Category Archives: Beginners

The Koch Brothers, The Cato Institute, And Why Nations Fail

By Simon Johnson

A dispute has broken out between the Cato Institute, a leading libertarian think tank, and two of its longtime backers – David and Charles Koch. The institute is not the usual form of nonprofit but actually a company with shares; the Koch brothers own two of the four shares and are arguing that they have the right to acquire additional shares and thus presumably exert more control. The institute and some of its senior staff are pushing back.

According to Edward H. Crane, the president and co-founder of Cato, “This is an effort by the Kochs to turn the Cato Institute into some sort of auxiliary for the G.O.P.” Bob Levy, chairman of the Cato board, told The Washington Post: “We would take closer marching orders. That’s totally contrary to what we perceive the function of Cato be.”

Far from being just an unseemly row between prominent personalities on the right, this showdown reflects a much deeper set of concerns for American politics and society. And it raises what I regard as the central question of an important book, “Why Nations Fail: The Origins of Power, Prosperity and Poverty,” by Daron Acemoglu and James Robinson that will be published on March 20. Continue reading

Ponzi Schemes for Beginners

By James Kwak

On the theory that the best defense is a good offense, Rick Perry has been insisting to anyone who will listen that Social Security is a Ponzi scheme. Probably hundreds of people have already explained why it isn’t, but I think it’s important to be clear about why Rick Perry thinks it is—or, rather, why his political advisers think he can get away with it.

A Ponzi scheme, classically, is one where you promise high returns to investors but you have no way of actually generating those returns; instead, you plan to pay off old investors by getting new money from new investors. Social Security is obviously not a Ponzi scheme for at least two basic reasons. First, there’s no fraud involved: all of Social Security’s finances are right out in the open for anyone who cares to look, in the annual report of the trustees of the Social Security trust funds. Second, a Ponzi scheme by construction cannot go on forever; no matter how long you can keep it going, at some point you will run out of potential new investors and the whole thing will collapse. I’m sure there are other obvious differences, but that’s enough for now.

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Social Security for Beginners

By James Kwak

In Monday’s Atlantic column, the part that upset the most people was (not surprisingly) the following paragraph on Social Security:

“The dollars are in programs like Social Security ($740 billion), which, per dollar, has a relatively small impact on the economy. Social Security doesn’t say what businesses can or can’t do, and it doesn’t say what people can do with their money: it mainly moves money from people’s working years to their retirement years, which means that in part it’s doing something that they would have done anyway.”

One commenter, for example, said that Social Security does tell you what you have to do with your money: you have to buy an annuity. Another said that if he could opt out of Social Security right now, he would, since he thinks it is a losing proposition for him.

I don’t think that any of the criticisms really addressed the main point I was trying to make: that Social Security has a smaller per-dollar economic impact than a regulatory agency like the CFPB. They are fairly typical of criticisms of Social Security, however, so I want to address them in a little more detail.

The debate is really about what Social Security is. A lot of people take the starting point that Social Security is an individual investment vehicle, and then they decide they don’t like it because it doesn’t look like the other individual investment vehicles they are familiar with (brokerage accounts, 401(k) plans, etc.). Other people think that Social Security is a welfare program, and since they don’t like welfare, they don’t like Social Security. But it isn’t either.

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“The Elderly” for Beginners

By James Kwak

As the AARP says that it is open to modest cuts in Social Security benefits, it’s worthwhile asking a more fundamental question: are Social Security and Medicare programs that benefit the elderly?

The answer may seem obvious. After all, the bulk of Social Security Old Age and Survivors Insurance benefits go to people over 62, and almost all Medicare beneficiaries are over 65. So it’s often observed in passing that our long-range budget issues are the product of transfers to the elderly. For example, in Restoring Fiscal Sanity 2005, Alice Rivlin and Isabel Sawhill write, “These big programs, which benefit primarily the elderly, will drive increases in federal spending in the longer run” (p. 36). Other commentators have occasionally argued that the problem is that the elderly have become too powerful and therefore claim too large a share of government spending, especially compared to the very young.* When you add to that the frequent complaint that, by running budget deficits, we are imposing burdens on our grandchildren, this age-based inequity seems even greater.

But the problem with this framing is that “the elderly” change every year. There’s nothing inherently wrong or unfair with a program in which you pay insurance premiums while you work and collect benefits when you retire. Saying such a program benefits the elderly is like saying that life insurance doesn’t benefit the insured, only the beneficiaries: it’s true in a trivial sense, but people still want and buy life insurance anyway.

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Health Care Rationing for Beginners

By James Kwak

“Obama-care kills Medicare as we know it. Obama-care raids $500 billion from Medicare to spend on Obama-care, puts in place a 15-panel board to ration Medicare by unelected bureaucrats.

“Our budget, repeals the raiding, gets rid of the rationing board, preserves this program, makes no changes for a person 55 years of age or older and saves Medicare, by reforming it for our generation, so it’s solvent. The president’s plan does not save Medicare, it allows it to go bankrupt, rations the program and raids the program. We get rid of the rationing, we stop the raiding and we save the program from bankruptcy.”

That was Paul Ryan on Fox News recently.

Ordinarily this wouldn’t be worth responding to, except to point out, as Sam Stein did, that Ryan’s proposed budget also “raids $500 billion from Medicare,” so the statement that “we stop the raiding” is, um, a lie. But it isn’t news that Paul Ryan has an issue with honesty, except perhaps for David Brooks.

But there’s a theme that is surfacing that goes something like this: OK, Ryan’s plan is extreme and has no chance. But we all know we spend too much on health care, and we have to spend less, which means that we have to ration care one way or another. Ryan does it by scrapping Medicare in favor of indexed vouchers; Obama does it by reducing Medicare payment rates and, more ominously, with “a 15-panel board to ration Medicare by unelected bureaucrats.”

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Allocative Efficiency for Beginners

By James Kwak

I was catching up on some old Planet Money episodes and caught Allen Sanderson of the University of Chicago talking about how to allocate scarce resources. The first day of introductory economics, he says, there are always more students than seats. Say there are forty extra people, and he can only accept ten more into the class. He asks the class: how should the ten slots be allocated? You can easily guess the typical suggestions: by seniority, because seniors won’t be able to take the class later; by merit (e.g., GPA), because better students will contribute more to the class and get more out of it; to the first ten people outside his office at 8 am the next day, since that is a proxy for desire to get in; randomly, since that’s fair; and so on. Someone also invariably suggests auctioning off the slots.

This, Sanderson says, illustrates the core tradeoff of economics: fairness and efficiency. If you auction off the slots, they will go to the people to whom they are worth the most, which is best for the economy as a whole.* If we assume that taking the class will increase your lifetime productivity and therefore your lifetime earnings by some amount, then you should be willing to pay up to the present value of that increase in order to get into the class. An auction therefore ensures that the slots will go to the people whose productivity will go up the most. But of course, this isn’t necessarily fair, especially when you consider that the people who will get the most out of a marginal chunk of education are often the people who have the most already.

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Medicare for Beginners

By James Kwak

This isn’t a post explaining how Medicare works in detail. It’s a post about why Medicare matters to you.

The basic “problem” with Medicare is that its liabilities are projected to grow faster than its revenues indefinitely because health care costs are growing faster than GDP (and Medicare’s revenues are a function of wages).* The “solution” proposed by Paul Ryan is to convert Medicare from an insurance program, which pays most of your health care expenses, to a voucher program, which gives you a certain amount of money that you can try to use to buy health insurance. I’ve described the main problems with this approach already: it transforms a large future government deficit into an even larger future household deficit, and on top of that it shifts risks from the government to individual households. Today I want to look at this from a different angle.

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Taxes and Spending for Beginners

By James Kwak

Over the long term, we are projected to have large and growing federal budget deficits. Assuming that is a problem, which most people do, there seem to be two ways to solve this problem: raising taxes and cutting spending. Today, the political class seems united around the idea that spending cuts are the solution, not tax increases. That’s a given for Republicans; Paul Ryan even proposes to reduce the deficit by cutting taxes. But as Ezra Klein points out, President Obama and Harry Reid are falling over themselves praising (and even seeming to claim credit for) the spending cuts in Thursday night’s deal. And let’s not forget the bipartisan, $900 billion tax cut passed and signed in December.

The problem here isn’t simply the assumption that we can’t raise taxes. The underlying problem is the belief that “tax increases” and “spending cuts” are two distinct categories to begin with. In many cases, tax increases and spending cuts are equivalent — except for the crucial issue of who gets hurt by them.*

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Tax-Exempt Bonds for Beginners

By James Kwak

Felix Salmon linked to an article by David Kotok on Build America Bonds (BAB), which reminded me that I’ve been meaning to write about them (now that they no longer exist). BAB were introduced in the 2009 stimulus bill. If a state or local government issues BAB, the federal government pays 35 percent of the interest on the bonds; the bondholder pays tax on all the interest, as usual for corporate bonds — but not for traditional state or local government bonds (“munis”). BAB were initially only authorized for two years, and were not extended in the recent tax cut compromise.

The Republican attack line on BAB is that they “subsidize states in more imprudent-type budget and debt scenarios” (Rick Santelli, quoted in Kotok’s article) or they are “a back-door handout for profligate state and local governments, allowing them to borrow more money while shifting some of the resulting interest costs to the federal government” (Daniel Mitchell). Well yes, BAB are a subsidy for state and local borrowing. But to criticize them for that without even mentioning the alternative is either uninformed or irresponsible.

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Shareholder Value for Beginners

Ever wondered how the private equity industry works? The New York Times has the story for you. (Thanks to a reader for pointing it out to me.) Yves Smith has a summary of the juicy bits.

The game is basically this. Thomas H. Lee Partners bought Simmons in 2003 for $327 million in real money and $745 million in debt. But that’s debt issued by Simmons, not by THL. To buy the company, they needed to pay the previous owners $1.1 billion in real money. The previous owners didn’t care where the money came from, so as long as THL could find banks or bond investors willing to lend $745 million to Simmons, the deal could go through. Since THL put up 100% of the equity in the new version of Simmons, they owned 100% of the company.

In 2004, Simmons borrowed more real money (by issuing new debt) and promptly gave $137 million of that real money to THL as a special dividend. In 2007, Simmons borrowed $300 million more in real money and paid $238 million of it to THL. So THL got $375 million in special dividends in exchange for its $327 million investment (plus an additional $28 million in fees). Simmons is now going into bankruptcy, unable to pay off all that debt, a casualty of the collapse in the housing market (houses => beds).

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Fed Chest-Thumping for Beginners

I generally avoid writing about monetary policy, since every economics course I’ve taken since college has been a micro course, and besides Simon is a macroeconomist, among other things. But since just about everyone in my RSS feed has been linking to Tim Duy’s recent article on the Fed, I thought I would try to put in context for all of us who don’t understand Fed-speak.

Duy takes as his starting point a series of statements by Fed governors and bank presidents indicating “hawkishness,” which in central banker jargon means caring primarily about inflation, not economic growth. (“Doves” are those who care more about economic growth and jobs, although, just like in the national security context, no one likes to be known as a dove. This itself is a disturbing use of language, since it implicitly justifies beating up on poor people, but let’s leave that for another day.)

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Can Openers for Beginners

We haven’t had a Beginners post in a long time, but David Kestenbaum’s Planet Money post about traffic court got that part of my brain going again.

Kestenbaum’s story is that he went to traffic court and the judge was a friendly populist, but not an economist:

“The judge went on to say that this was the “people’s court” and explained that if she gave probation on a ticket, no points would appear and the insurance companies wouldn’t find out. ‘This court is not in the business of enriching the insurance companies,’ she said.”

Aha! Kestenbaum, who after a year on Planet Money is an economist, even if his Ph.D. is in physics, points out that whether or not people get points on their licenses doesn’t affect insurance company profits. They need to charge bad drivers more because their loss payments for those drivers will be higher; if they can’t find out who the bad drivers are, they will just raise premiums on everyone.

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Statistics and Basketball for Beginners

I think that the general difficulty that many people have in understanding statistics is an important problem, because it leads people to misinterpret the world around them. General managers of baseball teams overpay for free agents coming off of good years because they underestimate the chances that the recent good year was just the result of variance around a mediocre mean – or at least they did until the Billy Beane era. Retail investors plow money into expensive mutual funds that have beaten the S&P 500 index for a few years in a row because they underestimate the chances that recent success is the result of pure, dumb luck; more importantly, the scandal of mutual fund expenses goes unchallenged because of the conventional wisdom that you should pay more to get into “better” funds. (I think it is possible, though unlikely, that some fund managers could actually be better than the market; but with all the statistical noise, you are not going to find them unless you look at a very long period of time.)

So I was happy to learn that my second-favorite radio show, Radiolab, was doing an episode on randomness. (You can stream it at that link, or download an MP3 from their podcast.) Their first segment does a good, clear job of debunking the human tendency to make too much of seemingly improbable events. For example, a woman in New Jersey wins the lottery in two consective years; what are the chances? But if you look at all the lotteries and all the lottery winners everywhere, it would be shocking if you didn’t have repeat winners.

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Shadow Banking for Beginners

Last Friday, Mark Thoma wrote a guest post for The Hearing arguing that the “shadow banking system” was a significant contributor to the financial crisis and needed to be regulated. This prompted a series of posts either attacking or defending his position; for a rundown, see today’s Hearing post.

For now, I just want to highlight the analysis by Mike at Rortybomb (hat tip Mark Thoma). (Those who have read Gary Gorton’s new paper can probably skip this post.)  Mike points out that people mean at least three different things by “shadow banking system:”

1) Subprime lenders, who were not subject to the same regulatory burden as depository institutions.

2) A market that trades “informationally insensitive” debt as the result of the repo market and securitized debt as collateral. Where depositors are corporations and money market funds and where lenders are financial firms.

3) Traditional firms who took big bets in the investment markets while their regulators were not present or asleep at the wheel.

For Mike, #2 is the the one that matters. Here’s his explanation:

A bank is, in abstract, an institution that borrowers short and lends long.

Your local bank borrows short deposits and lends long investments. If it needs liquidity it can always go to the central bank’s discount window. The central bank’s discount window is the market maker of last resort for this banking system. [Regulated banks can always borrow money from the Fed at a pre-set interest rate, so they always have access to cash.] This prevents bank runs. In exchange it is regulated by the government.

Your local shadow bank took in money in the repo market as deposits, and used senior tranches of debt as the collateral. Now what happens when it needs liquidity? There is no market maker of last resort who the system as a whole could turn to. Repeat that again. It exists in the shadows, there is nowhere to turn to for emergency liquidity. There is no regulation/liquidity tradeoff here. This is what is meant by being unregulated – not that there weren’t any government agents in sight.

I’ll take that last paragraph a little slower. A repo, or repurchase agreement, is a transaction where one party (the “shadow bank”) sells some securities to another party (the “depositor”) in exchange for cash and simultaneously agrees to buy those securities back at a predetermined (higher) price at some date in the (near) future (like tomorrow). In effect, the depositor is lending cash to the shadow bank, and holding the securities as collateral; the difference in the two prices is the interest. It wants the collateral because nothing else is guaranteeing its loan to the shadow bank (as opposed to ordinary FDIC-insured deposits). The collateral is generally worth at least as much as the amount of the loan, to minimize the risk to the depositor; but the remaining risk is that the shadow bank won’t make good on the repo and the collateral will fall in value.

Why would this happen? The depositors do it because they get higher interest rates than they can get in an ordinary deposit account at a commercial bank. Why would the shadow bank offer higher interest rates? It wants to attract the cash so it can lend it out at a yet higher interest rate (“lend” here could mean buying up subprime mortgages to package into securities that are then used as the collateral for more repurchase agreements to start the cycle again); it doesn’t want to become a commercial bank because commercial banks were traditionally more highly regulated. For example, the major commercial banks were significantly less leveraged than the investment banks during the boom.

The problem that Mike highlights is that there was no liquidity backstop for the shadow banking system. So when the “depositors” got nervous about investment banks like Bear Stearns, they refused to roll over their repo agreements (that is, when the shadow bank closed a repo by buying back the securities, the depositor refused to lend new cash via a new repo), or they imposed a larger “haircut” – they lent less cash for the same amount of collateral. The result is a bank run – only this time the run is on the shadow bank. (Gorton focuses on a slightly different problem, which is that when the same collateral doesn’t bring in as much cash, you have to shrink your balance sheet by dumping assets.)

Mike’s analysis draws heavily on Gorton’s paper, which is helpfully summarized by Ezra Klein. The basic conclusion of both Mike and Gorton is that banking systems need to be reliable, the shadow banking system is a banking system, and hence the shadow banking system must be regulated to some degree. Robert Lucas, quoted in Mike’s post, puts it well:

The regulatory problem that needs to be solved is roughly this: The public needs a conveniently provided medium of exchange that is free of default risk or “bank runs.” The best way to achieve this would be to have a competitive banking system with government-insured deposits.

But this can only work if the assets held by these banks are tightly regulated. If such an equilibrium could be reached, it would still be possible for an institution outside this regulated system to offer deposits that are only slightly more risky but that also pay a higher return than deposits at the regulated banks. Some consumers and firms will find this attractive and switch their deposits. But if everyone does, the regulations will no longer protect anyone. The regulatory structure designed in the 1930s seemed to solve this problem for 60 years, but something else will be needed for the next 60.

By James Kwak

“There Were Ratings That We Saw That Made No Sense To Us.”

This American Life had another good financial crisis episode by the Planet Money team this past weekend. There’s a story on regulatory holes by Chana Joffe-Walt and one on rating agencies by Alex Blumberg and David Kestenbaum. The latter had some money quotes (starting around the 40-minute mark).

Jim Finkel, Dynamic Credit, which creates structured products: “There were ratings that we saw that made no sense to us. We knew the rating agency models and metrics, and we could replicate them ourselves, and we couldn’t make sense of what they were doing.”

Felicia Grumet (sp?), Bear Stearns, who was involved in creating structured products: “It makes me feel really bad, so actually it’s very hard for me to acknowledge . . . I knew what I was doing. I knew I was doing things to get around the rules. I wasn’t proud of it, but I did it anyway.”

One of the heroes is Mabel Yu, a buy-side bond analyst at Vanguard, who couldn’t get the rating agencies to explain the ratings they were giving to structured products – and therefore refused to recommend them internally at Vanguard. Who knew? Not only do you get lower costs at Vanguard, but better fund management, too? (I have most of my money at Vanguard, but it’s in all in index funds or near-index funds, so I guess I wasn’t benefiting from Yu’s research.) 

By James Kwak