In which we are the protagonists in the low comedy of our economy

This morning I was rereading Merton and Bodie's "A Conceptual Framework for Analyzing the Financial Environment" in The Global Financial System: a Functional Perspective, published in 1995 but still immensely interesting*. This passage, though, ended the paper:

In the traditional bank arrangement, there is a mismatch between the liquidity of the deposits issued by the bank and the loans backing those deposits. Indeed, it is this mismatch in liquidity that is often cited as the root cause for banking panics...

The current environment of low and secularly declining transactions costs for securitization supports a hierarchical and incremental chaining approach as an efficient means for providing liquidity. Liquidity is enhanced whenever a collection of assets is "repackaged," and the resulting collection of assets created have a smaller bid-ask spread than the original assets. Thus highly illiquid and opaque assets can be financed with short-term debt instruments. Portfolios of the more liquid of those securities, in turn, can be used as assets to back other securities that will have even greater liquidity, and so on.

Thus, at each link in the chain, the differential in liquidity is relatively small. Cumulatively, it is possible to create virtually perfectly liquid securities while minimizing the danger to the system of ever experiencing a "crisis" because of a mismatch between the liquidity of an intermediary's assets and liabilities.

The idea is appealing on the face of it, but we can't, obviously, still believe it. If I was going to criticize, I think I would start with how the authors seem to be confusing instrument-level liquidity with institutional-level and how these could be quite different markets. But this is pretty unsatisfying, if only because these institutions are just collections of individual assets anyway.

I think the better answer may be that it wasn't securitization at all at fault in the recent difficulties. Of course, at the rate we're ruling out causes, we may eventually have to accept the sole remaining explanation for the near-seizing up of our vaunted financial system--no matter how improbable it may be: collectively we're no smarter than a troop of chimpanzees.

OK, maybe it's not that improbable.

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* We're having a contest to see who can have the most boring Saturday. I'm winning.

Not yet Enough

I was reading Skidelsky's critique of Keynes' "Economic Possibilities for Our Grandchildren". In Economic Possibilities, written in 1930, Keynes asked

What can we reasonably expect the level of our economic life to be a hundred years hence? What are the economic possibilities for our grandchildren?

He concluded that by the year 2030,

Assuming no important wars and no important increase in population, the economic problem may be solved, or be at least within sight of solution.

Because economic growth makes us wealthier, at some point people would have enough--"the absolute needs...satisfied in the sense that we prefer to devote our further energies to non­-economic purposes"--and would cut back on hours worked.

This seems reasonable (if a bit far from the problems we face today) but Skidelsky notes that, despite significant progress in the developed countries towards what Keynes viewed as enough, we are not working less.

...We are two-thirds of the way towards Keynes’s target. We might therefore have expected hours of work to have fallen by about two-thirds. In fact they have fallen by only one-third – and have stopped falling since the 1980’s.

This makes it highly improbable that we will reach the three-hour working day by 2030. It is also unlikely that growth will stop – unless nature itself calls a halt. People will continue to trade leisure for higher incomes.

Skidelsky says the reason is that

The accumulation of wealth, which should be a means to the “good life,” becomes an end in itself because it destroys many of the things that make life worth living.

Now, I think Skidelsky is a genius, both in his biography of Keynes* and his more recent book on Keynes' renewed influence, Keynes: The Return of the Master. But I think his acceptance of Keynes' definition of enough--about eight times the average income of 1930--is the flaw, not human nature.

It must have seemed to Keynes that incomes eight times higher than the then-current incomes would be an enormous amount. Today the average US household income is about $68,000**. Imagine if the average household income were north of $500k. Everyone would certainly then have enough, wouldn't they?

This is probably how Keynes felt. And it's true that we've become wealthy in terms of what people thought they needed in 1930. In 1934--soon after Keynes wrote Economic Possibilities--food, clothing and shelter consumed 76% of household income, on average. In 2002-2003, these expenses were only 50% of household income***. (And, god knows, we are consuming more food, housing and clothing than we were in 1934, so our well being has increased more than these numbers indicate.) Far more households can now afford the basics they need to survive, and far more households have much more money left over after they buy these basics.

What have we done with all this new wealth, this extra income? Why haven't we, as Keynes expected, cut back our working hours, and thus our incomes? Why haven't we realized that we now have enough? Skidelsky thinks it's because of our paucity of imagination.

But maybe instead it's because once we had food, shelter and clothing, we realized that we needed more. We've moved up the hierarchy of needs, from physiological to safety. Now that we can, on average, afford the physiological needs, we are spending on health and education. In this light, the enormous increase in the costs of these services might be the desirable result of our ability to finally afford them.

Or, at least, start to afford them. Our healthcare debate is now dominated by whether we really can pay for everyone to have basic healthcare. Costs have increased at jaw-dropping rates, and many feel that we've lived beyond our means for too long already. Even with incomes that Keynes would think were more than enough, we find that we don't have nearly enough for what we now think we need.

But this also points to the solution. Just as we grew into being able to afford the basic needs, we need to grow into the ability to afford these new needs. On healthcare, for instance, the question is not How can we keep the cost down? but, instead, What policies can we enact to be able to afford it sooner? The answer to Skidelsky's question--How Much is Enough?--is that what we have now isn't enough: it would be inhuman to have the means to make peoples' lives better and then not do it, to be able to save lives and then not save them. Instead, we need to think about what we can do to increase our rate of economic growth. What can we do to be able to afford quality healthcare for all, not 100 years from now, but within our lifetimes?

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* Although not so much a genius that I read the full three volumes. I read the 1056 page "abridged" version.
** Median is about $50k and, while the median is more telling about how the average person lives, I think using the average is a better measure when talking about societal income.
*** Source: "100 Years of of Consumer Spending", US Department of Labor Report 991, May 2006.

Being allowed to make your own decisions, right or wrong

There was a fairly banal column over at the New York Times last Friday, complaining about being condescended to by a bank "customer service" rep.
“Did you want to add him to the account, or open a separate joint account?” she asked.

“We’ve talked about the options,” I said, giving my husband, James, my secret “not again” look, “but we’d just like to add him to this account.” I smiled pleasantly... “Are you sure?” she pressed on... I assured her that we had considered it and decided to stick to the original plan... She sat back a little in her chair and gave me a half-nurturing, half-scolding tilt of the head. “What would your mother say?”

I went on to read the comments, thinking there would be unanimous annoyance at the bank. Instead, there were an awful lot of people saying that the bank service rep was probably "right" and implying that being right was more important than respecting the customer.

I find this directly comparable to the claims by various boosters that they are doing consumers a service by placing relevant ads in front of them. The idea that someone else is determining what is right for you, based on incomplete knowledge about your situation and your decision process does not seem like an advantage for the consumer. It may sometimes result in a better match between consumers and products, true. But it will always impinge on the consumer's autonomy. I think there needs to be some greater good than slightly better product matching to justify this as a net increase in welfare.

Clearly, if the people advocating the benefits to the consumer of ad targeting believed it, they would instead be advocating better tools to help the consumer choose, not a process that is best adapted to targeting the most persuadable, rather than the best fit.

There are advantages to ad targeting, for the advertiser certainly, and for certain media outlets, but not for the consumer.

How to rake it in by screwing your customers

A long, long time ago I was at Prodigy when we decided to change from hourly pricing to a flat rate of $19.95 per month. Flat rate pricing was clearly preferred by our customers, and our competitors who were offering it were taking them away from us.

Problem was, when people are accessing the internet by dialing into 28.8k modems, more hours online meant more peak demand meant more modems needed, meant more expense.

As we evaluated the price change, I noticed that some of our formerly best customers would now become our worst customers. For instance, there was a bunch of die-hard group text-based RPG fans who spent 100+ hours online per month*. Paying by the hour they were great customers, but with a flat rate they were our worst. We had to ditch the RPG.

In fact, we had to ditch any content that people spent a lot of time with. It turned out that the people who liked the service the most, who spent the most time on it, were our worst customers. Our best customers were the people who never logged on but never got around to turning off the monthly bill.

I lost interest in this business model and moved on; businesses that do better as their customers do worse should not survive.

I was thinking about this today because of my friend Josh's excellent blog entry on the Google Mortgage thing and on retail banking in general.

Unlike most people's mental model of retail banking operations, banks do not make most of their money on the difference between the rates at which they lend versus the rate they offer for savings. American banks, quite distinctly from banks elsewhere in the world, make the bulk of their money from fees and charges. Invisible and often unavoidable consequences of little clauses in contracts that no one ever reads.

Banks' best customers are the ones who are getting screwed by the banks. Banks' worst customers are the ones who are probably pretty happy with their bank. This perverse incentive shouldn't persist, but it has. What's it going to take to change it?

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* This was a lot back then.

Skidelsky on Scapegoating

Here's something I've been trying to say for a year, poorly. Skidelsky in his new book, Keynes: The Return of the Master, says it succinctly:

Whenever anything goes badly wrong, our first instinct is to blame those in charge--in this case, bankers, credit agencies, regulators, central bankers and governments. We turn to blame the ideas only when it becomes obvious that those in charge were not exceptionally venal, greedy or incompetent, but were acting on what they believed to be sound principles: bankers in relying on risk-management systems they believed to be robust, governments in relying on markets they believed to be stable, investors in believing what the experts told them. In other words, our first reaction to crisis is scapegoating; it is only by delving deeper into the sources of the mistakes that the finger can be pointed to the system of ideas which gave rise to them.

As the crisis fades and everyone turns their attention elsewhere, I don't want to forget the lesson learned: what we know about economics is incomplete. Even more, no serious student of economics can now claim that any of the current "systems of ideas" are more than simplistic, directional models. No one knows nothing, and the people who claim to are fooling themselves.

On Regulation and Innovation in the Financial Industry

Yesterday President Obama said

We started taking shortcuts. We started living on credit, instead of building up savings. We saw businesses focus more on rebranding and repackaging than innovating and developing new ideas that improve our lives.

But contrast that with this, from November of last year:

The Securities and Exchange Commission this week issued a formal cease and desist order against peer-to-peer lender Prosper Marketplace Inc.

The San Francisco company said in October that it was no longer accepting new lenders or loans as federal regulators consider the company’s application to establish a secondary market for loans made on its person-to-person lending site. That process is expected to take months.

It's easy to talk the talk about wanting innovation, but government regulation and innovation are inimicable. It's hard enough to start a new company. It's next to impossible for a startup to comply with government regulation that is opaque, one-size-fits-all, slightly different in each of the 50 states and written by lobbyists to benefit incumbents. To comply with the regulations, companies have to hire expensive, well-connected lawyers and go through a several month process. As an early-stage investor, I probably wouldn't invest in working cold fusion if it required the company to be government regulated.

I know everybody and their mother thinks the solution to all our financial system woes is more regulation, but it's worth considering that the US financial services industry is probably the most heavily regulated industry in the world (and if it's not, then it's second only to our incredibly inefficient healthcare industry.) It seems everybody and their mother thinks that if beating your head against a brick wall isn't working, well, just beat harder.

I'm not against regulation, really. I just think that if the regulation we have isn't working, we need to go back and figure out why, rather than layering on a new layer of regs. We should also go back and figure out who wrote our current regulations and burn them in effigy, to better motivate the current regulation writers. Nothing focuses the mind like a hanging.

The first principle in writing new regulations should be an explicit statement of what we are trying to achieve. And if what we are trying to achieve is that no one loses money ever, then perhaps what we want is not a financial system at all. That goal would be best achieved by returning to the gold standard and issuing safes to every home.

But whatever the goals are, one of the primary ones should be to promote innovation. And one of the primary goals of that innovation should be promoting diversity of business models. After increased regulation, the primary prescription in the mass media for the financial system is making sure that no company is too big to fail. This worthy-sounding goal is a non-starter in today's economy. Even if every financial services firm in October of last year had been split into 100 identical sub-firms, we would have had the same problems. Paul Kedrosky has talked about making sure that firms are less tightly coupled as one solution to rolling failures. While I believe this, I wonder if it's possible to implement.

But if you turn the problem 90 degrees on a completely different axis, we can address the tight coupling along functional axes: if we had many types of firms, then even if they are financially intertwined, only a small subset will fail in any given crisis. This idea--that diversity is key to the resilience of an ecosystem--is widely understood by ecologists, biologists and evolutionary scientists. The benefits of biodiversity are inarguable.

We need an appreciation of diversity in our financial services companies. We need to encourage innovative startups that try to provide crucial financial services--like converting savings into investment--in new ways. We need hundreds of them, understanding that most will fail. (Innovation is akin to an evolutionary process in this.) We need to change our regulations to encourage innovation, rather than discourage it. The president needs to stop placing blame and start planting seeds.

And we need to get over the fact that some blameless people will lose some of their money some of the time. Because with the financial services monoculture we have now, every taxpayer loses a lot of money every ten years or so.

Why Bankers Will Continue to Make Just as Much as They Used To

I can understand the brouhaha over banker pay. Bankers make a lot of money. And the seeming unwillingness of the banks to lie low on the compensation front for even a quarter or two makes me wince.

Case in point, this New York Times article: After Off Year, Wall Street Pay Is Bouncing Back

Even as the industry’s compensation has been put in the spotlight for being so high at a time when many banks have received taxpayer help, six of the biggest banks set aside over $36 billion in the first quarter to pay their employees, according to a review of financial statements... If that pace continues all year, the money set aside for compensation suggests that workers at many banks will see their pay — much of it in bonuses — recover from the lows of last year.

Yes, bankers will get paid as much this year as they did before the financial services meltdown.

Another number in the article jumped out at me: "Historically, investment banks have paid workers about 50 cents for every dollar of revenue." This is surprisingly similar to the amount paid to employees of ad agencies and other marketing services firms. It is also surprisingly similar to the amount paid to consultants and lawyers (adjusting for the implied equity-ownership pay in partnerships.)

The headcount-expense/revenue ratio in professional services firms is so universal because the economics of salaries and revenue are linked. We (and the mass media) tend to think of firm revenue being set in one supply and demand market and eexpenses being set in another and firms forming only in that uncommon circumstance where the revenue is enough to support the expenses. This may well be true for companies that make widgets: whether or not the widgets are made is a consequence of whether or not they can be made for less than they sell for.

But in a professional services firm, this is not how it works. The demand for the firm's product is also the demand for the underlying labor, so these demand curves are linked in a simple fashion. The supply curves, obviously, are also linked. Because of this--and the industry dynamic it creates--professional services salaries are the amount left from firm revenue after rent, technology and returns to equity-providers are paid*. Since these other amounts are generally within a small range of percentage of firm revenue, the amount paid to employees will be as well.

If you think bankers make too much money, focusing on how much they are paid will get you nowhere. If they are not paid 50% of firm revenue, they will go to another bank that will pay them that much. If no bank will pay them that much, they will go start a new bank. If that sort of compensation is outlawed at any bank present or future, they will start a bank where they are the equity owners and get paid that much. The money has to go somewhere, and it's not going to go to the providers of capital because the providers of capital to professional services companies have no negotiating leverage.

Taxes would work. In most of the business world, it seems that the highly compensated are paid on a de facto post-tax basis, so if taxes are raised, compensation is raised to correct for it. But this can't be true under my theory of professional services firms. So that's one way.

But I believe that outsize salaries are the result of a market failure, so why screw around with taxes when we should be addressing the market failure itself? I'm no expert here, so I'm not going to expound in detail my pet theories of why banking services cost so much. But in general I think that financial services regulations are far too oriented around who is allowed to provide certain services and how they are licensed when they should be oriented around actually protecting people who need protection. These two things are supposed to be the same, in principle, but they have not turned out that way.

I know it's easier to get the average person incensed over someone's pay than to get them to think about reforming a market--especially a market the average person could care less about--but I guarantee that no matter what the government does, no amount of bluster over how much bankers make will change their pre-tax compensation a single iota unless they focus on why revenue per employee is so high.

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* Yes, I don't believe payments to owners in professional services firms are the residual profits. And why should they be, when the employees can leave and set up shop across the street with almost no need for equity capital? In the implicit negotiation over distribution of revenue, the employees have all the bargaining power. The equity will be paid a fair return, but will not receive any structural increases in revenue. On the other hand, the equity will continue to bear the majority of the variability in profits. This view, while not the standard economic view, has the advantage of being supported by reality. (It also accounts for why non-partner-owned professional services firms tend to conglomerate, but that's another post.)

There's lots of bad economic news, so much that not much of it breaks through the clutter for me anymore, but this did:

Tufts accepts 26 percent of pool, suspends need-blind admissions:

The admissions office ... stopped practicing a need-blind admissions policy toward the tail end of the process, a decision that affected five percent of applicants, Dean of Undergraduate Admissions Lee Coffin said.

Admissions officers were able to first read every application in a need-blind manner, during which they did not consider an applicant's ability to pay. But with more families requesting larger amounts of aid due to the recession, officers suspended need-blind practices for the final 850 applications -- of 15,038 total -- when potential financial aid ran out.

"We read every application need-blind, conducted committee need-blind, and then we ran the numbers and realized that we just couldn't do it, that we had gone as deeply as we could go," Coffin said.

I bet this is a problem a lot of colleges and universities are facing this year and may face the next few years. This is where the government funding should be going; investing in education for young people is the best possible use of our economy's surplus.

Read Romer in Post-Scarcity Prophet:

When you're thinking about the future, you never really know what we're going to discover, but I think there's a reason to set for ourselves an ambition of trying to raise the rate of growth by half a percent per year.

... If we can make the choices that increase the rate of growth or real income per person to 2.3 percent per year, in 50 years we can get extra income per person equal to what in 1984 it had taken us all of human history to achieve.

One policy innovation, for example, that would boost the growth rate would be to subsidize universities to train more undergraduate and graduate students in science and engineering.

Subsidizing education is as close to free for our society as anything we know of. I haven't run the numbers, but I suspect that the break even on this investment (in a steady state) is shorter than anything else we can think of.

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Two asides.

1. I don't agree with Romer on all of this, especially the idea that only science and engineering should be subsidized. Romer is focused on technological discovery as a driver of growth, but in my observation, ideas are discovered by people from all disciplines. Romer makes this point, although seemingly unintentionally, in his EconTalk podcast:

Research grants to universities are not the best way to develop all different types of ideas. Imagine that all music that we could listen to was produced by academic departments of music on college campuses. If you've ever listened to what music people write when they do research, it's pretty unlistenable stuff. The pure university research path isn't the way I want to get the music I listen to or the books I read. But, on the other hand, if you have the kind of things like open source, there is a kind of democratic element where people in open source have to cater to--or lots of things on the web that are free--they're catering to not just a narrow group of peers, but a wider audience. And that creates incentives for people to create things that are valuable for large numbers not just small elites.

If we want better music, give tuition subsidies to lots of music students rather than grants to a few music professors. This seems rather obvious in the arts, but it's almost certainly more true in other academic departments. The idea that "physics advances funeral by funeral" is a by-product of the current university system.

I also don't think that anyone, government included, know where we should focus our research to create ideas. Romer says "we never really know what we're going to discover..." and this is true not just within science, but within knowledge as a whole.

2. For my friends who conflate economics and finance: growth is not evil. The point of creating more income in a society is not to have more rich folk or to consume more stuff. Growth in income, although measured in dollars, is the ability to create more value, not more money or more things. We create additional value primarily by a better arrangement of materials, not the greater use of materials. So, a laptop today is more valuable than a mainframe computer of thirty years ago even though it uses less resources and costs quite a bit less. (There is a somewhat involved argument about why this creates a more even distribution of income, but that's pretty OT.) That growth often means more use of resources and more inequality is a bad outcome, but--IMHO--is not caused by growth itself but by the inefficient tuning of the institutions that encourage growth.

Growth is society becoming more productive. This additional productivity doesn't just mean that more people have gigantic flat-screen televisions (although certainly many people will use their excess production this way) but that we have better health outcomes, less incentive to fight over resources, more personal freedom and, hopefully, even the ability to increase the percentage of the pie that goes to people who currently have less.

More Capping

Another voice in my crusade (such as it is) to stop paying exorbitant salaries to everyone on the government dole.

In the hubbub surrounding President Obama’s decision to cap salaries of commercial-bank CEOs at $500,000 (if they receive future federal funds), the salaries of college and university presidents have been flying under the radar. Some reconsideration is due, particularly because substantial taxpayer dollars go into their services, with more funds coming via the stimulus package. State and federal taxpayers subsidize public universities substantially, but even private schools benefit from things like tax-subsidized student loans and tax-funded faculty research...

The 184 public research universities [in The Chronicle of Higher Education's survey of college and university presidents’ compensation packages] had 59 presidents whose 2007-2008 compensation packages were worth more than $500,000. The average for this $500,000-plus club was $654,000... Of the 32 research-intensive private universities, 31 had 2006-2007 presidential compensation packages worth more than $500,000, the average being $895,000.

HT: Alex Tabarrok, Marginal Revolution.