Law, Economics, and Regulation

One of the curious things about coming to law school was discovering the very high regard that “economics” is held in, at least in some areas like torts and contracts, where “law and economics” has become the primary theoretical construct. In essence, this school of thought holds either that the law has developed in such a way as to promote efficient economic outcomes, or that it should promote efficient economic outcomes. There is now an empirical branch of law and economics, but historically the law and economics approach was largely theoretical. For example, in United States v. Carroll Towing Co., 159 F.2d 169 (2d Cir. 1947), Judge Learned Hand wrote that the whether behavior is negligent should be determined by multiplying the probably of an accident by the cost of the accident and comparing that to the cost of taking precautions. Twenty-five years later, Richard Posner argued that this rule would lead to the optimal level of accident prevention, because it doesn’t make economic sense to pay more for accident prevention than the corresponding reduction in the expected costs of accidents; at that point, the firm would be better off just paying damages to accident victims. (There, now you don’t need to take first-year torts – just apply that principle everywhere.)

The Hand-Posner principle has filtered into the world of public policy and regulation as the argument that the benefits of regulation must exceed their costs. This argument is ascribed to Cass Sunstein, who “cruised through Tuesday’s Senate confirmation hearing” to be the “regulatory czar” in the new administration, which sounds much more powerful than “Administrator of the Office of Information and Regulatory Affairs” in the Office of Management and Budget. Sunstein is a widely respected law professor who specializes in just about everything (constitutional law, administrative law, regulation, and now behavioral economics – he co-authored Nudge – with a brief foray into the death penalty on the side).In principle, he would be able to review new regulations being defined throughout the executive branch. So the cost-benefit model of regulation – already favored by the previous administration – may become more firmly entrenched in the federal government.

While this makes perfect sense in principle, I’m skeptical of how it works in practice. The basic problem is that it’s difficult if not impossible to measure either the probability of an accident or the expected costs of the accident, especially since there is a wide range of potential accidents and a wide range of potential outcomes (among other things, the same injury to different people will have a different compensable value, since damages are based in part on wage loss).

Take seat belts, for example. This should be an easy case: it couldn’t have been that hard, back in the 1960s, to estimate the number of lives and injuries that would be saved by installing seat belts and making their usage mandatory. It shouldn’t be that hard to estimate some of the expenses that would be saved – police and firefighters, vehicle damage, medical expenses, etc. But what about death or long-term disability? Or just simply having recurring back pain for the rest of your life? What is that worth? It is true that our legal system has ways of valuing these things, but they are outgrowths of common law (whenever you hear the term “common law,” think of 16th-century English judges deciding cases about horses and cows, and you won’t be too far off) and they produce results that are at worst perverse – if you’re going to run over someone in a car accident, hit the old person on Social Security, not the young hedge fund manager – and at best incomplete. For the most part, if it can’t be bought and sold in a market (like cars, or labor), it has no value.

This can be a particular problem when it comes to regulations that affect health or the environment. It affects any chronic health condition that simply makes people feel worse, since it’s difficult to quantify the cost of your feeling crummy. (I know there are economists who work on this kind of valuation; they include my wife, which is why I know how difficult this is.) Then imagine trying to do the cost-benefit analysis on reducing emissions of greenhouse gases. It’s easy to estimate the cost of technology to reduce smokestack emissions. But what’s the cost of not doing so? How do you estimate the total cost of the ice caps melting, sea levels rising, violent storms becoming more frequent, huge swaths of agricultural land turning to desert, and so on? How do you estimate the benefits of new shipping lanes opening up? And how do you estimate the likelihood of any of this happening?

Finally, to return to our favorite application, imagine that the government had considered the idea of systemic risk regulation five years ago. It would have cost money; it would have created new disclosure requirements for banks and possibly hedge funds; it would have required countercyclical measures in a boom that would dampen economic growth. Those are the costs of regulation. And how would anyone have estimated the benefits? No one would have estimated the scenario we face today – trillions of dollars of asset writedowns, 3.3% contraction in the U.S. economy and counting, even more severe damage elsewhere in the world economy. And as a result, the regulation would have died.

To be honest, I’m a bit conflicted about this whole issue. I think that conceptually this is the right way to think about government policy, and in many areas we could certainly use more of it. But it’s a mistake to think that all policies can be boiled down to cost-benefit calculations when one side of the equation is difficult or impossible to measure accurately, and the last thing we need today is more economics-based overconfidence. Sunstein did say that the approach shouldn’t put regulation “in an arithmetic straitjacket,” so we’ll have to see what he actually does.

By James Kwak

60 responses to “Law, Economics, and Regulation

  1. There is a difference between being negligent and imprudent. It is imprudent to rely upon expected values alone. That is why people talk about worst case scenarios. Prudence is a virtue that has lost its appeal. But it may be staging a comeback. :)

  2. There is more to cost/benefit analysis than expectation value. (Hence concepts like “risk-adjusted returns” in finance.) Reducing uncertainty itself can have value, even if it costs more than the expected value of the losses. In particular, I would argue that prudential regulation is more about dealing with the “fat tails” on the probability distributions than it is about reducing overall average costs.

    You make good points about the difficulty of applying this sort of analysis in practice… But what is the alternative? “Go with your gut”? Whose gut?

  3. Interestingly, much of the opposition to a regulatory focus on cost-benefit analysis came from pro-regulation folks. But interestingly, this method has played in their favor in some arenas. For example, small particulates regulation:

    http://www.brookings.edu/articles/1997/summer_environment_lave.aspx

    Even under Christine Todd “I want to kill the EPA” Whitman, the EPA still found that regulating small particulates had a payback of 12 to 1. (80 billion benefit to around 6 billion cost)

    Not that the Bush Administration has acted aggressively on that study, but framing the debate in terms of costs has strengthened the technical merits of the pro-regulation arguments.

    Likwise, placing a number on the statistical value of a life (somewhere in the neighborhood of 6 million dollars) has also sharpened the debate. Performing valuation studies to make claims that visibility in national parks is worth X, or that reduction in asthma is worth Y, have provided a focal point for a technocratic debate that can easily spin out of control (so that _nothing_ gets done).

    If the debate consists of endless streams of people presenting opinions and stories in front of a congressional panel, we are apt to end up with lousy regulation. The lack of reason – and rational argument – in policymaking contributes to “tabloid regulation”. That is, writing costly laws and rules that create huge costs, but yield small (yet highly visible) benefits.

    Yet in the US, we seem to have a cultural aversion to technocrats – preferring that drinking buddies run key government programs.

  4. “Yet in the US, we seem to have a cultural aversion to technocrats – preferring that drinking buddies run key government programs.”

    That’s an insult to drinkin’ buddies everywhere.

  5. The law and economics approach, and it’s implication of judges deciding cases on the basis of wealth maximization, reminds me of the old socialist calculation debate. Is a judge capable of calculating the vast and unexpected economics consequences of their decision? It’s hard enough to reach conclusions based on the law and fairness.

  6. As someone who did cost/benefit analysis for years at EPA, here are two big elephants in the room:

    1. the use of discounted when it comes to the cost of lives saved = you go out far enough (100 years or so) and you don’t care who dies. Is this really a society we want?

    2. The benefits and costs don’t go to the same people. If even we can say that Chevron’s emissions make them a boatload of money that offsets the illnesses and deaths at the plants around them, that doesn’t make it right, moral or fair. Appalachia is having its ecosystem destroyed so we can enjoy cheap electricity from coal, but they get poisonous water and dead forests and streams. Still ain’t fair.

    I could go on and on with this, but let me say – this makes for bad policies that do not protect the powerless.

  7. Not all laws are enacted simply to exert a cost-benefit to culture. We enact laws to protect people from the very worst behavior man can offer up. Wall Street gave us some of the very worst – now it’s time for the government to develop strong regulatory protection from such behaviors in the future.

    Isn’t pharma regulated to make sure the profit motive doesn’t end up killing people? Doesn’t always succeed as planned, but for the most part, it works. Yes it’s costly to research new products and submit NDAs, but it becomes part of the cost of doing business in the pharma industry.

    Same will happen with Wall Street. It will be costly to comply with regulatory controls, but far better than collapsing the economy over and over again.

    Our lives have become dependent on the instruments, services and products offered by Wall Street. Thus, sadly, the execs on Wall Street need to have the government hovering over their behavior like the very worst kind of helicopter parent. It is essential, otherwise they would risk our life savings over and over for their profit.

  8. bobgreenfest

    I have NEVER seen a spreadsheet, financial projection, IRR, estimate, whatever, that could not be done in a different manner, with an equal set of reasonable assumptions, and show a different result. Doing well or doing the right thing is a matter of conscience, not a matter of economics, statistics, or some other mathematical formula to drive policy.

    I recently wrote LEEDing the Way: The Green Movement and Sustainability which discusses, among other things, the cost associated with saving the environment vs. saving the environment. I don’t believe it will be an economic model that provides the answer to this issue, or other financial issues.

    For additional insight into this and other financial matters, please see http://www.bobgreenfest.wordpress.com.

  9. revknits got it. The elephant in the room with any of these analysis – paying a small amount today to avoid the possibility of a larger cost tomorrow – comes from having some sort of discount rate to value costs today versus tomorrow, and we can’t rely on markets to give us the discount rate of quality of life over time (much less across heterogeneous people).

    Just a minor change in that assumption can completely flips the results.

  10. What is being missed is the concept of morality (or ethics). Economics is the study of money, so everything ends up being measured by money, but some things can’t be dealt with this way.

    There have been some other attempts like using happiness as a measure, but so far they haven’t caught on.

    There seems to be a relatively simple test, it has to do with resource limits. Take universal health care in the US. It is obvious that we can afford to cover everyone, the country is wealthy enough, so the debate is over who will pay. This is immoral, those who currently benefit disproportionately don’t want to pay more. It’s that simple.

    Even in the area of world poverty the planet is currently wealthy enough to provide everyone with a minimum standard of living. Moving the bottom billion from $1 per day to $2 (the UN objective) would cost $400 billion per year, the US spends twice this on militarism. Once again an immoral position is hidden in false economic arguments.

    The difficulty arises when the cost of doing right exceeds the amount of funds (or resources) available. Only in this case can arguments about economic efficiency or who suffers the sacrifice be invoked properly. I’m not aware of any such situations at present, especially as concerns US regulatory policy. Perhaps imposing limits on green house gases using the presently available technology might be such a case, but no one is willing to do an accurate assessment of costs.

    Every study that comes out still depends upon (politically biased) projects of future costs. The Stern report and the reactions to it are the perfect example.

    The appropriate thing to do is to pick the ethical solution and then ask how to minimize the cost to achieve it. Using this criteria Sunstein’s appointment is a disaster. He believes that he is smarter than everyone else and is thus permitted to bypass democratic mechanisms which should be used to make policy. If society is to make choices than society needs to be involved in the decision making, not some libertarian czar.

  11. Anne: “It will be costly to comply with regulatory controls, but far better than collapsing the economy over and over again.”

    How costly will it be? After all, we have fairly recent history of a generation or two during which the business cycle was moderate and the banks did not “throw themselves off the cliff every 10 years”, as I read on another blog.

  12. robertdfeinman: “What is being missed is the concept of morality (or ethics).”

    I think that it is worse than that. We have powerful professions and institutions in our culture that believe that amorality is ethical.

  13. When it comes to regulations I do believe there is a place for cost / benefit analysis and then there is a place for morals. For example, if a car company intentionally replaces a metal part for a plastic part knowing it will cause more deaths – that’s immoral. However, requiring a car company to equip all new vehicles with breathalyzer activated starters which would certainly prevent deaths – goes too far into social engineering.

    When it comes to financial regulations cost benefit analysis probably does hold more weight than morals, because it’s so convoluted. I certainly believe the bankers were trying to maximize profits, but most didn’t believe they were doing anything morally wrong. Bernie Madoff didn’t cause the economic collapse; he was simply exposed by it. It was caused by individual actions that taken in isolation were simply risky, but taken in total caused systematic risk; the very definition of a problem that requires regulations. If however the regulations can be written in such a way that they use the profit motive, either in actuality or through “nudging” rather than seeming like fiat – they will be a lot easier to implement. We have to remember that all these changes not only have to be able to work – they have to be able to make it through Congress.

    Lastly, this new regulatory system needs to be set up in such a way that the “correct” political appointments can’t simply ignore them. This is probably more vital than the specifics of the regs. Not only do we have to follow Buffett’s advice and have systems that even an idiot could run, because eventually an idiot will; we also have to have a system that can’t be thwarted by appointing a “goodfella” to be SEC chairman, or Treasury Secretary. Yes I mean Cox, but probably more Snow than Paulson.

  14. Min – I confess that I’m REALLY hung up on the fact the US Treasury Secretary stood before Congress last fall and said if we do not prop up Wall Street with a hefty bailout, we will no longer have an economy.

    And the amount of money he wanted to bailout the financial system was – and remains – astonishing.

    If we are to believe what Paulson told us last fall, this was not just an anticipated dip in the regular old business cycle. This was a catastrophic failure of the financial system that took us to the point of complete destruction.

    Wall Street firms clogged up their pipes with an enormous mountain of “toxic assets” that has posed a terrible threat to our nation – at least according to Paulson and other economists last fall.

    The idea that we should not regulate the behaviors that got us to this point just blows me away.

    How many S&L scandals, LTCM scandals, Continental Bank scandals, meltdown on Wall Street scandals do we need to realize that regulation is needed to protect the economy (and consumers) from the reckless behaviors exhibited by those on Wall Street?

  15. While cost-benefit analyses may help pro-regulators, they may also encourage us to make decisions in an economic context that should be made in a social one.

    Sure, $6 million dollars per life grabs the attention, but I consider mine to be priceless.

  16. People tend to under-estimate future costs, especially where rare events are involved. Perhaps it would help if those involved had to make their analysis public. That might force them to consider the public-relations nightmare of “We believe that two dead children a year is an acceptable cost of business,” which could lead to a better evaluation of the future costs, and maybe even fewer dead children.

  17. There are numerous problems with these sorts of analysis.

    1. In theory, a rule of strict liability will result in the same amount of precaution as a negligence rule. I believe Epstein argued for this in the 80’s.

    2. It ignores all distributative issues. Or as Brad Delong might say the market has a social welfare function. http://delong.typepad.com/sdj/2009/04/hoisted-from-the-archives-a-non-socratic-dialogue-on-social-welfare-functions.html Law and economic types think they are merely engaged in technocratic judgements, but really they are deep into making value judgments.

    3. The onus is on justifying the new regulation. But its far from obvious to me that everything not prohibited should be permitted. So for instance, why is the burden on those who want clean air on water to show that those goods are more valuable than the benefits of pollution and not the other way around?

  18. See Mandelbrot on economic statistics. A fair expected value is useless to anyone living if it arrives in centuries. If, as seems likely, there is no limit to the cost of an unregulated economy, then a cost benefit analysis is not possible, and decision-making must be undertaken on some other basis. Really, take a look at Mandelbrot’s cotton-market statistics. Go to the original papers (some of them are reprinted at the end of Fractal Geometry of Nature if you can follow the math–the implications are staggering.

  19. Anne: “The idea that we should not regulate the behaviors that got us to this point just blows me away.”

    Absolutely. Some people actually seem to believe that stuff. Others, I think, are trying to con us.

    Anne: “How many S&L scandals, LTCM scandals, Continental Bank scandals, meltdown on Wall Street scandals do we need to realize that regulation is needed to protect the economy (and consumers) from the reckless behaviors exhibited by those on Wall Street?”

    People do not tend to learn from history. Fortunately, in a way, with Reaganesque deregulation — why is Summers in this administration? — we have experienced a few economic crises ourselves. That should be enough, if we can get through the ideological noise (to put it politely). I am hopeful that we do not have to have a full catastrophe to get the message.

  20. I think it’s more like neo-cons et. al. don’t believe in any kind of morality. They take their moral education straight from the Athenians in Thuycidides: ‘might makes right.’ And frankly, this isn’t a moral problem in my humble estimation. Ask yourself: what are morals? what are ethics? Is there such a thing as a ‘universal morality?’ And does morality or ethics have a place in this conversation?

    The way I see it, this is a psychological problem. The country is built on narcissism. This belief that one is the center of the known universe extends itself to the idea that one can manipulate reality to be whatever is desired by ‘speaking’ it into existence, so to speak. This idea is utterly false. Reality, Truth, the Good, etc. etc. keeps slapping us in the face, and we don’t want to take our medicine that you can’t conjure up whatever you want to exist. This world is nuts.

  21. charles kincaid

    This discussion is apt as we are embarking on a national examination of our healthcare delivery system. In the interest of being concise, let me say that the short term solution for any situation where you are compelled to make a payout is to do everything within your ability to limit that payout, in the name of profit maximization, and then bondholder/shareholder payout. That actual people suffer from such a limited set of criteria for what is prudent for a manager to do, is or has been of limited concern in the staus quo of our current delivery system. Ken has it precisely correct, the future costs have been consistently avoided in denying healthcare to those who are un- or under insured. GM said seat belts would mean the end of the US auto industry, and yet it was stupidity and crummy cars, greedy unions, overpaid executives, and foreign competitors that brought about the end of GM.
    Bean counters and math whizzes are great at some things, the rest of us must thrash out the morality of say building very profitable, sold all over the word, incredibly effective, cluster bombs, which kill more children and animals than combatants? Is everything reducible to cost/benefit analysis, NOT. cdk

  22. Very good point about the discount rate…

    1) The use of discounting assumes that the _financial_ discount rate is actually a good measure of the _social value_ discount rate.

    In other words, it assumes that the value of a park in 60 years is equal to its value now, discounted by (1-r)^60. But in fact, that park is a resource that will grow _more_ valuable over time, not less. It may even grow in value at a rate _faster_ than the discount rate (particularly if natural resources become relatively scarce compared to other goods/services), in which case the discount rate should be negative!

    The discount rate also posits that if I took the same money and _invested_ it in some other social endeavor, it would turn into something that increases in value over time at rate 1+r. Except when financial return is a poor measure of real return. (Remember, GDP is a measure of economic production, not quality of life – if I break a window and someone fixes it, GDP goes up, quality of life went down.).

    But this is not really an indictment of cost-benefit analysis – it’s an indictment of specific abuses. For instance, I might argue that the discount rate for regulation should be the population growth rate – NOT the interest rate. So if population is growing at 0.9% a year, then human life in 30 years is worth 76% what it is worth today. But if you use a discount rate of 5%, then in 30 years a human life is worth 21% what it’s worth today.

    Devil is in the details, but you do need some discount rate… And I will defend that proposition if anyone asks.

    2) This argument has formed the basis of the tax-and-transfer system of regulation. Which, in theory, works if you can specify the costs, find a way to levy a tax, and figure out how to transfer proceeds to those harmed in proportion to harm.

    The problem with stopping all activity that yields negative externalities is that all economic activity would come to a halt. I drive a (fuel efficient) car; this contributes minutely to someone suffering. Hence, no car…

  23. gabrielspeaks

    Bold and insightful post; The authors clarity on the issue of social activism
    and truth it brings to bear on the prospects for the future give us all reason for hope. The question is: Are people ready to hear the good news yet? I for one AM!

    Way to go, we’ re all behind you, and were all in this together.

  24. Hey James, great article. Its gotten some interesting conversations among me and some fellow law students. I just finished my first year at the University of Pennsylvania. First semester, in my Torts class, we began learning law and economics from our Professor John Klick, who is a senior economist at RAND and a J.D. Early on, I wrote him this letter, which I think reflects some of the ideas that you’re expressing in your essay.

    Dear Professor Klick,

    As I was working on the reading in our class, I had some thoughts which I wanted to share with you.

    In “the cost of accidents” (page 163 in the casebook) it is argued that the way we calibrate costs is based on “the party or activity which can most cheaply avoid them” and that in the absence or certainty of who that party or activity is, the costs should be put on that “with the lowest transaction costs in the market.” There is an idea that follows that there is some model that the market would eventually reach “perfectly.”

    I have some moral issues to take with this whole set of analyses. Let’s take an environmental example. For some specific corporation X, burning fossil fuels- let us say coal- is the cheapest way for them to produce energy. They could invest in renewable resources, but they are more costly. As one organization, their total contribution to the sum of carbon dioxide in the atmosphere is very remote in relationship to the total amount put out by all actors. Now I happen to believe that global warming is happening and that it is induced by human actions. Without getting too detailed, let us just assume that if global warming continues as predicted, it will cause major issues across the world for millions of people. Let us focus on one specific subset of people: ecological refugees. Conservative estimates are that by 2050, 250 million people will become refugees from their native homes because of climate change. Is the cost to these people greater than that to the company that must change their habits of acquiring energy? I think so. But that judgment will only be made by a person taking into account a certain framework of circumstances. The problem with this efficiency model is that it tries to hide behind the veil of the market and argue that it produces efficient outcomes not based on value judgments. Yet in assessing these “costs” we are making judgments all the time: judgments about what should and shouldn’t be considered costs, and judgments about how those costs can or should be quantified.

    How are we to judge what has the lowest transaction costs? I will grant that the transactional costs of changing our entire energy market in the world will costs billions if not trillions of dollars. But are the costs of not acting equally great or greater, if it means the destruction of entire population centers, even countries as they go underwater? Are the costs not greater if it means an overall lower quality of life for hundreds of millions of people? Who makes the judgment and how do we quantify it?

    If I were able to quantify the costs of shifting over all our energy to renewable and put it in column A, and then quantify all the costs of global warming that will occur if we don’t do A and put them in column B, and it turned out that A was less costly, would that mean we should continue on as planned? Even if it means wholesale loss of human life and suffering? What about long term costs?

    I am very fascinated by torts but I can’t seem to agree that we can entirely remove justice from such an important area of law. I know there is an important role for economics to play in these kinds of considerations, but I am having trouble squaring that with my own sensibilities about what is right and fair in our society.

    I apologize if these thoughts are rambling and incoherent, but I hope that as we move forward this semester you can help me develop a clearer understanding of how this law and economics theory functions and if and how I can make it work with my beliefs (and hopes) about using law to create a more just and equitable world.

    Sincerely,

    Adam Schwartzbaum

  25. DesolationRow

    “The Hand-Posner principle has filtered into the world of public policy and regulation as the argument that the benefits of regulation must exceed their costs.”

    If back in 1954, you put the costs of integration into a cost/benefit equation, I’m guessing the answer would have been to not integrate. The savings from no longer having to install two identical water fountains within a few feet of each other probably would not have outweighed the huge police presence required and general social unrest. But the country did what was right and in fact put some more regulations in place in 1964 and 1965. I’d say those have worked out pretty well.

  26. The Economic Analysis of law is not specifically about judges using economic metrics to calculate consequences of their decisions. Find me one judge that wants to pull out the Financial Calculator to write part of their opinion, or that knows how to operate one =)

    The point of the theory is really to encourage economic growth through legal frameworks that foster efficiency. Regulation is an important tool of this concept. The idea of efficient economics in general is to reign in costs so we all have added benefits. Economic analysis of law looks to burden those creating the costs with the duty to pay for it, this way they either eliminate the cost or make sure the benefit is enough to compensate those that are hurt.

    Now apply this to regulation. If we don’t regulate banks within certain frameworks what do we have? Huge risks are taken. Leverage by concept (using other people’s money) creates major inefficiencies. I sell an unqualified person a mortgage and off to the races. Who knows whose money I just levered. I completely externalized that risk on someone else. When everything falls apart, big bailouts come, and we have the largest examples of Moral Hazard on earth. Societal benefit goes negative to the trillions. Granted we had (and still have) no idea how to prevent this.

    My point is, an Economic Analysis of bank regulation would show we need to eliminate the Moral Hazard as opposed to simply require banks to be more transparent. Find a way to put the risks back on the books.

    Today WSJ talks about Obama wanting to limit pay in Financial Services, as if restricting pay based on volume (of loans) is the solution. That is economically inefficient. Depending on how that is set up it could have a few different results. One, capping pay would mean after a certain volume I stop since there are no more benefits to me. Two, not capping pay but decreasing it per item sold means I just seek out more people (anyone with the cash/credit and a pulse) that can buy it. Both are inefficient.

    Why not set tighter standards for who and how we lend money. Wouldn’t that require the ambitious to seek out the qualified borrowers as the more they find the more they make? So quantity and quality converge to both have high pay for Wall Street and people that can pay back the money they borrowed. This would be an economically efficient regulation. (This is a loose example, I realize it is much more complex but I don’t have 10,000 pages and an army of experts to consult at the moment.)

    I guess I’d sum it up as saying that an economic analysis of the law would form regulations that modify behavior to achieve efficiency and not simply derive more numbers to achieve transparency. This is our task and it’s like operating on a heart while blindfolded after just finishing your first year in medschool.

  27. Stats Guy: “The discount rate also posits that if I took the same money and _invested_ it in some other social endeavor, it would turn into something that increases in value over time at rate 1+r. Except when financial return is a poor measure of real return.”

    When I was a kid I saw this problem in a book. If you put $1 in a saving account at 3% (the book was written in the 50s) compounded yearly, how much money would you have after 2,000 years? It is an astronomical amount, of course. It was a math book, but I took away this lesson. You can’t do it.

    Benjamin Graham said that the goal of investing is to preserve capital. Not to increase it, to preserve it. Smart man.

    Now, in the short term, like a human life span, or a couple of hundred years, maybe you can earn compound interest in real terms, but in the long term, who knows? We only have a couple of hundred years of history in which that was possible, and to do so we have been burning up resources, both literally and figuratively, at a tremendous rate. Can we do so indefinitely? Should we even try?

  28. Desolation Row: “If back in 1954, you put the costs of integration into a cost/benefit equation, I’m guessing the answer would have been to not integrate.”

    That is my guess, too. The South may have been poor, but the known value of exploiting tenant farmers and household servants, who were mostly the descendants of slaves, would probably have been calculated as greater than the value of allowing them equality.

    People intuitively make cost benefit analyses all the time. Slavery was dying out in the American South until the invention of the cotton gin created a demand for cheap cotton pickers.

    Come to think of it, is there an economic argument against slavery? The only one that I have heard is from the Yes Men, and that was a spoof. (Exploiting Africans who live at home and feed themselves is cheaper than slavery. ;))

  29. tippygolden

    Here is how Canada deals with actuarial health insurance:

    “…to facilitate reasonable access to health services without financial or other barriers.”

    — Canada Health Act

    See: http://www.hc-sc.gc.ca/hcs-sss/medi-assur/cha-lcs/index-eng.php

  30. My sentiments exactly, Adam. Recently, I concluded a course of Law and Economics that I was studying as an undergrad at my local state college. The professor (an economist) had the annoying habit of discounting the rule of law, in favor of making his economic arguments work using calculations. Even when presented with copies of the statutes relevant to our discussion, he insisted on arguing the law away, in an effort to give balance and viability to the economic viewpoint.

    If economists are making adjustments (mistakes) with their numbers in order to justify certain specific outcomes (desired by whoever hired them for their analysis), then what will happen to the rule of law?

  31. A governments budget is a reflection of the morals of that society. Resource allocation indicates where priorities lie, especially when looked at over time.

  32. James, I love your article. Very thorough and insightful (inciteful?). I have spent most of my life with the law, and much of it as an interested participant in evolving economic theory. Interestingly, each is touted as science, and yet each in its own way is about as scientific as “political science.” Which is to say, that each has a strong element of both philosophy and psychology as components. The real upshot of this is that each contains enough “slippage” in its theories (and practices) to make it more or less subject to the whim and intents of its proponents, and thus places it firmly in the realm of politics. The example of the law and economics of regulations is a nearly perfect example of the convergence of these properties. With each new major shift in either the real world (e.g. the Great Depression) or political atmosphere (e.g. the Great Deregulation debates of the 80’s and 90’s), there has come a new (and thoroughly vetted) assault on the status quo (e.g. the enactment and repeal of Glass Steagle).

    The ultimate upshot is that so long as the convergence of this troika is kept under the purview of politicians and their supporting wonks, the continued move toward “justified economic chaoes” will continue unabated.

    I am old, but I still have hopes that the American system will find a way to remove the interaction of the law and economics from the political arena, and put it in the hands of a large group of independent scholars, called, say, the “National Board of Economic and Legal Policy.” Such a board would be populated by three separately nominated groups: 3 economists and lawyers nominated by the each of the two parties, and the third group of six elected by the public by referendum. The group would have statutory authority of either (a) make law and policy on all materes economic and (b) to vet any proposed law or amendment to law or policy which would add or change toe existing law or policy,. The board would by completely private and would not accept any input that they did not initiate from any outside source. All decisions made would be considered absolute. Their members would be under constant surveilance to prevent any outside influence and ensure privacy.

    Otherwise, we will continue to get policies that are bought and paid for by constituancies which act out of pure self interest, and with no real desire for supporting the general welfare of our society, regardless of what they say.

    This may sound overly cynical, but I assure you, that it is simply realistic. And, since I know this won’t happen (real reform), things will simply continue to move chaotically. The real problem, as I see it, is that we are at the ultimate crossroads in both the economy and world climate. And, my real concern is that those who truly care enough to take strong enough action for reform in each area will not have the power to effectuate it.

    The situation doesn’t make me angry, but just very sad. I lived through the Cold War. Oddly enough, I feel far more insecure now than I did then. The future we face is truly terrifying.

  33. Remember the Ford Pinto and the gas tanks that tended to explode if it were rear-ended? The cost of curing the problem was, on a per car basis, fairly trivial, about $13.00 or so, as I recall. But the cost-benefit people at Ford multiplied that amount by the number of cars they expected to sell and compared it to the costs of paying any tort claimants.

    Of course, they did not include in their calculus the “horror factor.” That is, the recovery that injured consumers would receive due to the gruesome deaths and injuries they suffered when juries learned that these consequences resulted from Ford attempting to nickel and dime its way to additional profit.

    There are, of course, contrary views. See the law review article here: http://www.pointoflaw.com/articles/The_Myth_of_the_Ford_Pinto_Case.pdf

  34. I knew taking the side of cost-benefit analysis would not be popular…

    In any case, here’s one argument for why earlier generations are more valuable…

    http://en.wikipedia.org/wiki/Most_recent_common_ancestor

    There are many fewer of them, and they have non-linear impacts on subsequent generations.

  35. Surgery, when performed badly, kills people too. Nonetheless, doctors still perform surgery.

  36. “If back in 1954, you put the costs of integration into a cost/benefit equation, I’m guessing the answer would have been to not integrate.”

    You need to consider the benefits too – and appropriately weight them.

    Antagonists of cost-benefit analysis loudly proclaim that one cannot put a price on certain values. Yet this position has only weakened their arguments – absolutism cannot possibly stand in a pragmatic court of law or any social system.

    Cost benefit analysis has the advantage of forcing agencies to put a price on those values – and if the price is too low, this provides a lightning rod for criticism.

  37. And how is a social context any more fair than an economic context? In an economic context, at least value is defined against a commonly agreed reference point that has some extrinsic worth.

    In a social context, value is defined in accordance with the ability of one party to exert influence over another party.

    If the standard for harm is not economic, then what praytell is the standard for harm? Who sets it? And how do we balance harm against harm?

  38. “Law and economic types think they are merely engaged in technocratic judgements, but really they are deep into making value judgments.”

    I think they know this. However, cost-benefit analysis has the advantage that these value judgments are made explicit, and exposed for criticism.

    Without expressing tradeoffs in a transparent manner, we increase opportunity for obfuscation and manipulation.

    “The onus is on justifying the new regulation.”

    This is a purely American phenomenon. In Europe, the standard is the Precautionary Principle, which puts the onus on innovators to prove no harm is likely. But the method of argument is still often cost-benefit analysis.

    http://en.wikipedia.org/wiki/Precautionary_principle

    We should not confuse the method of argument with the politically determined status quo ex ante.

  39. Sure are some smart commentators here. Thanks to all.

    But this was the best. I hope you don’t mind if I borrow your lines. (not for profit of course)

    “It is obvious that we can afford to cover everyone, the country is wealthy enough, so the debate is over who will pay. This is immoral, those who currently benefit disproportionately don’t want to pay more. It’s that simple.”

    Thank you , robertdfeinman. The health care issue is a big deal to me.

  40. Healthcare economics a topic in its’ own right. One of the ironies of the ‘swine flu’ panic is that it ignores the death rate from drug reactions (i.e. such as vaccinations).

    “The JOURNAL of the AMERICAN MEDICAL ASSOCIATION (JAMA) Vol 284, No 4, July 26th 2000 article written by Dr Barbara Starfield, MD, MPH, of the Johns Hopkins School of Hygiene and Public Health, shows that medical errors may be the third leading cause of death in the United States. The report apparently shows there are 2,000 deaths/year from unnecessary surgery; 7000 deaths/year from medication errors in hospitals; 20,000 deaths/year from other errors in hospitals; 80,000 deaths/year from infections in hospitals; 106,000 deaths/year from non-error, adverse effects of medications – these total up to 225,000 deaths per year in the US from iatrogenic causes which ranks these deaths as the # 3 killer. Iatrogenic is a term used when a patient dies as a direct result of treatments by a physician, whether it is from misdiagnosis of the ailment or from adverse drug reactions used to treat the illness. (drug reactions are the most common cause).” http://www.cancure.org/medical_errors.htm

  41. access, perhaps – but whether they receive adequate, competent or any care another matter altogether. Another issue being how the reporting, occurrence and economics of medical malpractice may differ between Canada and the U.S. given the U.S.’s more litigious culture, supported by its’ relatively large, powerful community of class action lawyers.

    “…The province is one of only 3 with legislation that allows doctors to apologize to patients and their families without fear it will be interpreted as an admission of liability. The province also compels health care workers to come forward with details of critical incidents, but protects them from publicity and legal liability. However, that system has been shaken by the recent disclosure of additional facts surrounding the death of Brian Sinclair, a homeless man who died after spending nearly a day and a half unattended in the emergency room of the Health Sciences Centre, Winnipeg’s largest hospital…” http://www.pubmedcentral.nih.gov/articlerender.fcgi?artid=2670923http://www.pubmedcentral.nih.gov/articlerender.fcgi?artid=2670923

  42. tippygolden

    mtm,

    What happened to this homeless man is shameful and tragic.

    He was also extremely marginalized.

    Canadians who are reasonable well-integrated have no problem with accessing our medical system.

  43. tippygolden

    Hope I am not hijacking this thread.

    In the part of Canada where I live monthly Medical Service Premiums (in Canadian dollars):

    $54 for one person
    $96 for a family of two
    $108 for a family of three or more

    Some OECD stats:

    HEALTH CARE SPENDING

    15.3% GDP USA
    10% GDP Canada

    $6700 per capita USA
    $3600 per capita Canada

    34% obesity rate USA
    18% obesity rate Canada

    6.7 per 1000 infant mortality USA
    5.4 per 1000 infant mortality Canada

  44. You lost me at Learned Hand. Or rather, our legal system lost me. I so hope that this expected value calculation nonsense is not the only game in town when it comes to determining negligence. What a country.

    Thanks, again, Mr. Kwak, for an excellent post!

  45. As you mention, one of the many problems with CBA is that it sidesteps moral questions entirely. An example from Peter Dorman is a situation where we can imagine a country where it is found that workers slcking off at their jobs cost the country, say, 1% of GDP each year (surely an underestimate). In the US this would be over $100 billion. Then imagine that each time a worker slacks off his/her name is put into a hopper. At the end of the year the hopper has millions of names in it (some names more than once). Finally, imagine that once a year there’s a big TV show put on, and one worker’s name is drawn from the hopper and he/she is put to death on national TV as a warning to all the slackers. Let’s suppose this results in such an increase of effort from the workforce that national output rises by 0.5%. This would be $50 billion in the US. Economists such as Viscusi and others, using wage-risk compensation models, have estimated the value of a statistical life at roughly $5 million (there’s a wide range of estimates). So for the “investment” of $5 million we can obtain a return of $50 billion. At 10,000:1 this is a hell of a benefit-cost ratio! Why don’t we do it? Because it offends our sense of proportionate justice and because it arouses an empathetic response. If we were already doing it, why would we stop it? We do in fact do this all the time through allowing toxic air and water pollution, unsafe work practices, untested industrial chemicals to be used and so forth. But because we don’t identify the individuals beforehand whom we are going to kill with these practices we excuse ourselves from any responsibility.

    I do think cost-benefit (or cost-effectiveness) analysis is a useful tool, but only as a way to illuminate the impact of our choices, not as a necessary-and-sufficient criteria for public choice.

  46. DesolationRow

    StatsGuy,

    Thanks for your resonse and I would agree with you in most cases…absolutism or inflexibility isn’t the way to go generally. However, I believe there are exceptions. For example, there are truly innocent people today in prison that refuse to accept the guilty verdict handed them. This most likely impedes any chance for early release as “The federal sentencing guidelines and sentencing guidelines in many states provides for reductions in sentences for “acceptance of responsibility.” I guess you could argue it all depends on how you value the benefit of not accepting responsibility for a crime you did not commit. In my mind however, I see this as a case where the costs in purely economic terms far outweigh the benefits. Sorry, I may have gotten way off track here but my point is there are cases where due to perceptions of justice or equality, a pure monetary cost/benefit analysis won’t suffice.

  47. StatsGuy,

    Why do we need a discount?

    In finance, the discount rate has a very theoretical basis in intertemporal consumption. In practice hundreds of thousands of people ruthlessly bet for and against it in interest rate markets, measuring it to a hundredth of a percent (1bp).

    So when I think of discounting when it comes to finance, I am very comfortable. I don’t have ANY comfort when it comes to discounting cost-benefit analysis here – I don’t even have a theoretical basis for the inputs. The fact that people can just make up values in these comments worries me greatly about it.

  48. StatsGuy: “And how is a social context any more fair than an economic context?”

    An argument can be made that the social context is broader than the economic one, and more inclusive. (Not that that is what Pete Muldoon had in mind. Nobody has defined their terms. ;)) Economic arguments, IMX, often seem to be narrow and to fail to take into account non-market values. Not everybody is a utilitarian. In fact, I suspect that utilitarians are in the minority, even in modern society, and surely they were in traditional societies. Hence the saying that an economist is someone who knows the price of everything and the value of nothing. (Pace Oscar Wilde, who said that about cynics.)

    “In an economic context, at least value is defined against a commonly agreed reference point that has some extrinsic worth.”

    Do you mean definition of value by price? See above comment. Was a tulip bulb really worth several thousand florins? Were U. S. houses really worth what they were priced at two years ago?

    “In a social context, value is defined in accordance with the ability of one party to exert influence over another party.”

    That’s a bit unfair, isn’t it?

    “If the standard for harm is not economic, then what pray tell is the standard for harm? Who sets it? And how do we balance harm against harm?”

    Humans have done that for millenia, without necessarily appealing to economic standards.

  49. StatsGuy: “Surgery, when performed badly, kills people too. Nonetheless, doctors still perform surgery.”

    Yes, but these days they wash their hands. ;)

  50. I am not an antagonist of cost benefit analysis. It is a useful tool.

    But morality encompasses more than that. It is a hard lesson of life that there are occasions when, to be moral, you cannot count the cost.

  51. Richard Hoogesteger

    It’s a good post but it is important also to look at the Hand rule from a strictly legal perspective. Specifically it is in many ways just a scheme to bypass due proces rights of compensation. What Hand did by striking down traditional British nuisance laws was to transfer control over clean air from individual property owners who previously had had the right to enjoin polluters from sending any contaminanats over their property to industrialists who could then pollute provided that their profits justified it. If you want a better understanding of this issue read Morton Horwitz “The transformation of American Law”, a brilliant book.

  52. tippygolden

    I’ll add here:

    Equity in health care in Canada means (in theory) every one has equal quality of care. Whether you are a high-wage earner, or poor, and everyone in between.

    The volume of debate in Canada is not over how to pay for premiums, or how to pay for medical care, when you or a family member is ill or dying.

    Rather, there are (for-profit funded) lobby groups that seek to convince Canadians we need to introduce more privatization. Moreover, they hijack our public discourse on how to improve our health care system, with well-funded PR campaigns.

    I suspect these “lobbyist” are cross-border and they are funded by the for-profit medical / pharmaceutical industries based in the United States.

    In the United States, these “special-interest” groups trash Canadian health care because they are afraid Americans might adopt something similar.

    Here is what the national correspondent for Time Magazine said, May 11, on the PBS News Hour.

    KAREN TUMULTY: “one thing that the industry is very much afraid of is what’s being called the public plan.

    It would be an option that would be built into health care reform under some proposals where people would have an option of buying into a Medicare-like government plan.

    The insurance industry has, as we all, seen studies that suggest, given that option, 130 million people would take it, which would essentially break the business model for the insurance industry…”

  53. “In a social context, value is defined in accordance with the ability of one party to exert influence over another party.”

    In the earlier days of the “jobs vs. environment” debate, battle lines were drawn based on interests, which then marshalled support using emotional arguments. From this, the anti-environmental movement was born (“Wise Use” and so forth). Not just a movement that values business, but one that viciously actually attacks environmentalists as crazy, unreasonable hippies.

    http://en.wikipedia.org/wiki/Environmental_movement_in_the_United_States

    http://en.wikipedia.org/wiki/Wise_Use_Movement

    The failure of the environmental movement to forward hard-hitting quantitative arguments led to widespread lack of credibility, and vulnerability to attack by crunch-heavy groups like CATO. Cost-Benefit analysis, initially created to contain environmental policymaking, has actually lent credibility to such groups as the NRDC, which can martial these arguments to present environmentalism as simple common sense regulation. This has moved the environment mainstream, to the point that even in the heyday of Bush II (when he was quite popular), most American’s still disagreed with his environmental policies.

    http://www.pollingreport.com/enviro2.htm

    The quantification of the BENEFITS of regulation has been critical in beating back efforts by special interests to stifle regulation as un-economical. The epitomy of this trend was Obama’s campaign – by far one of the most popular planks was the creation of Green Jobs (aka, regulation was not just good for us, but good for the economy). This claim was backed up by numbers.

    This was a soft cost-benefit analysis. We did not put specific value on each job, but voters made the calculation themselves.

    By shifting the debate to costs and benefits, Obama forced the discussion into technical details on the exact number of jobs that would be created and the cost (rather than emotional arguments of families vs. owls). On this ground, pragmatists can win. But when the debate is carried up to “principles”, special interests (e.g. CATO institute) can defend practically anything in terms of “individual freedom”, and environmentalists can defend anything in terms of sanctity of nature.

    In policymaking, which has to abide by specific process rules (read Neil Kerwin’s book on Rulemaking – he’s the public administration version of Cass Sunstein), making the calculation specific is helpful on many dimensions. Cost-benefit analysis merely sharpens the practical debate.

    Prior to cost-benefit analysis, _every_ argument was emotional, and without context to the costs. Environmentalists marginalized themselves.

    Nor is cost-benefit analysis antithetical to environmentalism. European countries uses it regularly… But, they adopt more risk-averse metrics (Precautionary Principle, lower discount rates).

  54. The flippant answer is because without a discount rate, asset valuations derived from value-flows are infinite.

    But here’s the real answer: to prioritize things.

    In an ideal world, government would identify all possible regulations and prioritize them without the use of a price mechanism. In the real world, regulation is messy. Regulations are proposed in response to observed needs.

    With zero discount rate, almost any proposed policy that offers a long term flow of benefits (even if marginal) yields infinite return. Thus, when an agency has to make a go/no-go decision on a rule, the answer is always “go”.

    This provides no reasonable way to prioritize which regulations are most important (both within agencies, and even worse, across agencies – let alone in comparison to other govt. or private priorities). And the agency (as well as society) has scarce resources.

    …..

    Here, btw, is a perverse case of how a zero-discount rate could be abused.

    Mining Company X (MinerX) proposes a mine that would cause immense local harm. (Displace an entire community, disfigure the land.) But they proposed to restore the community and the land at the end of 40 years. They even post a nice fat bond to secure this promise. This creates a large short term fixed cost, but the cost is finite in time.

    In exchange, MinerX offers to buy a few acres of surrounding land and preserve it forever… Put it into trust with the Nature Conservancy. With a zero discount factor, this donation has near-infinite social value, and can compensate for virtually any amount of short-term devastation.

  55. @Min

    And you are right that any characterization of an opposing argument which can be delivered in once sentence is going to be a bit unfair… I hope it explains the point, however.

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  59. @ StatsGuy

    Many thanks for the clarification. :)

    One thing that concerns me in our national or worldwide debate is the idea that economics not only can but should encompass value. In my opening note I talked about the decline of the virtue of prudence. I think that many of our troubles, including the degradation of the environment and the current fiscal crisis, can be traced to imprudence. Can prudence be justified by expected value in the marketplace? More generally, is there a justification for prudence in economic theory? That is not a rhetorical question. If there is one I would like to see it.

    When I was a kid I learned that the marketplace undervalues virtue. As an adult, I have not been disabused of that notion. Hence the saying, “Virtue is its own reward.” It had better be, eh? ;)

    I know that you are critical of arguments based on stories. In the post-post-modern world, that is a good thing. (Elvis really is dead. ;)) But the uncertainties of the world can overwhelm precise calculation, and stories can encapsulate relevant experience that has stood the test of time. I remember thinking during the Reagan era, “Haven’t these people heard about the seven fat years and the seven lean years?” Bible-belt conservatives certainly had, but for some reason seemed quite content to have the U. S. become the world’s greatest debtor, and to cut taxes during boom times.

  60. Nightengale

    Bayard;
    No matter how many numbers they shovel in, statiticians cannot fill the huge, gaping hole in the American social psyche. The level of regulatory erosion we are witnessing today may well be without precedent. This is, indeed, terrifying. It appears our culture has “pulled anchor” on any steadying regulatory regime addressing anti-speculation and trading. All sense of the connection between behavior (i.e. unbridled speculation) and consequences (i.e. the American public gets to pay for politically-sanctioned, white collar gambling…in more ways than one) has been removed. Any one would deduce that these actions are wrong, and that we are posed with a “cause and effect” question.

    Today’s conversation occupies the space at the intersection of economics, politics and regulation. Following the first Great Depression, policy makers saw the glaring need to interject ethics into their conversation: the SEA and the CEA would call for a higher level of moral reasoning in the debate over what is legal vs. what is right. Numbers were not part of that equation.

    Regulatory leadership – from any branch of government – must rise above the simplicity of mathematical models. A statistical argument can be made in support of any policy objective. In sum, statistics divert our attention from the macro-level dialogue many appear to be avoiding.

    I could not agree more with your recommendation for an independent regulatory unit protecting the American taxpayer from the nightmare of another bailout. Eventually, we will run out of money. Politicians have failed. The only answer is to work toward creating an informed electorate, supported by real-time information from an independent regulatory agency.

    Insecurity is a normal response when people awaken to the reality. We have experienced not only the blatant abuse of (political) power, but also the neglect of the enforcement agencies hired to serve the public interest. Both have caused the economic crisis we face today.