January 28, 2012
A Thought on Expectations Formation

A psychological experiment of the 1960s, called the Wason selection task, uncovered a curious phenomenon. The task, developed by psychologist Peter Wason, confronts a test subject with four cards placed on a table before one. On one side of each card is a letter. On the reverse side is a number:

And the subject is given a rule such as: If a card has a vowel on one side, then it has an even number on the reverse side. The subject is then asked to indicate all and only those cards that must be turned over to determine whether the rule is true.

The correct answers are “A” and “5.” Why? To verify that the rule holds (in the case of these four cards), we want to find potential violators of it. If we find none, the rule holds. The rule says that if a card has a vowel on one side, then it has an even number on the reverse side. So we check the “A” card to see whether it does indeed have an odd number on the reverse side. If it has, the rule is falsified. If it hasn’t, the rule holds (at least in the case of this card). We wouldn’t check the “M” card, since the rule says nothing about cards with consonants on them. So whatever is on the reverse side of the “M” card, that couldn’t violate the rule. We also wouldn’t check the “6” card. The rule says that if a card has a vowel on it, then it must have an even number on the reverse side. It doesn’t say that if a card has an even number on it, then it must have a vowel on the reverse side. So turning over the “6” card could not tell us whether the rule holds. Finally, we would check the “5” card. Again, the rule says that if a card has a vowel on one side, then it must have an even number on the reverse side. But what if a card has an odd number, like “5,” on one side and a vowel, like “A,” on the reverse side? That would violate the rule. So we must check the “5” card.

Nearly everyone gets this wrong. People usually correctly choose the “A” card, but only 5 to 10 percent also choose the “5” card. Usually subjects choose two cards: “A” and “6.” Why this seemingly dismal performance? One might think it shows that humans have a poor grasp of conditional implication. But that turns out not to be the case. Consider this contrasting example, from follow-up studies carried out by various researchers:

You’re a police officer charged with enforcing the drinking laws. You enter a tavern where the tavern owner says: If a person is 20 years old or younger, he or she is not drinking alcohol. Each card represents one person. The reverse sides of the first two cards state whether the person is drinking alcohol. The reverse sides of the second two cards state the person’s age.

You’re asked to indicate all and only those cards that must be turned over to determine whether the tavern owner’s statement is true. The answers are, of course, “Age: 15” and “Drinking Beer.” You’ll check what a 15-year-old, but not a 27-year-old, is drinking. And you’ll check the age of a beer drinker, but not a tea drinker. Logically the task is the same as the abstract version of the task described above. In both cases one seeks to verify a conditional rule by looking for violators of it. Yet nearly everyone gets this one right. Why the difference?

Psychologists have debated the issue for many years. My view is that there’s a semantic and a syntactic aspect to it. The semantic aspect is that people understand from everyday life what the conditional statement of the tavern owner means. That is, they know about drinking laws and how they work. On the other hand, at an abstract level, to understand the concrete rule one must also understand the structure of the statement, its syntax. My hypothesis is that one’s understanding of the semantics of the situation (the context) cues an underlying syntactic structure (part of universal grammar) onto which the content is fitted. By fitting the content to an underlying syntactic structure, I propose, one gains a full grasp of conditional implication, including the inference rules modus ponens and modus tollens. With the abstract rule, by contrast, there’s no semantic clue to cue the relevant syntactic structure, and so people don’t grasp conditional implication in that case.

To illustrate, let’s consider what a proposition communicates. First, take a simple declarative sentence: “The unicorn lies in the rain.” It’s a concrete statement. It picks out a real (real in a world that includes unicorns) occurrence that humans can easily grasp conceptually. Comprehension of the sentence means conceiving not, for example, a “pattern” of a unicorn lying in the rain, but an actual unicorn lying in the rain, raindrops moistening its coat, etc. Now take the conditional statement, “If it rains, the unicorn lies beneath the tree.” The topic is no longer a unicorn, but a rule, namely, the rule that if it rains, the unicorn lies beneath the tree. Superficially the sentence may seem to depict a mere pattern—the unicorn lying beneath the tree when it rains. But there’s more to it than that. The sentence expresses a regularity: it says that whenever it rains, the unicorn lies beneath the tree. Thus in grasping the sentence, one conceives not just a pattern but some plausible, perhaps vaguely understood, mechanism underlying the pattern—some reason why the unicorn (systematically) lies beneath the tree when it rains. Such inferences can occur in multiple ways. But in this case it occurs through the semantics of the situation—through an understanding of context. Humans, with experience of the world, know about the undesirability of exposure to rain. So if an animal goes beneath a tree when it rains, we generally presume it’s to avoid getting wet. This suggests an implicit syntax, an additional “clause” not explicitly stated in the sentence, but there nonetheless. I’ll set it in brackets:

“If it rains, the unicorn lies beneath the tree [to avoid getting wet].”

For some, it may not be “to avoid getting wet,” but to avoid, let’s say, getting watermarks on its horn, or something like that. But the point is that to grasp the statement, one must posit something in the implicit clause, some underlying mechanism that associates antecedent and consequent systematically. The statement in effect says that there’s something in the nature of things that causes the unicorn to go beneath the tree when it rains. Absent the implicit clause, the sentence lacks meaning. It would be like an incomplete sentence (say, “The unicorn beneath the tree”).

In the concrete version of the selection task (the drinking age rule) there is also an implicit clause:

“If a person is 20 years old or younger, he or she is not drinking alcohol [since we’re prohibiting such activity in accordance with the drinking laws].”

As with the unicorn, it’s the semantics of the situation (our knowledge of the drinking laws) that compels us to posit this particular mechanism as the underlying force generating the pattern.

In the abstract version of the selection task, by contrast, there’s no such mechanism. Confronted with the rule, “If a card has a vowel on one side, then it has an even number on the reverse side,” people can conceive of no plausible reason why a card with a vowel on one side should have an even number on the reverse side. There could be a game that has such a rule, which people could learn. And having learned it, people will perform the modus tollens inference nearly effortlessly. But when confronted with the rule initially, we perceive it to be about as meaningful as an incomplete sentence.

Thus the key factor distinguishing performance on the abstract and concrete versions of the selection task, I hypothesize, is that in the concrete case one perceives a mechanism (a law, a social convention) that links antecedent and consequent, while in the abstract case, one perceives no such mechanism.

Note that the posited mechanism needn’t be well understood. To take another example: “If a mushroom is parasol-shaped and has white gills [description of a poisonous amanita mushroom], then one shouldn’t eat it.” The test of whether people grasp conditional implication is whether they can make the modus tollens inference, i.e., whether they can tell that if one eats such a mushroom and suffers no ill-effects, then either the rule is wrong or the mushroom isn’t in fact white-gilled and parasol-shaped. And I think it’s fair to say that most people will grasp that. But note that people needn’t know specifically why some mushrooms are toxic or how the toxins affect the body, etc. They need only understand that there’s something in the nature of things that ensures the stated consequent.

Another example: “If I flick the light switch, then the light turns on.” Again, people needn’t understand how light bulbs work to grasp conditional implication here, only that there’s something in the nature of things such that flicking light switches causes lights to turn on. It seems fair to say that most people will be able to make the modus tollens inference: if one flicks the switch and nothing happens, there’s something wrong in the normal workings of the mechanism whereby flicking switches causes lights to turn on.

Now to the implications for expectations formation. “Rational expectations” is often described as the idea that people will not be systematically wrong. In terms of the above analysis, this would seem to mean: if people believe if x then y, and then not-y occurs, yet x has also occurred, people won’t continue to believe if x then y. Example: suppose people believe, “If we set this three-year wage contract so that wages rise by 2 percent per year, then real purchasing power will be constant over that period.” And now suppose the contract is set in the specified way, yet real purchasing power falls. People are confronted with a falsification. And if they’re rational, they’ll discard their prior belief.

Parsing the rule according to the above schema, we have: “If we set this three-year wage contract so that wages rise by 2 percent per year, then real purchasing power will remain constant over that period [because inflation over the next three years will be 2 percent annually].” People generally won’t know exactly why inflation would be 2 percent annually. They may vaguely accept that the government, perhaps the central bank, will act in a way that keeps inflation at that rate. Or they may view it as resulting from something the president does. Or they may think it’s a physical law. But the idea that there is some concrete mechanism underlying their belief about the maintenance of purchasing power at a constant level is integral to the belief. The question of whether rational expectations applies in this case then is whether, when confronted with a false consequent, people make the modus tollens inference, i.e., whether, when not-y occurs (though x has occurred), people rationally conclude that if x then y is false. And probably in the case of wage contracts and inflation, people will be rational in this sense.

So “rationality” doesn’t mean having perfect knowledge, but efficiently utilizing all available information to discard false beliefs. This, of course, is what science is all about. Science is a system for efficiently allocating the best available information to those who can use it to update or falsify prior beliefs. The result is a body of unfalsified hypotheses, i.e., knowledge. But note that even scientific “facts” are posited relationships between variables, where the mechanisms underlying the relationships are ultimately mysterious. Hence there is a certain frothiness even in science, especially at the cutting edge.

The point is that there is an inherent mimetic aspect to the transmission of information. A rule such as if x then y is transmitted from mind to mind, with the implicit bracketed expression that specifies the mechanism linking x and y at least somewhat (and perhaps very) murky in the minds of both informer and informed. The paradigmatic illustration is a recipe. A recipe is an algorithm that can be passed intact from mind to mind and that enables its possessor to replicate a particular dish. No one, including the recipe’s inventor, need understand the chemistry by which the recipe has its effect. But the extraordinary thing is that, even without knowledge of the underlying mechanisms, many people can, by following a series of if-then rules, achieve the same result.

Also note that information structures, as Kenneth Arrow observed many years ago, are indivisible. In the case of the recipe, this means one cannot modify it and still have the same dish. One way of looking at this: it’s easily imaginable that one’s utility is maximized, given one’s resources, with recipe A, and that a slight modification of the algorithm, to recipe A’ (not a change in the quantities of the ingredients but in the process of combining them), causes utility to drop significantly, but that the initial utility level is re-attained through a massive modification of the recipe, to recipe A”. In other words, there are “non-convexities,” a problem for consumer choice theory. What the indivisibility of information suggests, for our purposes, is that chosen options can be utility-maximizing, somewhat arbitrary (since utility may be maximized at disparate points along a utility curve), and widely shared (since information structures are indivisible and the transmission of information is mimetic).

Rational expectations is a long-run equilibrium condition that can be useful in thought experimentation. By assuming that all agents are in effect scientists, the theorist eliminates the black box of human cognition from the analysis (controls for the “randomness” of human psychology), laying bare the “systematic” forces in the economy. Such a condition plausibly applies to the world of science. Science as an institution systematically funnels the best available information to scientists in a given field. Experimentation is simplified through controls, so there is minimal ambiguity about when a claim if x then y has been falsified. And there is an ethic of acceptance when one’s belief or hypothesis has been falsified. I say “ethic,” but there’s no real choice in the matter. Refusal to accept empirical disproof of a hypothesis is to derogate oneself to pariah status, as religious heretics were of old.

Misdirection occurs in science, of course. Eugenics and the bleeding cure for ailments are examples. But these are “short-run” phenomena. Historically, the “short run” in science could be quite long, as with the bleeding cure and the Ptolemaic model of the solar system. But it’s fair to say that the “short run” in science gets shorter and shorter. The cold fusion “breakthrough” of Pons and Fleishman lasted about three weeks. When the South Korean scientist Hwang Woo Suk faked stem cell data, it took just a few years for science to correct its error.

And a kind of leveling occurs in the economic world, as well, in the long run. If an expected price is wrong, the real world will reveal that tangibly, typically in the form of lost money. In the “short run,” however, in which we live, beliefs and expectations are constantly buffeted by many forces. And unlike in science, there’s no disciplined subjection of beliefs to controlled experiment. Falsification in the economic world occurs, but often through “hard landings”—certainly not through controlled laboratory experiments—and typically with significant costs.

A bubble occurs when people purchase an asset because they expect its price to keep rising. The idea that a price will keep rising implies that people believe the phenomenon is systematic, i.e., that there’s something in the nature of things generating the continuous price rise. In effect people believe, “If I purchase asset x, then I will get a capital gain [because something is causing the price of asset x to rise].” The bracketed expression is necessarily present and necessarily vague. Present, because people must believe the relationship is systematic. (Otherwise they won’t act.) Vague, because the mechanism that would underlie such a relationship is largely hidden.

Why would such a meme get propagated? Wishful thinking is no doubt part of it. Economic self-interest of speculators seeking a well-timed exit is another factor. And of course all this feeds on itself: a rising price reinforces belief in a rising price and thus in the meme that says something is systematically generating the price rise. And so forth. Then there’s the issue of irreducible uncertainty. By definition, from inside a bubble one can’t tell with certainty that one is in a bubble. Until the bubble bursts, and there’s a tangible falsification of the belief, there will be debate about whether a bubble exists. And as long as there’s debate, interested parties will spin arguments or narratives convincing to at least some that the asset is a good investment. Bubbles burst when the price starts to fall, i.e., when supply outstrips demand. The meme is then empirically disconfirmed, and people have what Paul Krugman has called their “Wile E. Coyote moment” and start plummeting back to earth.

September 29, 2011
Conservatism: A Rumination

(my quasi-scientific effort to explain the Other)

To function, we need beliefs. Intelligence gives organisms the capacity to manipulate the environment in novel, adaptive ways. That requires that we have beliefs about (or models of) what will happen when a given action is performed. If I want light, for example, I must flick a light switch. But to flick a light switch, I must believe that flicking the light switch will give me light. I can’t know that it will. But if I don’t believe that it will, why would I flick the switch, and how would I get light? If we implement a stimulus program to rescue the economy, we must believe that it will have the intended effect. We can’t know that it will. But given certain theoretical and empirical considerations, we believe that it will. And so we act.

How do we acquire beliefs? Broadly, in two ways. (1) Through our own observations. That is, we seek out patterns in the world, even sometimes seeing causation where there’s none. And (2) through the observations of others. That is, we often obtain beliefs from authority, for example, from experts or people we trust. The latter is generally adaptive. We can’t acquire all the knowledge we need on our own, so we often use people better placed than ourselves to get it. (And language, of course, enables information to be cheaply passed to any number of people.)

And what is belief? It has two aspects: (1) recognition of a pattern (or regularity, or association, or rule of the form “If p then q”); and (2) a conception of some underlying force that systematically generates the pattern. We generally don’t know, or care all that much, about the latter. Understanding the mechanics behind an observable pattern can even be maladaptive since the cognitive cost of gaining that knowledge is large while the practical benefit is typically minimal. I don’t need to know how electricity works to turn on a light. To learn about it might indeed be maladaptive since the cognitive cost of acquiring the knowledge would be large while the gain, in terms of my capacity to have light, would be nil. It’s generally enough to apprehend the pattern and simply assume that something in the nature of things generates it.

Nevertheless, though we’re often blithely ignorant of the nature of the forces that underlie patterns, the notion that something is there, some underlying force systematically generating the pattern, is integral to belief. What we believe when we believe is that each time conditions X obtain, outcome Y occurs. (“Conditions X” may be a vast context of circumstances.) And that requires confidence that something deep in the nature of things systematically causes it. Belief then consists in confidence that a certain pattern is somehow in the nature of things.

Of course beliefs may be wrong and so must be revised periodically. But it would be dysfunctional to revise them instantly any time the expected effect of an action doesn’t occur. If I flick a light switch and nothing happens, I shouldn’t conclude that flicking light switches doesn’t cause lights to turn on. My confidence in the underlying forces that generate the pattern is unaffected (unfalsified) by one instance in which the pattern doesn’t occur. And though I may not understand those forces well, it’s adaptive that my confidence in them remain intact at least until the failure of light to appear when the switch is flicked becomes the predominant pattern.

So beliefs must have a certain durability. But how durable should they be? Here’s where the trouble starts. My hypothesis is that conservatives are less prone to revision of belief than non-conservatives. Specifically, they’re less likely to abandon their conceptions of the underlying forces that generate observed patterns than (shall we say) liberals (or others on the left) are. By itself, this is neither good nor bad. As noted, the precise connection between surface patterns and the underlying forces that generate them is typically vague, indeed ultimately unknowable. And people will simply differ in their predilections about when to revise their conceptions of the underlying forces that generate patterns, as events may or may not warrant.

Conservatism can indeed be adaptive. As noted, it’s dysfunctional to abandon beliefs instantly any time the expected effect of an action doesn’t occur, or any time a new idea appears. I gave the example of light switches, but the principle applies broadly. A reflexive skepticism about fads or new-fangled ideas is probably warranted. Burke was right about the French Revolution. Dostoyevsky was right that Raskolnikov was wrong that he, a “new man,” had the right to kill a corrupt pawnbroker. (Of course the extent to which Dostoyevsky was really right depends on the extent to which Raskolnikov wasn’t a straw man but a legitimate representative of his generation.) Efforts to build economic utopias in the 20^th century have proved the road to hell.

So everyone should be conservative to some degree. But it’s just basic human adaptiveness to change one’s mind when facts change. And a refusal to do so will at some point get dysfunctional. If we still believed earthquakes were caused by the whims of gods, we wouldn’t have developed seismology and so wouldn’t be able to prepare for them and spare countless lives. If we still believed illness was caused by disequilibria between the four “main” bodily fluids (blood, yellow bile, black bile, and phlegm), as doctors did as late as the sixteenth century, life expectancy would be much lower. (Life expectancy at birth in Tudor England was 35.)

So, on the one hand, one can’t revise beliefs instantly whenever an expected outcome doesn’t occur. On the other hand, it’s dysfunctional to maintain beliefs when evidence has eliminated all reasonable doubt that they’re wrong. Determining exactly when a belief should be abandoned is tricky. In modern times we have an institution, science, that systematically sorts out those beliefs that are warranted, discards those that aren’t, and over time generates an ever vaster body of beliefs that can be regarded as knowledge. “Rationality,” by my definition, means revising one’s beliefs in response to changing information. Science is then the epitome of rationality. Not that individual scientists are themselves strictly “rational” in this sense. But science, as a systematic means of utilizing all available information to form our best understanding of the world, is. A scientist proposes a hypothesis. It’s subjected to strenuous efforts by hundreds if not thousands of very smart people using the best testing methods available to falsify it. If the hypothesis survives the onslaught, it gains acceptance. If not, not. 

One manifestation of conservatism is an anti-science bias. Every major anti-science initiative historically has been from the right, whether the Catholic Church’s condemnation of Galileo, attacks on the teaching of evolution, climate change denial, etc.

Systematic Wrongness

Conservatism reaches its dysfunctional extreme with hyper-religiosity or political movements like the Tea Party. To take the latter, according to an April 2010 CBS poll, 66 percent of Tea Party supporters “think global warming will have no impact,” 64 percent “think Obama has increased taxes,” and 59 percent believe Obama either wasn’t born in the U.S. (30 percent) or are unsure about it (29 percent). One might ask: wouldn’t such blatant irrationality be selected out of a species that thrives on its ability to learn about the realities of its world? Well, as noted above, the realities of our world are complex and necessarily not-fully-understood. And it’s adaptive, to some extent, to resist switching beliefs when evidence turns against them. Inevitably there will be a fringe that’s most resistant to switching its beliefs. For reasons noted below, it may be optimal for groups to retain false beliefs in some circumstances.

Why is systematic wrongness such a powerful social force? I’ll propose three things: (1) conservatism itself, (2) the benefits of social solidarity, and (3) us-versus-them (or tribal) psychology. Conservatism, as described above, is simply the predilection to resist switching beliefs even when evidence turns against them. Everyone is to some degree conservative in this sense. But conservatism can be bolstered by a sense of social solidarity, as when a social group collectively holds a false belief. False views about Obama’s birth, for example, aren’t the product of rational individuals weighing evidence and arriving at a conclusion. Rather it’s a meme, an idea transmitted “virally” from mind to mind within a social circle. Acceptance of such a meme can be a badge of membership in a group, which for good Darwinian reasons may give people a sense of social solidarity. The cost of not knowing where Obama was born is trivial. The benefits of the social solidarity that come from believing the same (wrong) thing can be substantial.

A sense of social solidarity can, in turn, be bolstered by us-versus-them (or tribal) psychology. Humans are a social species. And of all the aspects of our environment that it behooves us to be able to predict, human behavior is surely the most important. How do we predict human behavior? As with beliefs generally, we don’t just extrapolate from observed patterns. We also employ a sense of the underlying “mechanism” that generates a pattern of behavior. In the case of human behavior the mechanism is “personality”—an abstract sense of the motivations, emotions, mindset, etc., that influence how a person will behave in different contexts. Finely-honed though our capacities to read personality are, there are limits. Human personalities are complex. But more important, I would propose, it may be optimal not to fully grasp another’s personality. Cognitively the task is taxing. And the benefits, beyond a certain point, probably diminish rapidly. Why might this be?

I assume that evolution equipped us with efficient means of acquiring social knowledge. And that would likely mean having fairly distinct categories of personality and a predilection to fit people into these categories. (To some extent, the categories may be inborn; to some extent we may be prepared to learn them.) The cognitive costs of acquiring social information would be minimized, since we need only assess people to the point where we can fit them to a category. The benefits of perusal of another beyond that point will then be minimal. We will wind up to a large extent with stereotypes that, though unfair in individual cases, enable us to navigate the social world fairly effectively, with a reasonable sense of who to avoid, who to deal with, who to help, who will help, who will harm us, etc.

Let’s take one category in which people are sometimes placed: “evil.” If you’re a member of a tribe and there’s a scarcity of resources over which your tribe vies with a neighboring tribe, it wouldn’t hurt to view members of the other tribe as “evil,” i.e., as having malicious intentions towards yourself and your fellows. You’ll then see members of the neighboring tribe as a threat and act accordingly. The attribution of “evil” is false, of course. But the other tribe will act in ways that favor the survival of its genes. And that may mean taking the resources of a neighboring tribe (yours) or even eliminating that tribe altogether. Having some such concept of the neighboring tribe—perhaps fleshed out with notions that they worship strange gods or are driven by demons—is, from your (or your genes’) perspective, advantageous.

One can of course unlearn the notion that others are “evil.” And in some circumstances (as when there are gains to be had from trade) that may be beneficial. But often—perhaps in circumstances more likely to prevail in prehistoric than in modern times—the benefits of viewing an out-group as malicious will dominate. Hence the utility of having the category “evil” “hardwired” into our perceptual apparatus. We need only find exemplars.

As I’ve hypothesized, conservatives are more reluctant to alter beliefs than non-conservatives. So broad categorizations of people in terms of “personality” (i.e., stereotypes) should figure relatively prominently in conservatives’ worldviews.

How does this relate to the false belief among some conservatives about Obama’s birth? I’ve suggested that conservatism, a sense of social solidarity, and tribal psychology combine to bolster such beliefs. Conservatism predisposes people to maintain beliefs even when evidence no longer warrants. Social solidarity instills in people a positive feeling from holding beliefs in common with one’s fellows. And tribal psychology slots others into an “other” category that enables one to imagine the worst of one’s “enemies.” The belief that Obama wasn’t born in the U.S. is a motivated belief, a way of keeping the other securely defined as “other.” So on balance, there’s no harm and some benefit (for this subset of the population) in believing Obama wasn’t born in the U.S. Of course that needn’t be the case with all false beliefs. If the belief is that house prices will always rise or that climate change is a hoax, it’s a different matter.

What does it take to alter a belief, or unlearn the notion that another is “evil”? Fundamentally, it requires changing one’s conception of the mechanism that underlies an observed pattern. In the case of “evil,” it means changing one’s view of another’s personality. In the case of light bulbs, it means abandoning one’s sense that there’s something in the nature of things that causes filaments to glow when electrons pulse through them. In the case of religion, it means losing one’s faith that an omniscient being controls all things. Etc.

So really my view is that conservatives are slow to alter their beliefs in the mechanisms that underlie observed patterns. Such mechanisms are metaphysical, often vague, constructs seen to embody the systematic forces that underlie observed patterns. But if conservatives are less likely than others to alter their beliefs in the underlying mechanisms, they’re also more likely to have a sense of underlying mechanisms. This dovetails with the common perception that conservatives are “rule-governed.” Indeed that may be the defining characteristic of conservatism. As I’ve noted, everyone is conservative to some degree in this sense. It’s adaptive to be so, since by tagging certain patterns as systematic, we distinguish those that will prevail from those that are ephemeral. Thus we can better model and manipulate our environment.

Impact on Social Discourse

To take an example: religion. Conservatives are more likely to be religious than non-conservatives. Religion posits the ultimate explanatory mechanism, an omniscient being as “Author” of all things. Religion (and conservatism more broadly) appears to impact social discourse in three main ways:

(1) It provides automatic answers. Whatever occurs, one can always say it was “meant” to be. Having automatic answers appears to be a feature of conservative cognition. (2) It’s rhetorically powerful. To win, or at least not lose, an argument, one need only invoke one’s faith. Unsurprisingly “God” appears often in political speech. It resonates with supporters and keeps opponents at bay. (3) It’s often used to castigate others, those who don’t follow, or who obstruct, “God’s laws.” This creates the sense that certain (perhaps liberal-minded) others are upsetting an order that would otherwise work to one’s benefit, making them a threat.

One might wonder why conservative ideology so fetishizes the “market.” Renting oneself out on a labor market, after all, without union protection, isn’t favorable to maintenance of stable beliefs about the world. I strongly suspect conservatives’ reverence for the “market” is more abstract than real. Yet the idea of an automatic mechanism that, unfettered, is the source of our riches and a means of distributing goods and services in accordance with people’s contributions to the production of those goods and services has a natural appeal to a conservative mind. Like religion, the “market” provides automatic answers (in the material realm of course, not so much the spiritual realm). Supply-and-demand is a single pervasive abstract framework within which most economic phenomena can be understood. (The term “invisible hand” even gives it a mystical sheen. Adam Smith meant nothing of the kind, of course.) And like religion, the “market” can be used to powerful rhetorical effect. It is of course commonly referenced by politicians claiming their policies are “pro market” or to castigate others who would obstruct the workings of a mechanism that would otherwise work to our benefit.

In truth, markets solve certain problems. Profit-seeking producers are motivated to provide a wide range of goods and services at low cost. Thus markets help efficiently allocate many of our resources to their best uses. On the other hand, markets don’t help with certain other problems. Public goods such as fire and police protection, ambulance services, a justice system, highway construction, education, defense, parks, Fourth of July celebrations, etc., are all best handled through government purchases or by direct government provision. And finally, markets cause certain problems. An under-regulated financial sector, as Adam Smith noted, and as history has shown repeatedly, is a menace to society. And of course there are many other externalities, especially environmental.

So we must approach markets pragmatically. They’re useful for certain things, useless for others, and potentially harmful in certain ways unless care is taken to mitigate or eliminate their negative effects. Everyone should know this.

Yet market fundamentalism—the view that society benefits more, the more markets are unfettered—is a curiously powerful intellectual attractor. Why it’s so difficult to recognize that markets have uses and limits, and leave it at that, rather than ideologize them, dividing people into camps depending on fealty to this rather abstract explanatory principle (“markets”) is, I believe, accounted for by my theory of conservatism. The “market” is perceived as an automatic mechanism that, but for the interference of a human hand, delivers optimal results. Parasitic politicians exploit this by championing their policies as “pro market” and castigating those—at best misguided, at worst nefarious—“others” who would interfere with the workings of this mechanism. Interestingly, the “market” is invoked far more often by its absence than its presence. If the price of oil rises, it can’t be because of growing global demand and/or supply disruptions, an accurate explanation. It has to be Ben Bernanke or speculators, a deliberate interference in a mechanism that would otherwise work to our benefit.

Conservatism is not the same thing as tribal psychology (there are “tribes” on the left as well as the right), but I suspect it’s positively correlated with it. As I’ve noted, “personality” can be viewed as an underlying mechanism generating human behavioral patterns. Thus conservatism and tribal psychology, I suspect, combine to form a basis for a particularly virulent brand of partisan politics.

Summarizing

So anyway, that’s my general theory of conservatism. To function, one requires beliefs. These consist not just of expectations about the persistence of observable patterns, but also conceptions of the underlying forces generating them. The latter are really the “stuff” of belief—abstract, often vaguely understand, notions about the underlying forces that generate cause-effect relationships across multiple scenarios. And people will simply differ in their propensity to revise beliefs in the light of new facts. Everyone resists revising beliefs, but some more than others. The latter are conservatives.

July 7, 2011
Flirting with Catastrophe

It’s hard to write when you’re speechless. The fact that Congress is even debating whether to raise the debt ceiling means our politics is broken. The fact that that the debt ceiling may not be raised… Well, I’m speechless.

What would happen if the debt ceiling isn’t raised? For one thing, according to a report (that only covers the month of August) by the Bipartisan Policy Center, it means federal spending would have to immediately contract by 44 percent. 44 percent. This would make Greek austerity seem feathery. Jay Powell, an undersecretary of the Treasury under George H.W. Bush and the report’s lead author, notes that a 44 percent cut in federal spending is a 10 percent cut in GDP. For comparison, in the final quarter of 2008 and first quarter of 2009 the economy contracted at an annualized rate of 6 percent, a downturn that brought us the Great Recession and lingering unemployment now at 9.1 percent. It’s hard to throw out numbers, since the nature of the situation is so unclear. But obviously there’d be a dramatic uptick in that statistic.

But it would be worse. If the debt ceiling isn’t raised, the Treasury will have to choose what to spend money on. The BPC paper lays out two scenarios, a “Protect Selected Big Programs” scenario and a “Protect Safety Net” scenario. In the former, the Treasury pays interest on the federal debt, Medicare and Medicaid, Social Security, defense contractors and unemployment insurance.,but stops paying military salaries and IRS refunds, defunds the Veterans Affairs Administration, the Centers for Disease Control, food stamps, education, and NASA, shuts down air control, freezes paychecks of all federal employees, and much else. In the latter scenario, the Treasury pays interest on the federal debt, Medicare and Medicaid, Social Security, food nutrition services/TANF, HUD, Veterans Affairs programs, and unemployment insurance, but stops paying defense contractors, military salaries, IRS refunds, federal salaries, and defunds NASA, the Department of Energy, Health and Human Services, the Interior Department, and much else.

However one slices it, the Treasury would take on dictatorial powers to determine which programs are funded and which policies are implemented. (No doubt Republicans espy the inevitably controversial decisions the Treasury will have to make as a chance for vitriolic critique and partisan gain.)

But it would be worse. Paying interest on the debt, as in the above scenarios, may seem to spare the bond market. But the Treasury must also “roll over” (attract new buyers into) almost $500 billion of debt that matures in August. That would almost certainly require higher interest rates. In addition, the ratings agencies may downgrade U.S. government debt, which would push rates still higher. Since interest rates in general (mortgage rates, credit card rates, auto loan rates, corporate borrowing rates) are linked to Treasury rates, interest rates in general will rise. (And did I mention that higher interest rates slow the economy?) And higher rates would force financial institutions to mark down the value of key assets (“riskless” Treasury bonds), probably pushing many into insolvency.

And there’s more. Recognizing that they may soon stop receiving government checks, government contractors, seniors, and others are likely to start hoarding cash, worsening the liquidity trap we’re already in.

And we haven’t even gotten to the possibility of default, which could throw the international financial system, which is built on the perception that U.S. government debt is perfectly safe, into chaos.

It really does take a stomach to peer into this abyss, and the Bipartisan Policy Center has done yeoman’s work. And remember, they looked only at August.

In sum, failure to raise the debt ceiling would be cataclysmic. Our two-year-old recovery, tepid though it’s been, would be a thing of the beloved past.

There’s no issue about who’s most culpable for the impasse. Obama’s starting bid in the Biden talks was $2 trillion in spending cuts for $400 billion in taxes, an 83:17 split. (And don’t forget that tax revenues and rates are at historic lows.) That’s more than bending over backwards to avoid a crisis. Eric Cantor and other Republicans walked out of those talks over the administration’s proposal to end tax breaks for oil companies and corporate jet owners.

Of course, it’s silly that there is a debt limit. Congress appropriates every penny of federal government spending and thus incurs every penny of federal government debt. Now it needs to vote on whether to pay that debt?

Why are the Republicans doing this? Why, when Republicans voted overwhelmingly to raise the debt ceiling seven times during the George W. Bush administration, are they balking now, pretending to care about a long-term debt problem they largely created? Why, two years into a tepid recovery, are we suddenly debating whether to tank the economy and take the world economy down with us? It seems too farcical to be true. And for many it is. Many observers simply can’t believe the Republicans would act so irresponsibly—that surely they’re just playing the “crazy” card for all its worth but will yank it back before push comes to shove. Besides, wouldn’t their Wall Street benefactors (our strange bedfellows) sit them down and explain that they will raise the debt ceiling?

But they’re playing a dangerous game. Think nuclear deterrence, Dr. Strangelove’s doomsday machine, Nixon’s “crazyman” theory of the presidency. The point is to keep your opponent from knowing whether you’re really crazy, or, perhaps better, to visibly tie your hands in a way that will force you to act insanely. The other side (the reasonable side) will have to back down. The Republican leadership perhaps isn’t crazy (though it’s hard to tell), but they’re tied to a Tea Party base that is.

My cynical best guess is that the Republican leadership wants to rattle the bond market just enough to raise interest rates, stall the recovery, and pin a continuously weak economy on Obama. This won’t help their Wall Street benefactors, but you win some, you lose some. The Republicans will still do all they can to neuter Dodd-Frank.

*As I write, a report has come out that Obama is offering cuts in Social Security and Medicare in exchange for revenue increases (rescission of Bush’s high-end tax cuts?). I’m guessing (hoping) this is just a way of exposing the Republicans’ intransigence and signaling to his opponents that he’s also tied to a base (a base that won’t tolerate cuts in these programs, as Obama surely knows).

January 20, 2011
About Arizona

Given that the shooter seems not to have been motivated by the extreme rhetoric of Republican politicians and conservative commentators, is it logical that the shooting should focus attention on that rhetoric? Perhaps not strictly. But two points. (1) Irresponsible right-wing rhetoric didn’t become an issue with the Arizona shooting. It’s been one almost since the start of Obama’s presidency. The salience of political issues rises and falls based on many factors. If the Arizona shooting raises the salience of an issue that is after all quite real, I don’t see the problem. (Proponents of the idea that 9-11 somehow awakened us to the threat of Saddam Hussein have nothing to complain about.) (2) The shooting gives us our fullest taste yet of what could actually result from this rhetoric.

Sarah Palin’s cross-hairs map and admonition not to retreat but “reload” are almost certainly just metaphors (meant to capitalize on solidarity with the gun community), just incredibly irresponsible metaphors. (Not sure about Sharon Angle’s “Second Amendment remedies.” If it’s not a call to violence, what is it?) But even outside the “eliminationist” vein, Republican and conservative rhetoric has been, well, crazy. Let’s take some statements about the health care bill:

• Former Arizona representative John Shedogg: “What we’re really getting here is we’re not just getting single-payer care. We’re getting full on Russian gulag, Soviet-style gulag health care.”
• Rush Limbaugh: “Who are we targeting in health care? Old people. Rationing the care of old people... And then it hit me....What’s the first thing Mao se Tung did? What was the cultural revolution? He took out the educated people. He took out people who had a cultural, historical memory of China's past.”
• Tom Coburn [to seniors]: “You're going to die sooner [if health care reform passes].”
• John Cornyn: “It will limit people's choices to, in many cases, to a government-run program like Medicaid which is essentially a health care gulag, because people will not have any choices but to take that poorly performing government plan.”
• Sarah Palin: “The America I know and love is not one in which my parents or my baby with Down Syndrome will have to stand in front of Obama’s ‘death panel’ so his bureaucrats can decide, based on a subjective judgment of their ‘level of productivity in society,’ whether they are worthy of health care. Such a system is downright evil.”
• John Boehner: “We’re about 24 hours from Armageddon…. This health care bill will ruin our country.”

If I honestly believed that politicians like Barack Obama and Gabrielle Giffords were trying to establish a “gulag” (chain of brutal labor camps for political prisoners) or “ruin our country” or create a Maoist Hell or hasten the deaths of seniors, I might think assassination an appropriate response. What the above statements actually reference is a moderate insurance market reform quite similar to the 1993 Republican counter-proposal (co-sponsored by Bob Dole) to Bill Clinton’s health care reform proposal and nearly identical to the reform plan championed and signed into law in Massachusetts by a plausible 2012 Republican presidential nominee. It’s not my ideal of health care reform. But it’s a vast improvement over what we have now. It keeps the present system almost entirely intact, including the for-profit private health insurance industry. But it eliminates the system’s most barbaric aspects. It ends denial of coverage because of preexisting conditions, ends rescission, requires automatic renewability of policies, limits annual and lifetime out-of-pocket fees, ends lifetime payment caps (so tens of thousands of Americans with insurance will no longer go bankrupt each year paying expensive medical bills), doesn’t cut benefits to traditional Medicare recipients (though it cuts those to Medicare Advantage recipients), extends the solvency of Medicare, establishes free preventive care (like cancer screening) for seniors, closes the Medicare “doughnut hole,” enables children to remain on parents’ health care plans until age 27, creates an individual and small group insurance market where insurers compete on price and quality rather than by denying claims, reduces the federal deficit by (according to the CBO) $138 billion in the first decade and $1.2 trillion in the second decade, extends insurance to over 30 million Americans (thus saving the lives of tens of thousands who would otherwise die each year for lack of consistent access to health care), establishes a number of programs (like the Medicare advisory board, bundled payments as an alternative to fee-for-service in the Medicare program, and comparative effectiveness research) to find ways of stemming rapidly rising health care costs (the root cause of our problem), and much else.

Few Americans would object to many of these things. What people object to is the individual mandate, the requirement that nearly everyone buy health insurance. But two points:

(1) The individual mandate isn’t separable from the benefits listed above. If insurers are to take all comers (i.e., not deny coverage based on preexisting conditions, not rescind coverage, automatically renew policies, etc.), there must be a mandate, since otherwise people will buy insurance just when they get sick, which isn’t viable. Insurance is a fund people pay into over time. That entitles them to make claims on that fund under certain conditions. If people haven’t paid into the fund in the first place, it doesn’t work.

(2) The moral high-ground is entirely on the side of the mandate. When someone without insurance requires emergency care, the rest of us pay for it in higher premiums. If it were possible to stipulate that those without insurance will be denied necessary care, fine. There’d be no case for requiring them to buy health insurance. But that’s not possible. In the special case of health care, a decision not to buy a product is not a decision not to consume it. And that consumption must be paid for. The health care bill thus mandates that those who can afford insurance buy it and those who cannot afford it get subsidies to buy it or receive care through Medicaid.*

If one has philosophical or technocratic or economic objections to the health care bill, fine. I respectfully disagree. But anyone claiming there were “death panels” in the bill (for a description of the “death panels,” see this), or that it would create a “health care gulag,” or that it follows a “Maoist” strategy of eliminating the elderly, deserves no civility whatsoever. The use of fear in politics is common. (And it’s not always unwarranted; there are things we should fear.) But the above-cited rhetoric about the health care bill is beyond the bounds of acceptable discourse. It bears no relation whatever to what would actually happen if the health care bill were implemented. Its sole purpose is to implant fear. And by using that other age-old political tactic of repeating something so often that people start to believe it, they’ve gotten this nonsense into the mainstream discourse.

And how dangerous is right-wing violence in America today? More dangerous than left-wing violence. Serious threats to Congress-members tripled after passage of the health care bill, according to federal law enforcement officers. (Threats to Obama reportedly have been four times higher, averaging 30 per day, than they were to George W. Bush.) Looking over a list of violent acts compiled by the Coalition to Stop Gun Violence, I count 12 acts of politically-motivated violence since July 2008. (Undoubtedly there were more. These are ones that made the news.) Eight resulted in fatalities for a total of 13 killings (not including the perpetrators, many of whom were killed in these incidents). Just one, which did not involve a killing, is plausibly “left-wing” in inspiration (a radical environmentalist taking hostages). The other 11 are plausibly “right-wing.” The motives are in some cases overlapping. Four appear to reflect generalized anti-government sentiment, three gun rights, three a sort of generalized anti-Democrat, anti-liberal sentiment, two the health care bill, and one abortion (the murder of Dr. George Tiller).

In one of the most underreported stories in years, in Spokane, Washington, on January 17^th, a backpack containing an “improvised explosive device” that could have “inflicted multiple casualties,” according to the FBI, was found on the route of an MLK Day parade shortly before the parade was scheduled to start. The bomb reportedly included a remote control detonator, was packed with shrapnel, and was placed facing away from a brick wall evidently to direct the bomb’s destructive force toward the street (i.e., onto the parade route). In contrast to other recent terrorist attempts, this wasn’t an amateur affair. It’s unknown who planted the bomb. If the prime suspects had been middle-Eastern in origin or descent, is it imaginable that the story would have gotten so little attention?

Threats naturally outnumber deeds by orders of magnitude. Words don’t kill, but they almost certainly provide insight into the mentality behind some of the violence. There are many, many examples. To take one, after passage of the health care bill, concealed handgun permit owner Charles Alan Wilson left voicemail messages on Senator Patty Murray’s office phone. He said Murray had “a target on her back” and that “since you are going to put my life at risk, and a bureaucrat is going determine my health care, your life is at risk, dear... I hope somebody puts a...bullet between your...eyes.” 

The man is obviously deranged. But on the narrow question of whether one should defend oneself if one’s life is threatened, he was rational. Now why would anyone think that a moderate (indeed Republican) insurance market reform would threaten one’s life? Oh right. Prominent national figures have been saying that it will. When people are repeatedly told that a moderate insurance market reform will threaten their, or their relatives’, lives, and the media regularly channel that message as if it were a legitimate point of view, some will believe it, and some will act on it. Yes, the man was deranged. But the lion’s share of the derangement—the idea that the health care bill threatens his life—was planted in his brain by unscrupulous and/or deranged politicians and commentators, many of whom hold prominent positions in the Republican Party.

Though the Arizona shooter seems not to have been politically motivated, the event gives us our fullest taste yet of what to expect as prominent Republicans continue to paint a picture of their moderately reformist opponents as evil. Most disheartening perhaps is that the debates fanning the rancor are almost entirely without substance. The Republicans favored the current version of health care reform until the Democrats favored it, at which point they had to switch positions for obvious reasons.

The Republicans’ objective is clearly to sow enough fear to give them an electoral advantage, a strategy that seems to be working. They can also calculate, if it were a priority, that some portion of the public will take their rhetoric at face value, and literally believe that Obama’s and the Democrats’ policies will “destroy the country,” or take away their gun rights or liberties or even lives. It strikes me as mathematics that events like those described above will continue to occur, and that some may well have the scale and character of the Arizona massacre.

*This, incidentally, is why the individual mandate is constitutional. The question is whether a decision not to buy health insurance enters the stream of commerce. Your bank account (and mine) diminishes as a result of others’ decisions not to buy health insurance. This doesn’t happen by magic, but because sales of goods and services (i.e., commerce) arise from those decisions. Ergo, in this one case (and I don’t know of any others that apply broadly to everyone regardless of circumstance), a decision not to buy a product impacts commerce anf thus is within the power of Congress to regulate. For a clear account of the legal issues and of why, unless the Supreme Court "is willing to rewrite hundreds of years of jurisprudence," it will not overturn the law, see David Cole.

On a more philosophical note, one may believe that health care shouldn’t be a right. But the reality is that it is a right. If someone without insurance is dying by the side of the road, they get health care, whether they pay for it or not. Unless you’re willing to practice what you preach (and that means (a) refusing emergency medical care if you haven’t bought health insurance and (b) denying emergency care to others if they can’t pay for it), just acknowledge that health care is different from other products. It is a right.

November 13, 2010
The Recovery in Context

There are two sorts of downturn. There’s the garden-variety type where businesses, having over-expanded, retrench, laying off workers and provoking a downward spiral of income, investment, output and employment. Expansionary fiscal and monetary policies (automatic stabilizers and a falling federal funds rate) then kick in, demand and supply expand, and the economy returns to growth. Such downturns are painful, but government has well-honed tools for addressing them with a minimum of political consternation.

The other type of downturn arises from an asset market collapse—the bursting of an asset bubble or a string of bank runs, for example—that wipes out vast quantities of wealth. Recovery then awaits reestablishment by households and/or businesses of prior wealth positions, an inherently long, drawn-out process. Government can help debtors recover their wealth through bailouts, stimulus, and expansionary monetary policy. But monetary policy can be of limited effectiveness in such circumstances, especially if the federal funds rate hits the zero lower bound, and bailouts and stimulus tend to be politically fraught.

Kenneth Rogoff and Carmen Reinhart, in their book This Time is Different, exhaustively survey downturns of the latter sort. They summarize their findings as follows:

Broadly speaking, financial crises are protracted affairs. More often than not, the aftermath of severe financial crises share three characteristics. First, asset market collapses are deep and prolonged. Real housing price declines average 35 percent stretched out over six years, while equity price collapses average 55 percent over a downturn of about three and a half years. Second, the aftermath of banking crises is associated with profound declines in output and employment. The unemployment rate rises an average of 7 percentage points over the down phase of the cycle, which lasts on average over four years. Output falls (from peak to trough) an average of over 9 percent, although the duration of the downturn, averaging roughly two years, is considerably shorter than for unemployment. Third, the real value of government debt tends to explode, rising an average of 86 percent in the major post–World War II episodes.

And how does the U.S. experience compare with the historical data presented by Rogoff and Reinhart? It’s early to compare rising government debt to the historical norm. But with respect to the other dimensions of their analysis, we find:

• Unsurprisingly, among asset markets it’s housing that’s dropped most sharply. Nevertheless it appears house prices will bottom out before hitting the Rogoff-Reinhart average.
• Equity markets, after a collapse at least as severe as the norm, have come roaring back.
• Employment was hit much harder than output, and part of that may be unusually fast productivity growth. Yet employment appears to be ahead of schedule in returning to tolerable levels.
• Possibly the great untold story of the downturn, when placed in context, is how quickly GDP growth recovered. Tepid though GDP growth remains by normal standards, it’s off the charts in the context of typical asset market collapses.

October 28, 2010
Obama's and the Dems' Achievements

• Passed the stimulus bill. It was too small mathematically to close the output gap, but:
• The CBO estimates it raised real GDP by between 1.7 and 4.5 percent, lowered unemployment by between 0.7 and 1.8 percent, and increased the number of people employed by between 1.4 million and 3.3 million.
• Blinder and Zandi estimate it raised real GDP by 3.4 percent, lowered unem­ployment by 1.5 percent, and increased the number of people employed by 2.7 million.
• Macroeconomic Advisers, IHS Global Insight, and Moody’s Analytics (and thus all major macroeconomic forecasting firms) provide similar estimates.
• Contrast that with the Republican policy of no stimulus. By CBO estimates, GDP would be lower by between 1.7 and 4.5 percent, unemployment would be higher by between 0.7 and 1.8 percent, and the number of people employed would be lower by between 1.4 million and 3.3 million.
• The stimulus also, among many other things:
• Invested about $100 billion into our crumbling national infrastructure and transportation system, the largest investment in American infrastructure since Eisenhower.
• Invested about $60 billion in renewable and clean energy, by far the largest such government investment ever.

• Passed the health care reform bill, which, among many, many things too numerous to mention:
• Ends denial of coverage because of preexisting conditions. 
• Ends rescission.
• Limits annual and lifetime out-of-pocket expenses and ends lifetime payment caps, so that tens of thousands of people with insurance will no longer go bankrupt each year paying expensive medical bills.
• Requires automatic renewability of insurance.
• Makes children eligible to remain on parents’ insurance plans until age 26.
• Requires insurers to spend 80 to 85 percent of premiums on medical care. (Currently they spend as little as 60.)
• Makes Medicare patients eligible for annual free preventive care services, such as cancer screening. 
• Closes the Medicare prescription drug “doughnut hole.”
• Expands Medicaid eligibility nationally to people with incomes up to 133 percent of poverty.
• Provides generous subsidies to help lower- and middle-income Americans buy health insurance. Consider the following schedule (which assumes a family of four with a $9,435 policy):

• For a family of four at 150 percent of the poverty level, the government covers 86 percent of premiums. At 175 percent of the poverty level, it’s 79 percent, etc. If you can’t tell that this is progressive legislation, you wouldn’t know progressive legislation if it hit you in the face.

• Expanded the State Children’s Health Insurance Program (SCHIP) to cover four million more children, bringing the total to 11 million children nationwide.

• Passed the Lily Ledbetter Fair Pay Act, which amended the 1964 Civil Rights act for equal pay for equal work.

• Passed the Hate Crimes Prevention Act (the Matthew Shepard Act) that extends hate crime status to crimes motivated by a victim’s gender, sexual orientation, gender identity, or disability.

• Passed the Family Smoking Prevention and Tobacco Control Act, giving the FDA power to regulate tobacco, including nicotine content and how cigarettes are marketed. President Bush threatened to veto the bill. The tobacco industry spent nearly $308 million since 1998 trying to block it.

• Passed the Omnibus Public Land Management Act, placing under federal protection more than two million acres of wilderness, thousands of miles of rivers and a host of national trails and parks - the largest conservation effort of the last 15 years.

• Passed the Credit Card Accountability, Responsibility and Disclosure Act, which, among many other things, requires that card issuers give card-holders 45 days notice of interest rate increases and that card-holders can cancel a card before such changes take effect, prohibits card companies from raising interest rates during the first year of a credit card contract, and eliminates unrequested over-the-limit fees.

• Overhauled the student loan system in which banks were subsidized to give loans that were guaranteed by the government anyway, so banks could effectively print money. The savings are now put toward actual aid to students.

• Canceled a bloated, irrelevant weapons system, the F-22, the first time ever that a major U.S. weapons system was cancelled.

• Appointed Sonia Sotomayor and Elana Kagen to the Supreme Court. Contrast that with George W. Bush’s appointees, John Roberts and Samuel Alito. John McCain said he was “very proud to have played a role in the appointment and nomination of two great Supreme Court justices, Roberts and Alito.”

• Signed a nuclear arms deal with Russia that would reduce both countries` nuclear arsenals by a third.

• Eliminated Bush’s rules restricting federal funding of embryonic stem cell research.

And so much else. Most of these things help people. And if that’s boring, I’m sorry. But that’s what governance is. At its best it’s about making people's lives better, incrementally, and often against enormous odds, as over the last two years.

If you’re too apathetic to vote, don’t claim you care about people.

September 27, 2010
The Structural Unemployment Story

Economics textbooks teach that there are three kinds of unemployment: frictional (when people voluntarily change jobs), cyclical (when downturns throw people out of work), and structural (when workers’ skills or locations don’t match available jobs). Obviously we’re now experiencing primarily cyclical unemployment. There was a housing bubble. It burst. That and a dramatically declining stock market wiped out a lot of wealth. So people now spend less. Unemployment accordingly has risen. Rocket science it isn’t.

Yet some economists and commentators would like to believe, and therefore do believe, that current unemployment is structural, caused primarily not by a deficiency of demand but by a mismatch between workers’ skills and the needs of the economy. David Brooks writes, “Today’s economic problems are structural, not cyclical. We are in the middle of yet another jobless recovery. Wages have been lagging for decades. Our labor market woes are deep and intractable.” (For sensible perspectives on the issue, see this, this, this, this, and this.)

As usual with Brooks, he provides no evidence, nor wastes time telling us what would need to be true if the structural unemployment story were true. So let me fill that in. What would need to be true is that depression in some industries is matched by exuberance (hiring, high wages, overtime) in others. After all, there’s no shortage of demand, just a change in the distribution of demand. So we wouldn’t see this picture:

 Yet the data here are real. The decline in employment is broad, not sectoral. The overall picture is this:

The above graph almost looks too patterned. And indeed some proponents of the structural unemployment story have seized on the sharp decline in construction employment to argue that the skills of construction workers no longer match those needed by the economy. But as Lawrence Mishel, Heidi Shierholz, and Kathryn Edwards note, in an important paper released last week by the Economic Policy Institute, they can’t have examined the labor market data too closely. For example, for the structural unemployment story to make sense, unemployed construction workers would need to comprise a disproportionately large share of the long-term unemployed. They don’t. Construction workers are 12.4% of current unemployment and 12.5% of long-term unemployment. Construction workers are thus as capable as most others of finding new work. There’s no mismatch between the skills of such workers and the needs of the economy.

Mischel, Shierholz, and Edwards also note that if unemployment were primarily structural, the ratio of job seekers to job openings would be about the same as in normal times—between 1 and 2. Currently it’s about 5:

The structural unemployment story also presumes, as the authors note, that “that millions of workers are now inadequately prepared for available jobs even though they were fruitfully employed just a few months or years ago.” Does this seem remotely plausible? The supply side plays a role in economic activity, but supply sider logic often puts the supply side through some awfully strange contortions (like cyclical downturns caused by technological regressions) that seem comical until one considers their policy implications.

What are the policy implications of structural unemployment? That demand-side stimuli—expansionary fiscal and monetary policy—can’t help the economy and so shouldn’t be undertaken.

On the other hand, what would need to be true if unemployment were largely “cyclical”? Well, cyclical unemployment arises from an overall deficiency of demand, which is marked by low capacity utilization (check), low inflation (check), low interest rates (check), unemployment spread across many industries (check), and a high ratio of job seekers to job openings across the economy (check). While the presence of these factors doesn’t logically guarantee that unemployment is mainly cyclical, it doesn’t contradict it. Which is more than can be said about the facts in relation to the structural unemployment story.

This isn’t to say there’s no structural unemployment. There’s always some imperfection in the fit between the labor force and productive capacity. And as high unemployment persists and more workers join the ranks of the long-term unemployed, structural unemployment will rise. But that’s a problem we can start to worry about if unemployment ever again reaches near the “natural rate of unemployment” (currently 5.2 percent, according to the CBO). The problem now is that millions of workers across most industries have been thrown out of work because people aren’t buying the products they normally make.

What could be driving the idea that we’re now experiencing mainly structural unemployment? Here, I think, we need to enter the psychological realm. But I’m unclear what the psychological mechanisms could be. Is it that some economists and commentators just feel they need to take up a contrary position to the one “liberal” economists and policymakers espouse and that motivated the obvious actions of stimulating demand when demand was depressed? Is it that policymakers and conservative ideologues just don’t want anything done about unemployment, and are looking for an excuse not to act? Or a way of bringing Obama down?

I sense that a large chunk of it is simply narrative opportunism. The unemployment rate is still high, an opening for the David Brookss of the world to explain that demand-side stimuli can’t really address our problems, which are deeper, “structural” in nature, as profound minds can grasp.

There’s a coherent supply-side story to tell about downturns (just as there’s a coherent demand-side story). But in this instance it doesn’t fit the facts about inflation, capacity utilization, interest rates, or recent historical events like a bursting housing bubble and a plummeting stock market. And of course it’s not remotely plausible that workers who were gainfully employed in many industries just a few years ago are suddenly incapable of running the nation’s productive capacity.

As noted in my most recent post, David Brooks seems to make little distinction between government and household debt. We face, he tells us in another column, a “debt crisis,” by which I assume he means not a sovereign debt crisis (though he’s curiously unclear about this), but one caused simply by too much consumer debt. He writes,

Deficit spending in the middle of a debt crisis has different psychological effects than deficit spending at other times… In times like these, deficit spending to pump up the economy doesn’t make consumers feel more confident; it makes them feel more insecure because they see a political system out of control. Deficit spending doesn’t induce small businesspeople to hire and expand. It scares them because they conclude the growth isn’t real and they know big tax increases are on the horizon. It doesn’t make political leaders feel better either. Lacking faith that they can wisely cut the debt in some magically virtuous future, they see their nations careening to fiscal ruin.

How he knows all this is a curiosum. He cites no polls or surveys. Probably wise, since the ones I’ve seen (cited in my most recent post) show debt and deficits to be at best a minor concern of people and businesses compared to unemployment and sales.

If borrowing is the scourge Brooks thinks it is, he should be happy that it’s down:

But Brooks really has it in for government borrowing, since it apparently betokens big government (“a political system out of control”), of which Americans—he never stops telling us—are skeptical. And that skepticism, he claims, translates into too little confidence to spend. Hence our troubles.

It’s very hard to see how Brooks’s narrative relates to reality. Government borrowing is what’s keeping us bobbing on the surface as opposed to plunging to the bottom. We see this when we decompose borrowing into its components:

(Source: Federal Reserve flow of funds data)

Government borrowing has risen while private sector borrowing has turned negative. Why is the increase in government borrowing a good thing? Because the source of our problem is a massive (and global) increase in desired savings, a liquidity trap in which people and businesses wish to hold their wealth primarily in liquid form rather than investing it productively. Government borrowing absorbs some of the excess savings, getting it into the economy rather than allowing it to sit idle.

U.S. government borrowing in these conditions has little effect on interest rates since, with demand depressed and factor utilization low, government borrowing doesn’t compete with private borrowing for scarce savings. At present government debt is just a relatively liquid substitute for money. Only as the economy recovers, and people and businesses are again willing to put their money in less liquid form, will government borrowing again compete for scarce savings with private borrowing, putting upward pressure on interest rates. That’s a concern, but it’s a problem we should want to have.

And as has been pointed out repeatedly by some, those with most at stake (and the most expertise) in U.S. government solvency, bond traders, are wholly unconcerned about a sovereign debt crisis—the prospect of which, Brooks claims, without evidence, is retarding private sector investment. Yields on all categories of Treasury debt are at or near record lows. Here are daily yields on all Treasury securities since 1990:

Treasury securities simply could not be the relatively liquid substitute for money they have become if bond traders doubted the future solvency of the U.S. government. Which is fortunate, since it affords us an enormous advantage in addressing the crisis. Low borrowing rates enable the government to do what the private sector currently can’t: mobilize idle savings, putting it to productive use.

All of this should be uncontroversial. It’s a pity some members of the commentariat feel it necessary to spin a counter-narrative that has little basis in fact or reason.

August 10, 2010
Systematically Wrong

It’s a curious thing when a commentator can’t seem to get anything right. Such was the case with David Brooks in a column several weeks ago. One can only take it as testimony to the mind-warping powers of ideology. Take this paragraph:

The Demand Siders don’t have a good explanation for the past two years. There is no way to know for sure how well the last stimulus worked because we don’t know what would have happened without it. But it is certainly true that the fiscal spigots have been wide open. The U.S. and most other countries have run up huge, historic deficits. And while this has helped save public-sector jobs, we certainly haven’t seen much private-sector job growth. It could be that government spending is a weak lever to counter economic cycles. Maybe monetary policy is the only strong tool we have.

Nearly every sentence in this paragraph is false or misleading. Let’s take it sentence by sentence:

1. “The Demand Siders don’t have a good explanation for the past two years.” The “Demand Siders” actually have the only explanation for the past two years. The bursting of the housing bubble and ensuing stock market collapse together eliminated about $13 trillion of wealth. These losses, through a thing called the wealth effect, reduced consumer demand by an estimated $500 billion per annum. The bursting of the housing bubble also caused residential construction to contract, which is estimated to have cost the economy another $500 billion in annual consumer demand. And then there was the bursting of a bubble in nonresidential real estate, which caused nonresidential construction to plunge, costing the economy another $150 billion in demand. The total loss in annual demand is thus perhaps $1.2 trillion. The effect of a demand shock (as some may recall from introductory economics) is downward pressure on output and prices (in contrast to a supply shock, which would put upward pressure on prices), which is what we’ve seen. (Numbers from Dean Baker.)

All evidence appears to be that, in depressed, deflationary circumstances, fiscal stimulus is effective whenever, and to the extent that, it’s been tried. In a statistical study of fiscal expansions during the 1930s, for example, Almunia, Bénétrix., Eichengreen, O.Rourke. and Rua found that “fiscal policy, where applied, worked extremely well…, whether because spending from other sources was limited by uncertainty and liquidity constraints, or because with interest rates close to the zero bound there was little crowding out of private spending.” Also, Adam Posen, who’s studied Japan’s “lost decade” of the 1990s and early 2000s extensively, observes, “Fiscal policy works when it is tried,” but in the case of Japan successful stimulus has repeatedly been thwarted by policy error—fiscal contractions that have undone the positive effects of stimulus. Posen writes that “when the Japanese government paid for fiscal stimulus in 1995, it got economic growth,” but “when it mistakenly pursued fiscal austerity in most of the remainder of the 1992-97 period, it got economic contraction”—a pattern repeated in the early 2000s.

And consider present-day experience in many Asian countries. David Pilling of the Financial Times writes:

However much Asians trumpet the value of parsimony, their governments have been as bold as any in opening the fiscal sluices. One reason is the bitter memory of the 1997 Asian financial crisis when the International Monetary Fund imposed fiscal austerity on several Asian countries. Those measures are now almost universally seen as a blunder that unnecessarily exacerbated economic misery… Unlike in the west, there is little debate in Asia about how well the stimulus worked. It has been spectacular. Asian output is well above pre-crisis levels. HSBC is predicting growth for Asia ex-Japan of 8.6 per cent this year. Rather than contemplating more stimulus, authorities are trying to cool things down.

I’ve shown the following graphs from Barry Eichengreen and Kevin H. O’Rourke in a previous posting, but let’s look at them again:

World Industrial Production

World Trade

Is it really hard to see that the current downturn was probably as bad as the Great Depression? That the reason we aren’t now in a second Great Depression is government actions—bank bailouts, but also demand-side stimuli such as expansionary fiscal and monetary policy—undertaken on an unprecedented scale in many countries? And that ending stimulus now, before recovery is assured, is a very bad idea?

Now, no one doing the math expected a $787 billion stimulus package over two years to fill the output gap. Let’s run through the math. This is very back-of-the-envelope, but back-of-the-envelope is appropriate here since we’re dealing with general magnitudes.

Okun’s law says that for every 1 percent increase in unemployment above full employment, GDP will be 2 to 4 percent lower than potential GDP. Let’s take the optimistic end of the range and assume that, for every 1 percent increase in unemployment above full employment, GDP is 2 percent lower than potential GDP. And let’s call full employment 5 percent (the CBO’s estimate of the NAIRU is 5.2 percent). Shortly after the stimulus was enacted, and before stimulus funds hit the economy, consensus forecasts of unemployment worsened to about 10 percent (and of course unemployment eventually reached 10.5 percent). So let’s say unemployment was forecast to be 5 percent above full employment. That means the output gap would be $1.4 trillion (10% x $14 trillion) during the first year of the stimulus and somewhat less than that the following year. To reduce unemployment by 1 percent should then require about $280 billion of additional annual GDP (since 2 percent x $14 trillion = $280 billion). To reduce it by 5 percent and close the output gap should then require about $1.4 trillion of additional annual GDP.

The stimulus bill spent $787 billion over two years. A little less than $100 billion of that was a patch of the AMT, so let’s call it $700 billion. And about $300 billion was offset by cutbacks and tax increases at the state and local level, so the net stimulus was about $400 billion. About two-thirds of the stimulus was spending and about one-third of it was tax cuts. Spending has higher multipliers than tax cuts; so let’s say the “spending multiplier” was 1.5 and the “tax cut multiplier” was 1. And let’s assume that half the money was spent the first year and half the second year. The addition to annual GDP over what it would otherwise have been would then be approximately:

(1.5 x $133 billion) + (1 x $67 billion) = $267 billion

If we get a 1 percent reduction in unemployment for every $280 billion of additional annual GDP, we get an approximately 0.95 percent reduction in unemployment after one year and about 1.9 percent after two years. If we factor in growth of the labor force, we might wind up with a reduction in unemployment similar to the estimates of Moody’s Analytics and the CBO for the fourth quarter of 2010, diagrammed below.

So the stimulus, according to this analysis, shouldn’t have been enough.

What would have been enough? My back-of-the-envelope math says $1.4 trillion (assuming no AMT fix). Taking out the $300 billion offset for cutbacks and tax increases at the state and local level, the net stimulus would be $1.1 trillion. The addition to annual GDP over baseline would then be approximately:

(1.5 x $367 billion) + (1 x $183 billion) = $733 billion

The unemployment reduction over two years should then be a little over 5 percent ($1.47 trillion ÷ $280 billion ≈ 5).

Interestingly, $1.4 trillion is the number reportedly proposed by the Treasury Department and very close to the one suggested by Christina Romer ($1.2 trillion) when the stimulus proposal was being formulated. The watering-down of these proposals by political considerations may be one of the tragedies of our age. (See Ray Lizza’s New Yorker piece; also this.)

These particular figures are not, of course, to be taken too seriously. The point is simply to illustrate that, using a textbook rule-of-thumb like Okun’s law, we can see that the stimulus ought to have been closer to the ballpark of $1.4 trillion than that of $787 billion. The stimulus, though obviously helpful (even a godsend considering the alternative), should have been insufficient to close the output gap and return the economy to full employment.

So the “demand siders” have a full—indeed the only plausible—explanation for the last two years. But that’s enough for sentence 1. Let’s go on to sentence 2.

2. “There is no way to know for sure how well the last stimulus worked because we don’t know what would have happened without it.” There’s no way to know for sure, in the strictest sense, how well the last stimulus worked. This is quite an uninformative statement. Obviously what we have are estimates, plenty of them, from reputable sources. For example, there are these from Moody’s Analytics and the CBO:

Macroeconomic Advisers and IHS Global Insight (and thus all three major macroeconomic forecasting firms) have produced similar estimates.

If Brooks or anyone knows reasons why the providers these estimates would be biased, they should explain. Republicans speak favorably of the CBO whenever its analyses support their policies. The head of Moody’s Analytics is former McCain adviser Mark Zandi.

It’s true some analyses suggest little or no positive impact from the stimulus. But these are a minority. The most prominent of them is perhaps Cogan, Cwik, Taylor, and Wieland, which estimates multipliers about a sixth as large as those of the above sources. But the reason for the difference appears to be the parameterization. In particular, fiscal expansions don’t happen in a vacuum, but evoke a monetary policy response, since the Fed at some point will have to raise interest rates to stem inflation. The quicker rates rise after a fiscal expansion, the larger the crowding-out effect will be, and the smaller the positive effect of the stimulus on output and employment. So a lot depends on how monetary policy is modeled. Moody’s, the CBO, Macroeconomic Advisers, and Romer/Bernstein all assumed relatively easy monetary policy over an extended period. Macroeconomic Advisers, for example, tells us:

Currently the nominal federal funds rate is pinned at nearly zero, and our favorite monetary rule suggests that it should be negative. Hence, when we prepared our analysis of ARRA, we explicitly assumed the Fed would not raise nominal interest rates in response to the stimulus because it wanted to encourage the largest possible impact on the economy. Furthermore, since the stimulus reduced slack in the economy and so put upward pressure on inflation (or prevented further disinflation), the real interest rate fell in our simulations. This is opposite the “normal” response of real rates in most reduced form models with an implicit (or explicit) monetary rule, and works to magnify the multiplier effects — as intended by the Fed.

In other words, because (a) the “correct” federal funds rate is negative, so that the federal funds rate will not likely rise for a considerable time, and (b) a fiscal expansion puts upward pressure on prices, the real interest rate

r = i - π   (real rate of interest = nominal rate of interest - inflation rate)

is destined to fall (or at least be lower than it otherwise would be). This creates a window in which a fiscal expansion is likely to be especially effective, i.e., with minimal crowding out.

By contrast Cogan, Cwik, Taylor, and Wieland tell us, “our analysis allows for the return to a stabilizing monetary policy after one or two years.” With possible deflation now on the horizon and the Fed making noises about engaging in unconventional monetary policy, it seems clear which parameterization was the more reasonable.

3. “But it is certainly true that the fiscal spigots have been wide open.” Not sure what Brooks means by “wide open.” If he means opened up to some degree, he’s right. There has been more federal spending. But the spigots haven’t been wide open if by “wide open” Brooks means unconstrained. The fiscal stimulus may or may not have been all that Obama could have gotten from Congress, but mathematically, as shown above, it wasn’t enough to close the output gap.

4. “The U.S. and most other countries have run up huge, historic deficits.” It’s true that the U.S. has run up huge deficits, but Brooks makes it appear that they’re entirely the result of the stimulus, which is anything but true. Much bigger contributors to the deficits are the Bush tax cuts (which Brooks supported) and the recession itself (i.e., the loss of tax revenues and automatic increases in, e.g., unemployment insurance and food stamps). Besides which, the whole point of the stimulus is to inject demand into a demand-starved economy. That by definition means deficit spending. Since stimulus is temporary, it doesn’t add significantly to long-term debt (unlike the Bush tax cuts that Brooks supported). Indeed by stimulating growth it improves long-run budgetary prospects over what they would otherwise have been.

5. “It could be that government spending is a weak lever to counter economic cycles. Maybe monetary policy is the only strong tool we have.” Most economists, including most “demand siders,” would agree that monetary policy is the best stabilization tool we have. Unless monetary policy is at the zero lower bound, in which case it’s largely ineffective. There’s nothing now to be done about short-term interest rates. They’re zero. And the Fed’s capacity to influence long-term rates appears to be minimal (see Krugman). Really this is the whole point behind arguments for stimulus. We’re in a liquidity trap, i.e., incomes and wealth are low, so demand is low and investment is unprofitable. That means that almost however much money the Fed puts into the economy (and the economy is now awash in cash), it doesn’t get used productively—a situation that will continue until demand recovers.

Is it really that hard to grasp that people and businesses don’t necessarily spend their money when (a) households are trying to recoup their lost wealth and (b) there are relatively few profitable investment opportunities?

How can demand recover? One way would be to leave the economy to its own devices (a “liquidationist” approach). After a long, savage depression during which vast amounts of capacity (including labor, i.e., lives) are wasted, wealth and incomes should start to recover. But luckily we have a better way. When demand is depressed, the government can step in and bolster demand through temporary deficit spending. It doesn’t adversely impact long-terms debt, since the spending is temporary, and in any case stimulating growth now makes future revenues higher than they would otherwise be. It’s not inflationary since, with demand depressed, pressure on prices is downward. There’s minimal crowding out of investment since in a liquidity trap there’s little competition for loanable funds. And the historical and contemporary evidence is that stimulus works when, and to the extent that, it’s tried.

Further down the column Brooks writes:

These days, debt-fueled government spending doesn’t increase confidence. It destroys it. Only 6 percent of Americans believe the last stimulus created jobs, according to a New York Times/CBS News survey. Consumers are recovering from a debt-fueled bubble and have a moral aversion to more debt.

(People, of course, believe the stimulus failed because unemployment is nearly 10 percent. And they don’t know that absent the stimulus unemployment would almost certainly be much worse.)

Brooks oddly conflates government debt and household debt. It’s all just “debt.” And Americans now have a “moral aversion” to it and therefore believe spending in general should stop. It’s unclear when Americans got this religion. They showed no “moral aversion” to debt during the housing bubble, or, as far as I can tell, ever:

And somehow now, in a depressed economy, when deficit spending is appropriate (for once), they suddenly have a “moral aversion” to it? To the extent that Americans have a “moral aversion” to deficit spending, I suspect it’s because commentators and politicians (many of whom supported the policies that caused the debt problem) keep nattering on and on about it, and falsely imply that temporary stimulus is a major contributor to long-term U.S. debt.

But actually debt and deficits aren’t major concerns of Americans. We can look at polls:

(See also this.)

The fact that Americans are now deleveraging has an obvious explanation: they have no choice, moral or otherwise:

Brooks is concerned about confidence which he claims government debt destroys. And what about mass unemployment? Does that affect confidence? Most Americans don’t understand that there’s a short-term tradeoff between deficit spending and unemployment. But if given their choice between policies that lower deficits and policies that lower unemployment, which would they choose? I wonder.

Still further down the column, Brooks writes:

You can’t read models, but you do talk to entrepreneurs in Racine and Yakima. Higher deficits will make them more insecure and more risk-averse, not less. They’re afraid of a fiscal crisis. They’re afraid of future tax increases. They don’t believe government-stimulated growth is real and lasting. Maybe they are wrong to feel this way, but they do. And they are the ones who invest and hire, not the theorists.

Yes, you can talk to entrepreneurs. And here’s what they say:

The National Federation of Independent Business (NFIB) has regularly surveyed small business opinion since 1973. The above statistics are from its June report. Here are the same statistics over a longer period:

Brooks writes as if he’s surveyed business opinion and is reporting his findings: that their main concerns are government debt and taxes. Obviously he’s done nothing of the kind. Taxes are a perennial concern of businesses, to be sure, though they appear to be less of a concern now than they’ve been over most of the last 25 years. And currently they’re superceded by sales, as one would expect when consumer demand has plummeted. Government debt, on the other hand, seems not to be on the radar at all.

Though businesses have their special interests, the bottom line is clear. The report comments:

Yet Brooks is adamant that businesses are concerned about government debt. Why? Does he so strongly believe that they must feel this way that he went ahead and asserted it without bothering to check whether it was true?  Curious, in any case, that entrepreneurs would be so concerned about government debt when those with most at stake in U.S. government solvency, bond traders, aren’t. The ten-year Treasury rate is now (August 10) 2.78 percent. Bondholders are demanding a 2.78 percent return to lend money to the U.S. government for ten years!

In an apparent attempt to seem empirical, Brooks cites a study by Lauren Cohen, Joshua Coval and Christopher Malloy of Harvard that found that increased government spending in certain congressional districts dampened corporate sector investment and employment. Brooks, invoking his theme of epistemic modesty, says, “You wish somebody could explain that one to you before you pass on more debt burdens to your grandchildren.” There are three problems with Brooks’s reference to the study. First, the study is at the local (congressional district) level, not the national level, which is the level relevant to the stimulus debate. Second, it uses data from the non-liquidity-trap years of 1968-2008 and thus doesn’t pertain to conditions relevant to stimulus in a depressed economy, which is the question we now face. And third, and most importantly, what the study actually finds is consistent with “demand siders’” views about stimulus. The authors write:

...the coefficient on firms in states with low unemployment is -0.016. For firms in states with high unemployment, the coefficient is 0.024 larger, which is sufficient to reverse the effect entirely (even considering the main effect of High Unemployment itself). This result can be interpreted as providing evidence consistent with the view that government stimulus crowds out private sector employment when the economy has little slack in the labor market, but does not when the economy is experiencing significant slack in the labor market” (italics added). 

This, of course, is an argument most stimulus advocates would make. Indeed the authors note, “…consistent with Keynes’ view that  crowding out should only occur under conditions of full employment, we find a weaker firm response to spending shocks when state-level employment is at or below its long-term historical average.” What they find, as noted in the above quote, under conditions high unemployment is a reversal of the crowding out effect they find under conditions of greater vibrancy.*

It’s not that the study supports Keynesian stimulus. The data don’t include the depressed economic conditions in which the question of Keynesian stimulus arises, so it doesn’t address the issue. Either Brooks didn’t read the article and/or he’s unfamiliar with the arguments for stimulus. I suspect both.

Modern-day Keynesians argue that we should spend when the economy is depressed and save when it’s healthy. (It’s not very complicated.) That prescription was followed by Keynesian-like economists who held power in the early 1990s. The result, by decade’s end, was surpluses as far as the eye could see, soon to be replaced by deficits as far as the eye could see, thanks to massive tax cuts supported by Brooks. Brooks and other conservatives, by contrast, apparently believe that we should save when the economy is depressed and spend when it’s healthy. This is simply not economics. You will not find this prescription in any macroeconomics textbook, including those by conservative economists. 

Brooks, an all-purpose pundit, must opine about the economy, though he obviously lacks a background in the subject. He finesses the latter fact by fitting economics to his narrative, the narrative that is his livelihood. What is this narrative? It seems to combine two main themes: that Americans are skeptical of big government, and that social reality is too complex for policy makers to adequately grasp and so their grandiose policy schemes tend to fall short. Most Americans lack Ivy League credentials or high IQs. But their skepticism of big government, and of the grand schemes of policy makers, shows a deep native wisdom. (Or at least it might be if they had it.)

So how should government proceed? Well, some modest policy-making is okay. Brooks’s advocacy of that makes him a “moderate” when compared to some of his right-wing brethren. But the third leg of Brooks’s narrative is the market. Policy makers, with their high IQs and impressive academic credentials, tend to be overconfident in their abilities to manage society. So intellectual modesty bids that we not tinker too much with the institution (the market) that is the fount of modernity and that centuries of evidence tell us embodies a collective wisdom vastly greater than that of any individual woman or man. 

The only problem with this is that that’s not what centuries of evidence tell us. Much of the last 300 years has been economically highly unstable, with booms, busts, bubbles, market failures, and depressions the most prevalent manifestations of our dynamic capitalist economy. It’s only in the post-World War II era, as the government has taken a bigger role in the economy, that large-scale instability has been more or less tamed.

One might have thought the third leg of this three-legged stool was knocked out in the fall of 2008. But now that the stimulus and other measures have rescued the economy from the abyss (though not restored it to full health), it becomes possible again to imagine, with appropriate blinders on, that the “market” is the self-correcting marvel people thought it was, that the insights gained over 70 years about the potential positive role government might play in depression-like circumstances don’t apply, and that all that’s needed to bring the economy back to health is some tinkering around the edges to raise confidence. But what Americans need isn’t “confidence.” (Confidence to what? Spend what they don’t have? Yes, that would be helpful.) What they need is income. And they’re not going to get it if we blunder into a Japanese-style lost decade. Brooks’s narrative is a force compelling us to do just that.

*The authors point to a likely “crowding out” effect—not crowding out in the traditional sense of increased competition for loanable funds driving up interest rates (since here we’re just talking about reallocations of government spending from one congressional district to another, not an absolute increase in government spending), but the possibility of increased competition for factors of production. One might reasonably expect government spending to entail such increased competition when labor markets are tight.

July 17, 2010
Four Instruments

Michael Lewis’s new book, The Big Short, is a story of discovery—discovery by a small group of investors (Lewis estimates there were “more than ten, fewer than twenty” such people in the world) that the financial world was perched on a precipice and about to crash violently to the rocks below. And they subjected their insight to an empirical test: they bet on it. (And won, of course.)

Some observers called the housing people; some noted the absurdity of the mortgage products (alt-A, no-income, option ARM, etc.) being pedaled to naïve homebuyers in the subprime mortgage market. But few perceived the extent to which institutional investors and even Wall Street itself had taken a long position in the subprime mortgage market. And it was no ordinary long position, but one multiplied many times over by derivatives, e.g., synthetic CDOs (many of these stamped “triple-A”). And it was a position made all the bigger by leverage, with investment banks allowed debt-to-equity ratios as high as 40-to-one.

A recurrent question in Lewis’s book is who was on the long side of the bets his protagonists (who were principally hedge fund managers Steve Eisman, Michael Burry, Charlie Ledley, Jamie Mai, and several associates) were making. That is, if they were shorting the subprime mortgage market—by buying credit default swaps on mortgage-backed securities and CDOs—someone had to be on the long side. (And they didn’t believe it could be the “smart money” firms selling them the credit default swaps, i.e., Goldman Sachs, Deutsche Bank, etc.) Discovering who that was, and how the financial system had become so extraordinarily fragile is the story of Lewis’s book. The drama is punctuated by various revelatory moments where one or another of Lewis’s protagonists peels back another layer of the mystery, perceiving some previously hidden aspect of the financial instruments and practices that had evolved to render the system so vulnerable. The end-result is a rather eye-opening view not just of the financial crisis but of human nature.

Not a complete explanation, but a significant degree of illumination, of the financial crisis, arises from consideration of four financial instruments that figure prominently in Lewis’s story:

1. Mortgage-backed securities (MBS)
2. Collateralized debt obligations (CDOs)
3. Credit default swaps (CDS)
4. Synthetic collateralized debt obligations (synthetic CDOs)

Let’s take each in turn.

1. Mortgage-backed securities (MBSs). Mortgage-backed securities are simple. They’re like mutual funds, only rather than stocks pooled together to yield dividends and capital gains or losses, they’re mortgages pooled together to yield interest and principle. How to securitize mortgages was a vexing problem in the financial industry for years. The problem, apart from default risk, was prepayment risk—the risk that falling interest rates might compel mortgage-borrowers to refinance, leaving lenders with prepaid mortgage balances to reinvest at now-lower rates.

So, the question was how to structure pools of mortgages in a way that would make them marketable to investors on a large scale. The answer was tranches, i.e., dividing investors into classes according to willingness to absorb default and prepayment risk. In the “senior tranche”—about 80 percent of investors in a security—investors would get the lowest risk and lowest return. In lower tiers they would get higher risk and higher returns. And in the lowest tranche of all, the mezzanine level, they would get the highest return but also the preponderance of default and prepayment risk. So in the event of default by some portion of mortgage-borrowers whose loans are included in an MBS, mezzanine level investors would be fully cleaned out before losses start to accrue to investors in the next higher tranche, and so on.

The ratings agencies generally stamped securities marketed to senior tranche investors as triple-A (i.e., as safe as Treasury bonds), those marketed to mezzanine level investors as triple-B, and those marketed to investors in between at intermediate grades. Tranching thus enabled the creation of a liquid market in mortgage-backed securities.

Nothing necessarily very amiss here. Arguably this is Wall Street performing its legitimate function of efficiently aggregating and allocating savings and distributing risk. Of course, when MBSs are backed largely by subprime loans, that’s a problem. But most MBSs weren’t backed by subprime loans. It seems that if Wall Street ingenuity had extended no further than MBSs, the catastrophe might have been averted.

2. Collateralized debt obligations (CDOs). One step beyond securitization of loans is securitization of securitizations of loans. This is essentially what a collateralized debt obligation (CDO) is—a sort of fund of funds, but rather than pooling together different mutual funds or hedge funds, it pools together different asset-backed securities, e.g., different mortgage-backed securities.

As Lewis explains,

Its logic was exactly that of the original mortgage bonds [or mortgage-backed securities]. In a mortgage bond, you gathered thousands of loans and, assuming that it was extremely unlikely that they would all go bad together, created a tower of bonds, in which both risk and return diminished as you rose. In a CDO you gathered 100 different mortgage bonds—usually, the riskiest, lower floors of the original tower—and used them to erect an entirely new tower of bonds.

So why create a new configuration of securities that were already on the market? Well, the problem with ordinary mortgage-backed securities is that they

…are too near the ground. More prone to flooding—the first to take losses—they bear a lower credit rating: triple-B. Triple-B-rated bonds were harder to sell than the triple-A-rated ones, on the safe, upper floors of the building… there were huge sums of money to be made, if you could somehow get them re-rated as triple-A, thereby lowering their perceived risk, however dishonestly and artificially. This is what Goldman Sachs had cleverly done. Their—soon to be everyone’s—nifty solution to the problem of selling the lower floors appears, in retrospect, almost magical. Having gathered 100 ground floors from 100 different subprime mortgage buildings (100 different B-rated bonds), they persuaded the rating agencies that these weren’t, as they might appear, all exactly the same things. They were another diversified portfolio of assets! [p. 73]

So a key motivation behind repackaging mortgage-backed securities into collateralized debt obligations was simply to make money. Since triple-B MBSs were “too near the ground” and thus unattractive to investors, investment banks packaged them into CDOs, making an argument about “diversification of risk” that convinced ratings agencies to rate them A, double-A, or triple-A. The result was a new higher-grade product confected entirely of lower-grade product.

One could argue that CDOs nevertheless embody the same idea as MBSs, and thus, like MBSs, increase the efficiency of intermediation—only on a grander scale. But Lewis’s protagonists didn’t see it that way:

A CDO, in their view, was essentially just a pile of triple-B rated mortgage bonds. Wall Street firms had conspired with the rating agencies to represent the pile as a diversified collection of assets, but anyone with eyes could see that if one triple-B subprime mortgage went bad, most would go bad, as they were all vulnerable to the same economic forces. Subprime mortgage loans in Florida would default for the same reason, and at the same time, as subprime mortgage loans in California.

And they calculated that to “wipe out, entirely, any CDO made up of triple-B bonds, no matter what rating was assigned it,… all that was needed was a 7 percent loss in the underlying pool of home loans” (p. 129). Thus they concluded that the CDOs were simply “fraud.” But since “the market appeared to believe its own lie,” and thus “charged a lot less for insurance [credit default swaps] on a putatively safe double-A-rated slice of a CDO than it did for insurance on the openly risky triple-B-rated bonds,” it was “also a stunning opportunity.”

3. Credit default swaps (CDSs). Lewis’s protagonists shorted the subprime mortgage market primarily by buying credit default swaps (CDSs) on MBSs and CDOs. Credit default swaps are insurance contracts on bonds. If you own a bond and want to hedge your risk, and someone is willing, for a fee, to assume that risk, then it’s hard to see a problem with purchasing a credit default swap. In this function a credit default swap is a straightforward insurance product.

But Lewis notes two other ways of looking at credit default swaps. First, since purchasing one requires no financial exposure to the underlying asset (unlike with ordinary insurance), and since credit default swaps are tradable in secondary markets (again, unlike standard insurance contracts), credit default swaps can be instruments of pure speculation.

And secondly, and more bizarrely, one could think of a credit default swap

…as a near-perfect replica of a subprime mortgage bond [or mortgage-backed security]. The cash flows of Mike Burry’s credit default swaps replicated the cash flows of the triple-B-rated subprime mortgage bond that he wagered against. The 2.5 percent a year in premium Mike Burry was paying mimicked the spread over LIBOR that triple-B subprime mortgage bonds paid to an actual investor. The billion dollars whoever had sold Mike Burry his credit default swaps stood to lose, if the bonds went bad, replicated the potential losses of an actual bond owner. [p. 75]

In other words, through creation of these insurance products that, again, (a) can (like MBSs and CDOs) be traded in secondary markets, and (b) require of the buyer no financial exposure to the insured asset, a kind of clone security is generated. For every MBS or CDO, there can be an analogous CDS with exactly the same financial characteristics, i.e., the same risk and same payoff triggered by the same events. This is a curious, even eerie, property for a financial asset to have, since, unregulated as they are, any number of these can be generated from only one underlying real (non-derivative) security. So the original MBS provides a kind of genome from which financial engineers can generate any number of copies. This opens up a new universe of financial activity.

And how well do credit default swaps square with Wall Street’s storied function of aggregating and allocating savings and efficiently distributing risk? Obviously, purchasing insurance on an asset one doesn’t own and that one can sell to another party, preferably when its price has risen, has little to do with hedging risk. Still there’s a long-shot argument to be made that selling vast quantities of credit default swaps, as AIG did, gains for the seller greater financial wherewithal for its other, more orthodox, insurance activities. (As I say, it’s a long-shot argument.) But it’s in their odd property of mimicking mortgage-backed securities that credit default swaps depart furthest from any conventional notion we may have of finance and its role in the economy.

4. Synthetic collateralized debt obligations (Synthetic CDOs). Here’s where the story takes its oddest turn. Since credit default swaps mimic the asset-backed securities they insure, in the sense that the parties on each side of the transactions transfer the same “premiums,” incur the same risk, and realize the same payoff or loss depending on the outcome of the reference event, logically one could combine credit default swaps, rather than MBSs, into one security and call it a CDO. That would be a synthetic CDO. Thus a synthetic CDO is a CDO composed not of asset-backed securities (and thus loans, ultimately), but of credit default swaps (which are just insurance contracts, not loans at all).

I mentioned revelatory moments—moments where one or another of Lewis’s protagonists peals off another layer of the mystery of who was on the long side of their bets. I’ll quote in full what is perhaps the book’s most dramatic passage (italics in original). Steve Eisman is finally face-to-face with someone on the other side of his bets, a synthetic CDO salesman named Wing Chau. Chau says:

Eisman hadn’t imagined that the investment bankers would have taken the credit default swaps he and others had purchased and packaged them into CDOs—that his shorting of the subprime market was adding more fuel to the inevitable fire.

Goldman Sachs and Deutsche Bank had been selling Eisman credit default swaps for years. Initially Goldman and Deutsche had intermediated between Eisman and (unbeknownst to Eisman) AIG, a situation that ended in 2005 when AIG realized it was selling many credit default swaps on MBSs backed largely by subprime loans. (Unfortunately at that point it was too late. The seeds of AIG’s destruction were sown.) Now Goldman and Deutsche were intermediating between Eisman and synthetic CDO confectors like Wing Chau.

And why would the investment banks and CDO confectors have created these new instruments, synthetic CDOs? Because mortgage lenders had run out of “Americans with shitty credit” to lend to and thus the “raw material” with which to generate the mortgages needed to create the MBSs. The thing is, at this point it didn’t matter. They didn’t need more “Americans with shitty credit.” They just needed the credit default swaps, which as noted earlier mimic MBSs and could be regenerated, on the basis of those MBSs, any number of times over. And from the CDSs they could confect CDOs, which likewise could be regenerated using CDSs (like those Eisman and others were bringing into existence through their shorting activity) any number of times over. Since the synthetic CDOs seemed diversified, and ratings agencies had neither the incentives nor the capabilities to properly assess their risk, they tended to be certified A, double-A, and triple-A. And so these assets could be passed to institutional investors in exchange for portions of the colossal quantities of savings that had accumulated around the globe.

There’s no possible pretense that synthetic CDOs somehow enhance Wall Street’s storied function of efficiently aggregating and allocating savings and distributing risk. The money investors pay for synthetic CDOs is apportioned between synthetic CDO salespersons and investment banks. Money received by purchasers of CDOs is just “premium” payments from the owners of the credit default swaps. Period. No money is lent to anyone. No risk is hedged. It’s just gambling, straightforwardly. The mortgages are just a physical reference, like horses in a horse race or a ball on a roulette wheel.

The moral of the story is that humans as a whole are unscrupulous and generally will go wherever they can go. And they aren’t necessarily very knowledgeable about the landscape into which they venture or how their activities shape it. Development of the derivatives products described here was, in a micro context, rational, as was that of the subprime mortgage products devised in the mortgage market. But of course these instruments helped create a catastrophe. Human ingenuity and energies are wonderful things. But to benefit from them, we need to subject them to the scrutiny of our rational self.