Ron Paul and the Fed

Recently I’ve been appalled by Ron Paul’s ranting s against the Federal Reserve. I’m so sick of hearing this populist tripe that I’ve decided to post my thoughts on it here.

The brunt of his argument is that the Fed is responsible for the current state of the economy, and that this all could have been avoided if there had been additional congressional audits in place that would have identified and corrected these apparent mis-steps. Not only does this show a complete lack of understanding of economics principles by Ron Paul, it also shows his total lack of understanding about politics.

Data shows that short and long term interest rate trends became detached around the beginning of the housing crisis. This was primarily due to a savings glut in the developing world that rapidly increased the supply loanable funds, lowering the price (long term rates). The Fed couldn’t have prompted this or subsequently pre-empted its effects. The Fed sets a target rate for short term rates by allowing banks to borrow from the Fed. The Fed doesn’t print money – it lowers the price for short term liquidity in the market, increasing the amount of cash that banks have available for issuing credit. Short and long term rates always moved in lock step until this global savings glut. Many have argued that the Fed should have raised short term rates in order to curb the rapid increase in long term lending. This type of thinking shows a lack of understanding for two reasons:

1. Since short and long terms rates were no longer moving in lock step changing the short term rate would not have changed the price of long term debt for consumers or for corporations – the funds were still available as the developing world was saving even at the very low short term rates provided for them.
2. Since the developing world was saving heavily at low rates, raising the rate of return would only have served to increase the supply of available funds further lowering the cost of long term debt (long term interest rates).

The primary aim of the Fed is to maintain an apprpriate and acceptable level of inflation, this is primarily done by controlling the amount of liquidity available to the market via short term interest rates. Changes in short term rates can often have other effects on the economy that may not be as popular as reigning in inflation. For example, Paul Volcker – Fed Chairman during the late 70′s and early 80′s – had to make the difficult decision to raise short term rates in order to reign in double digit inflation. This came at a time when unemployment was already high making it even higher. This may well have been an uderlying cause of the back to back recessions of the early 80′s, however without these difficult policies it is very likely that we would still be experiencing double digit inflation, and therefore double digit interest rates. To say that Congress could make these difficult decisions shows Ron Paul’s absolute lack of understanding of the political process. Regardless of how helpful a particular policy would be, the political process always sides with the outcome that is most popular. This is the paradox of democracy – people want what they want, but they may not know enough about the consequences to be making the rational decision. Clearly Ron Paul has missed this train too – unless he actually thinks that these difficult decisions don’t need to be made? Linda Lowell sums it up pretty well:

“if you listen to floor debate or the questions elected representatives ask in hearings, you’ll realize too few of them actually know the difference between reserve requirements and capital requirements, or how bank reserves are related to the supply of money and credit. In other words, are they equipped to closely monitor the Fed? To second guess the deliberations of the FOMC? To opine whether a coupon pass or system RPs would be more effective at a specific point in time?”

The other problem with Ron Paul’s ramblings about openness and audits for the Fed is that the Fed already is audited, and is incredibly open about its various dealings. It’s all over their website. Maybe Ron Paul isn’t familiar with the internet? Or maybe he doesn’t know enough about economcis to grasp the information provided? The Fed is even audited annually by a top accounting firm.

The biggest reason the Fed has been so sucessful in reigning in inflation (thus keeping long term rates in check) has been the confidence the public places in the ability of the Central Bank to make these difficult decisions and to ge them right. Most people don’t understand enough about the inter-workings of credit and liquidity to actually assess the validity of the FOMC decisions on interest rates, but they know that interest rates are lower and so in inflation. This proves that the Fed is getting it right.

Hey Ron Paul  – take your “revolution” elsewhere. As for me – I’ll take my mortgage at %5 over 15% any day.

Scare Tactics from both sides of the Aisle

Recently Democrats have blasted Repulicans as fear-mongers and obstructionists who are simply trying to halt the health care debate in its tracks by scaring people. As a member of the Republican party it shames me to say that they are correct. It seems like the primary arguments coming from Republicans are more or less ridiculous. In all reality Democrats are doing exactly the same thing. Its just politics. Unfortunately for Republicans, the Democrats are more subtle about their scare tactics.

Whereas Republicans go on about “Death Panels” and “Rationing”, Democrats go on and on about the threat of the country going broke because Health Care will eventually overtake GDP. None of these things are true, but they are all based on some factual information. I would like to discuss some of the common misconceptions surrounding health care, and separate fact from fiction. I have a feeling that this would just be too long of a post to try and include all of them here, so I will make a series of posts over the next couple of weeks.

Myth 1. Unsustainable Growth in Costs

Democrats tout this as the primary reason for health care reform. They claim that at the current rate eventually everyone will go broke just trying to pay for their health care. That is only partially true. At the current rate of growth the Government will go broke trying to pay for health care for the millions of baby boomers set to retire in the coming years. On the other hand there is no reason to think that regular people will no longer be able to afford adequate health care in the future with or without reform.

First let’s discuss the the truth in the argument. At the current rate Medicare and Social Security will become compeltely overwhelming for the governemnt as more and more baby boomers retire. Not only has this group generally done a poor job saving for retirement, many have lost tremendous amounts of money in the recent recession. This means that most of this group will rely on the benefits provided by the government. Couple that with people continuing to live longer and you’ve got a very large bill coming due. This looming debt will have to be paid for somehow. We could cut benefits now, which would meet pretty firm resistance and would be horribly unpopular. We could raise taxes to pay for the increased costs. Or we could finance the costs with increased government debt, this is where the “break the bank” argument comes in.

Any reform that truly “bends the cost curve” will need to address this, and it will require more than an advisory panel to discuss Medicare spending. In all reality it will likely require trimming back the benefits as well as a combination of the other items discussed above. How Democrats think that adding 50 million people to the rolls government subsidized  health care will reduce costs is completely beyond me.

Even in the private sector health care costs have skyrocketed over the past couple of decades. There are several reasons for this rapid increase. I see two of the primary reasons as follows:

• Increases in medical technology make more tests possible, these tests are also expensive. Since people don’t shoulder these costs themselves these tests also become more common even if they may not reveal additional information.
• People have become increasingly unhealthy. With so many ways to treat an unhealthy lifestyle why not eat donuts and drink energy drinks? This seems to be the attitude most Americans have adopted. Any cross-country comparison of costs needs to take this into account. Americans are choosing to be unhealthy and our increase in private health costs reflect that choice.

Both of these reasons are rational. The problem is mis-aligned inentives. Until people start paying for the costs of their health care (or at least a proportional share) they will continue to incur costs disprportionate to their benefit. Reform needs to center on altering these incentives. Whether or not the governemnt regulates reforms it is likely that the private sector will begin to change those incentives by charging higher co-pays and/or charging some percetnage of the cost. Once these costs outweigh the benefits of drinking energy drinks and eating donuts people will begin to change their behavior.

The private sector will eventually re-align incentives on its own in order to bring down costs. In the end it is the government that needs to change its spending habits. Adding 50 milion people to government subsidies will not reign in tose costs. In reality in order to bring future costs into reasonable ranges it will be necesary to cut benefits rather than increase them.

Risk Aversion and Health Benefits

There has been a lot of talk lately about health care reform and what should be done about rising costs etc. In any policy decision a cost-benefit analysis must be performed to evaluate whether or not the plan is worthwhile. If the costs are greater than the benefits clearly the plan would not be worthwhile. Meanwhile, if the benefits outweigh the costs than it would be relatively easy to argue that the policy is worth enacting. Unfortunately the true costs and benefits are often ambiguous. This means that only rarely are we able to put together a truly accurate cost-benefit analysis. This seems to be the case in the debate about health caare reform.

In a previous post I discussed breifly how risk aversion plays into how individuals value health care. I would like to elaborate on that topic here to help shed some light on how we should think about the costs and benefits of health care reform.

Risk aversion implies that people would pay a premium to avoid risk. Think about auto insurance; people pay periodic premiums in order to avoid having to pay for the full cost of a possible accident.When it comes to health insurance we pay monthly premiums (generally subsidized by employers) in order to avoid footing the bill for the full cost of a possible illness. Since people are generally risk averse, they would prefer to pay health premiums over time rather than be forced to unexpectedly pay a lump sum to cover the costs of medical bills. This means that even if the sum of the premium payments is more than the expected cost of future medical bills people would still prefer to pay the premiums (since there is still a possibility that the actaul medical bill may be much higher).

If employers no longer need shoulder the costs of health benefits, there would certainly need to be a subsequent increase in employee salaries. Larry Summers would have us believe that this will make U.S. companies more competitive. However, the value that employees associate with health care is not equal to the cost shouldered by the employer. If it were employees would be indifferent between salary and health care. However, studies show that employees at firms that offer health insurance often have higher salaries than employees at firms that do not offer health coverage. (This implies that employees prefer health insurance to a monetarily equivalent increase in salary.) If employees do prefer coverage to salary than employers would be required to increase salaries disproportionately to the amount saved by no longer paying health care costs. Rather than make U.S. employers more competitive internationally it may well make them even less competitive by forcing them to pay even higher salaries.

Larry Summers’ argument – BUSTED.

“Schlocky” Arguments Abound…

When Cristina Romer called Larry Summer’s argument that the health care costs shouldered by U.S. companies make them less competitive internationally “schlocky”, not only was she dead on, but she could well have used that same term to describe a lot of the arguments made by the Obama administration lately. Unfortunately, the administration seems to assume that  most people don’t know enough about economics and insurance markets to see through the political smoke screen of “schlocky” arguments. Even more unfortunate, they’re probably right. I’d like to take some time to sift through the populist drivel and think about the real underlying issues.

1. Health Care Costs & International Competition

Larry Summers wants the Obama administration to argue that relieving U.S. corporations of the need to pay health care costs will actually make them more competitive internationally by reducing employment costs and allowing them to pay their employees higher salaries. This may make for a great sound-bite on CNN but when it doesn’t pass muster when held to a higher standard of critical evaluation. The fact of the matter is, that employers and employees alike think of their health coverage as a part of their compensation package. From the employer’s perpective – eliminating the cost of health benefits and increasing the employee’s salary by an equivalent amount will have no effect on the amount of people they employ, or the amount spent on each employee. From the employee’s perspective – being forced to pay for private insurance but having their salary increased by roughly the amount that they would pay in premiums would make them at best indifferent to the change. So at best, it will have no effect on international competitivness.

At worst these policies could cause these employers and employees to be even worse off. Consider that employees are generally risk-averse (would pay to avoid risk). This means that they would prefer to take a cut in salary rather than have to pay out medical costs later. In other words, they would prefer the health coverage to an equivalent salary increase. (More on this in a later post.)

Also consider the tax benefits associated with employer provided health coverage. If employers are no longer forced to shoulder the “burden” of employee health costs, they will have to increase salaries, and thus pay more taxes. Employees will have a similar experience – since health premiums are taken from pay pretax income, giving them the monetary equivalent via an increase in their salary would mean more taxes (not to mention the taxes required to pay for a national health care plan).

2. Competition in the Market for Health Insurance

Another favorite argument of the Obama administration is that by creating a “public option” for health care we are injecting much needed competition in the market for Health Insurance. It’s not often that you hear democrats arguing for a free-market solution; unfortunately, in this case it’s a misguided attempt at garnering bi-partisanship. To infer that there is not enough competition in the market for health insurance implies a fundamental misunderstanding of markets. We certainly do not a a monopoly problem, or even a duopoly problem, there are several competing firms with relatively little barrier to entry for new firms. In layman’s terms -plenty of companies already compete to provide health care, adding another company to the market would not increase competition, or create downward pressure on prices. It would have zero effect on consumers.

However, the government sponsored program would not be subject to the same constraints as a private company. It would certainly not attempt to maximize profits, and would likely have it’s premiums mandated by the federal government. It would also be required to accept anyone who applied (rejecting applicants would be like rejecting votes for incumbent politicians).

Those familiar with the economics of insurance will recognize immediately the pitfals associated with these requirements.  When the premiums are too low, too many unhealthy (expensive) clients will sign on, and the company will lose money. If they don’t have the option to reject coverage, or at least charge higher premiums, to less healthly clients there will be no way to mitigate these costs.

The fact of the matter is that, given the requirements imposed on a government sponsored health provider, it would inevitably post enormous financial losses. When this happens, the reflexive and obligatory, governmental response wil be to subsidize its operations through a taxpayer funded bailout. This type of policy will not, and cannot save the public money on health insurance. At best, it would be a way for healthy people to help foot the bill for the unhealthy members of our society.

Despite the snappy sound-bites and feel-good ideals of the Obama administration, there is very little economic support for the arguments they make. Once basic principles of economics are taken into account it becomes clear that not only will these proposals have zero positive effect overall, but they may well have a sizable negative effect on health care expenditures as well as the economic well-being of employers and employees alike.

Risk and Regulation

Several politicians have proposed that the current economics crisis was caused by a lack of regulation, and therefore, the solution to the current crisis will be to increase financial regulation. Proponents for this approach come from both sides of the political spectrum. The current administration seems to believe this argument, and Richard Posner recently added his name to the list.

It is true that regulation in financial markets has decreased over the past several years, and along with that decrease in regulation has come an increase in market volatility and the emergence of large market bubbles. At first glance this would validate the hypothesis that deregulation led to the current financial crisis.  Before you jump to the same conclusions remember that correlation is not necessarily causality.

The idea that deregulation caused the current financial crisis is essentially rooted in the Federal Reserve’s keeping the Fed Funds Rate low for the past several years. In other words, the Fed kept short term interest rates low which in turn kept long term interest rates low. Low rates of interest for long term loans (like mortgages) caused the real cost of housing to decrease for consumers. Decreased cost of consumption drives up demand and the housing bubble emerges. Again, this appears logical on its face; however, there is one key fact that turns this argument on its head. Alan Greenspan elaborates on this key fact in his recent article in the Wall Street Journal. He says:

“… it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages. Between 2002 and 2005, home mortgage rates led U.S. home price change by 11 months. This correlation between home prices and mortgage rates was highly significant, and a far better indicator of rising home prices than the fed-funds rate.”

In the end it was outside factors driving long term interest rates to low levels during those key years, and not the Fed Funds rate as is normally blamed.

But, regardless of who is to blame for the financial crisis, would more regulation actually help rein in these types of bubbles in the future? I suggest that the answer to that question is no, with a caveat. Regulation, as suggested, would limit or even eliminate the mortgage backed securities (MBS) and credit default swaps (CDS) that are behind the current recession.

The real problem is not that financial companies were intentionally acting against the interests of consumers, or even that their interests are somehow in conflict with the interests of consumers as so many people suppose. The problem is that the people who managed the MBS’s and CDS’s did not understand the inherent risks associated with them. Robert Merton gives an excellent (albeit lengthy) explanation of the nature of these assets and the risk associated with them.

My suggestion is that regulators need not be given more power (they have plenty). I suggest that what they really need is a better understanding of the nature of the assets and asset bundles being traded. The increase in complexity in the financial market does not need to be eliminated, it needs to be understood. These complex financial tools have created huge amounts of wealth, and they can and will continue to do so in a real sense as long as we take the time to understand the risk associated with them.

Note: This article from Wired also gives an interesting explanation of one of the primary misunderstandings of risk associated with MBS’s and CDS’s.

Split or Steal?

This is an interesting video I watched on Greg Mankiw’s blog. Try and think of how you would play the game if you were in the same situation. Would you split or steal?

Click here for the video

After watching this I thought to myself, what would I do in this situation? If I pick split, I am banking on the other player picking the same thing, when clearly their best choice is to pick steal if they know I am picking split. But, the same can be said of the other player; if I know they are picking split my incentive is to pick steal.

Even with time to discuss between the two of us what our intentions are, they only way to convince someone else to play split when you do is to pay them in advance (or otherwise adequately convince them) the difference between what they would make by picking steal and what they would make by picking split. In other words make them indifferent between the outcomes of the choices. This means that you may as well pick split in hopes that they will to simply out of the kindness of their heart. And while studies suggest that this happens more frequently than you might think, I wouldn’t bet the farm on it.

It seems to me the only real solution to this dilemma is to promise to pick steal. I think if I were in this position I would simply say to the other person, ” I am going to pick steal; I will split the money with you, but I refuse to bet on your generosity.” This means that they can either bet on your generosity or go home with nothing. You might make your promise of generosity more credible by writing a check or making some other indication of your sincerity, but in the end the other player likely has very little reason to doubt that you would pick steal after promising to do so.

My question to readers is this: Would this work? Would someone be willing to bet on your generosity when clearly you would not bet on their’s? Would their anger at your threat cause them to discount the potential value of your generosity or would they be willing to bet since at least that has a chance of being better than nothing. It seems to me that if this position were percieved as a threat, people would be willing to pick steal as well just to make sure that you don’t go home with anymore than they do. However, if it were percieved as the logical choice given the circumstances it might acutally work.

It Begins…

At the request of my lovely wife, Blair, I have decided to create an outlet for my odd shade of nerdiness. I’ve created this blog as a place to incite discussion of those things that I find interesting or amusing. Odds are it will contain several random topics ranging from math, econ, and stats, to food, history, and literature.

Although my thoughts, and hence my posts may seem somewhat random, there is an underlying reasoning for the variation; hence the title of the blog. My hope is that I will be able to bring up topics that may be of interest to everyone and anyone.

Let the great experiment begin!