Category Archives: links to my essays

Regulatory miscalculation

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Two examples.

1. Stephen Matteo Miller writes,

While these findings do not establish that the Recourse Rule caused the financial crisis, they are consistent with the view that the rule encouraged securitizing banks, especially the largest ones, to hold the assets that turned out to be at higher risk of distress. In other words, though the Recourse Rule may have been intended to lower risk-taking, it may have encouraged greater risk-taking on the part of these banks.

The Recourse Rule got its name because its primary provision was to force banks to keep capital against assets that had been sold with recourse, meaning that the assets could be put back to the bank if they lost value. But another provision of the rule allowed banks to reduce capital against mortgage securities with AA and AAA ratings. Freddie Mac and Fannie Mae warned about the distortions this would create at the time the rule was issued, in 2001. I have discussed its role in the financial crisis of 2008 in Not What They Had in Mind and in The Regulator’s Calculation Problem, the latter focusing on the book by Jeffrey Friedman and Wladimir Kraus that emphasizes the role that capital (mis-)regulation played in the lead-up to the crisis.

2. Saad Alnahedh and Sanjai Bhagat write,

Regulations were announced by the U.S. Securities and Exchange Commission (SEC) in July 2014 to increase MMF [money market funds] disclosures, lower incentives to take risks, and reduce the probability of future investor runs on the funds. The new
regulations allowed MMFs to impose liquidity gates and fees, and required institutional prime MMFs to adopt a floating (mark-to-market) net asset value (NAV), starting October 2016. . .we find that institutional prime funds responded to this regulation by
significantly increasing risk of their portfolios, while simultaneously increasing holdings of opaque securities.

Variable costs approach zero

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Jan De Loecker and Jan Eeckhout write,

We document the evolution of markups based on firm-level data for the US economy since 1950. Initially, markups are stable, even slightly decreasing. In 1980, average markups start to rise from 18% above marginal cost to 67% now. There is no strong pattern across industries, though markups tend to be higher, across all sectors of the economy, in smaller firms and most of the increase is due to an increase within industry. We do see a notable change in the distribution of markups with the increase exclusively due to a sharp increase in high markup firms

Tyler Cowen brought up the paper in order to criticize it. Greg Ip covered the controversy.

Variable costs are costs that increase as the business produces more output. They include costs of materials and the labor cost that is involved in direct production. My explanation for the two-Jans result is that variable costs are tending toward zero in many industries. (I think that this is also Tyler’s explanation, but I prefer to use more specific examples and less technical jargon.)

My notes on the topic.

1. Fifteen years ago, I noticed the trend toward declining variable costs. I wrote an essay called asymptotically free goods, “where research and development costs are high, but the marginal cost of the final product or service is low.” Think of a pharmaceutical that is expensive to develop but cheap to manufacture. Think of cell phone service providers, where the marginal cost of transmitting another gigabyte of data is close to zero. Think of a hospital, where most of the cost is overhead (if the amount of medical services that a hospital were to supply on a given day declined by 1 percent, the amount by which its actual costs would decline is close to zero). Think of an Internet service, such as Facebook, with high costs of development and maintaining a data center but with extremely low cost of adding another user.

The point of the essay is that under marginal cost pricing, these would be free goods. If variable cost approaches zero, then markup over variable cost approaches 100 percent. [update: a commenter points out that this statement was in error. The ratio of price to variable cost approaches infinity as variable cost approaches zero.] (In the case of Facebook, the marginal cost of serving an ad is close to zero, and the markup that it charges advertises therefore approaches 100 percent).

2. When I taught economics in high school, I would say that “price discrimination explains everything.” That is because most businesses do not operate in the textbook world of perfect competition. Instead, firms are focused on recovering fixed costs. To do so, they apply different markups to slightly different versions of products, trying to recover more fixed costs from the less price-sensitive buyers. That is why movie theaters charge so much for popcorn, why airlines have different classes of seats, why cable TV providers offer bundles, and so on.

3. In manufacturing, the share of production workers is declining, but the share of non-production workers is increasing. Overall, we are producing more output with fewer workers on the assembly line (and I would guess that materials costs also are lower).

4. My guess is that, if anything, the two-Jan’s paper understates the trend toward high markups. That is because my guess is that most corporate data allocates more labor to variable cost than really belongs there. Garett Jones pointed out that these days most workers do not produce widgets. Instead, they produce organizational capital. Garett Jones workers are part of overhead, not variable cost.

5. In textbook economics, the term “monopoly power” is pretty much by definition the ability to charge a price above marginal cost. By that definition, it is very hard to think of real-world businesses that do not have monopoly power. If you want to say that the textbook model of perfect competition is baloney sandwich, I would have to agree with you.

6. But lack of perfect competition does not mean that government regulators know better.

7. Lack of perfect competition does not mean that there is no market discipline. There is still competitive discipline, but a lot of it comes in the form of creative destruction rather than in the form of prices being driven down to marginal costs by copycat entry.

8. Government intervention can easily take the form of trying to stop creative destruction. For example, demand that autonomous vehicles be accident-free, rather than merely less dangerous on average than human-driven cars.

Re-reading David Brooks

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Almost twenty years after it first appeared, I review Bobos in Paradise.

What Brooks might have foreseen, but did not, was how this Bobo project would play out as it gathered momentum. In the last two decades, we have witnessed the acceleration of the long-term trend toward expansion of the more abstract-oriented industries, such as finance and entertainment, and a decline of the more concrete-oriented industries, such as manufacturing and mining. As a result, the cultural influence of Bobos has soared. The Bobos became insistently cosmopolitan on issues of immigration and foreign relations, increasingly aggressive in their assault on traditional ideas about gender, and increasingly eager to stifle the speech on campus of those with whom they disagree.

Greg Ip Praises Economics

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He writes,

By stripping the emotions from pressing problems, economists can often illuminate the most practical ways to tackle them—but only if ordinary people and their representatives are prepared to listen.

There is a gulf between small-scale society and large-scale society. Use the Dunbar number as a breaking point, so small scale means less than 150 people and large scale means more than that. At small scale, coordination problems can be solved by intuition and mutual recognition. You do not need markets or centralized command. But at small scale you cannot have much specialization, and you cannot provide complex goods and services.

At large scale, the coordination problem becomes much more complex. Economists pay attention to this, and that makes them wiser than non-economists who do not.

But many economists are far too oriented toward the possibilities of centralized command (government regulation) as a coordinating mechanism. And they are too smug about what they can accomplish using math and statistics.

For my perspective on the topic of Ip’s essay, see How Effective is Economic Theory?

Revisiting Halberstam’s The Best and the Brightest

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I write,

I have come to see the “can-do” attitude, and its attraction to politicians and the public, as very dangerous. On economic matters, the “can-do” adviser offers the promise of a free lunch: increased access to health care without raising health care spending; tax cuts that “pay for themselves”; budget deficits that will create millions of jobs, projected with outrageously exaggerated precision.

I credit this book with helping to start me on my political journey from left to right. Although it criticizes the Vietnam policy from a left perspective, it never endorses the Chomsky silliness of saying that Vietnam was a capitalists’ war for markets.

Halberstam offers lessons to both sides in the Trump era. The anti-Trumpers would do well to reflect on the way that establishment group-think can be costly. For Mr. Trump himself, I have this admonition.

he should try to restrain the urge to be an intimidator. The office of the President is intimidating in its own right. The President needs honest advisers more than he needs yes-men.

Richard Bookstaber on Economic Methods

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I have a long essay on his book, The End of Theory. One brief excerpt:

In conventional economics, people are assumed to know, now and for the indefinite future, the entire range of possibilities, and the likelihood of each. The alternative assumption, that the future has aspects that are not foreseeable today, goes by the name of “radical uncertainty.” But we might just call it the human condition. Bookstaber writes that radical uncertainty “leads the world to go in directions we had never imagined… The world could be changing right now in ways that will blindside you down the road.” (page 18).

Read the entire essay. It is another attempt to address issues of economic methods.

On the state of economics

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I have a long essay on the scientific status of economics in National Affairs. A few excerpts from the conclusion:

In the end, can we really have effective theory in economics? If by effective theory we mean theory that is verifiable and reliable for prediction and control, the answer is likely no. Instead, economics deals in speculative interpretations and must continue to do so.

Young economists who employ pluralistic methods to study problems are admired rather than marginalized, as they were in 1980. But economists who question the wisdom of interventionist economic policies seem headed toward the fringes of the profession.

This is my essay in which I say that academic economics is on the road to sociology.

My Review of Kevin Laland

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The book is Darwin’s Unfinished Symphony, which is still my favorite non-fiction book of 2017. My review says,

Laland weaved together mathematical models, simulation exercises, experiments, and observations in a way that was much more persuasive than most social science. I recommend that economists read the book in order to stimulate thinking on how to improve our research methods.

The make-or-buy decision with respect to human capital

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From a National Academy of Sciences report:

As long-term employment becomes less common, new ways of providing for health care and pensions for all workers need to be considered that transcend their relationships with particular employers. For example, one option would be to institute portable pension plans administered by membership organizations dedicated to the well-being of their members.

Pointer from Timothy Taylor, who includes this quote from the report:

Many employers are increasingly viewing their relationship with employees as a short-term commitment rather than a lifelong investment. As Manpower Group CEO Jonas Prising recently put it, `Employers have gone from being builders of talent to consumers of work.’

Note, however, that this supposed decrease in the share of long-term relationships between employers and employees is not so evident in the data.

Still, I think that the trend is toward firms making more and more use of generic software. (I predicted this almost twenty years ago.) In fact, software-development specialists make more and more use of generic software.

Gary Becker developed the distinction between specific human capital, which is tied to a particular firm, and generic human capital, which can be used anywhere. The more that firms outsource non-core functions and make use of generic software the less they need to invest in specific human capital. Thus, they will tend to do less talent-building and act more like “consumers of work.”

Losing health insurance that you do not want

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Tyler Cowen writes,

many of the poor do not value health insurance nearly as much as many planners feel they ought to, in large part because they are already getting some health care.

He quotes from the abstract of a paper by Amy Finkelstein, Nathaniel Hendren, and Mark Shepard. They conclude that most low-income people would not choose to pay for health insurance if they had to. My thoughts:

1. I would be careful about concluding that people do not value health insurance based on their preferences when their incomes are low. Perhaps if you raised their incomes a lot, they would value health insurance more highly.

2. Almost 15 years ago, I wrote an essay called Health Insurance Do-nots. I recommend it as relevant to the current discussion.

3. While people with low incomes get above-board subsidies for health insurance, many people with high incomes get subsidies, also. Government workers, for example. Or people who get employer-provided health insurance, which is subsidized through the tax system.

4. If my wife and I could be assured of paying the same price for medical services that our insurance company pays, we would be much better off self-insuring than getting our Obamacare insurance. If you cumulate over 5 years, we would have to incur well over $100,000 in medical procedures in order to make back our premiums/deductibles under Obamacare. And note that we separately pay for our own long-term care insurance, which addresses the biggest health-related financial risk that we face.