about it.  Precisely because if you change the institutions but don’t change the culture, you’re not going to change the institutions” (p. 128).  Development economist William Easterly follows up on this point when he says “I don’t think anyone has figured out how to create or change values, or even understands very well the origins of different values in different countries” (p. 176).

The development question is not merely a matter of distributing recipes and watching prosperity develop.  Recipes often come with buried cultural assumptions that we take for granted, because they are so ingrained for us.  These things could include very basic cultural attitudes about the importance of work, the attitudes about the proper role of the two genders, the religious attitudes about older values and change, attitudes about money and trust, as well as more technical attributes like the available skills, the physical infrastructure, the financial infrastructure, etc.

Examining and understanding the roots of cultural values may go well beyond the intentions of Economics 2.0, but if they are the foundation of economic institutions, then a shaky understanding at the ground level will continue to be a problem.

Update:  Take a look at Arnold Kling’s thoughts on the review along with comments.

'Pig 05049' by Christien Meindertsma

While over in the Netherlands last year, I came across a book at a museum in Rotterdam that I couldn’t put down.  The book is called ‘Pig 05049‘ and it is a photographic documentation of all the commercial products that are made from various parts of a pig.  Here’s a description:

Christien Meindertsma has spent three years researching all the products made from a single pig. Amongst some of the more unexpected results were: Ammunition, medicine, photo paper, heart valves, brakes, chewing gum, porcelain, cosmetics, cigarettes, conditioner and even bio diesel.

Meindertsma makes the subject more approachable by reducing everything to the scale of one animal. After it’s death, Pig number 05049 was shipped in parts throughout the world. Some products remain close to their original form and function while others diverge dramatically. In an almost surgical way a pig is dissected in the pages of the book – resulting in a startling photo book where all the products are shown at their true scale (1:1).

Just today I came across news that this book has won a 2009 Index prize, and I can’t say I’m surprised.  It’s a remarkable view of how our world actually operates, showing connections most of us have no awareness of.