Market Distortions


On the blog Carpe Diem, Mark Perry shows One Chart to Explain the Entire Financial Crisis (see post of the same title on July 29).   Here’s the chart, for Ed Pinto at the Census Bureau:

Before 1995 less than 5% of mortgages were made on homes where the buyers put less than a 3% down payment on their home.  By 2008, that increased to 40% of mortgages.

The old rule of thumb for mortgage companies was 20% down payment.  There was good rationale for that hurdle.

If you had 20% to put down on a home, it demonstrated to your lender that you had developed responsible financial behaviors.  The 20% made homeowners more likely to take care of their property because they had a substantial equity stake in it.  It also gave lenders some cushion for home price fluctuations.  If you stopped paying the mortgage and the lender foreclosed and sold the home, there would be a good chance that they would get all of their money back and the owner would get some back.

The chart shows a gradual, but only slight increase in this percentage from 1980 to 1995, and then it picks up shortly thereafter.


I think several things happened. All led to market distortions.  That is, the signals and feedbacks that had previously worked well in keeping the housing market healthy stopped working.  They got distorted.

First, politicians became overly concerned with increasing home ownership rates. They leaned on Fannie Mae and Freddie Mac to make it a priority to make it easier for folks to buy homes.  This led to relaxing the previous 20% down payment rule-of-thumb.  Politicians had the cause-and-effect backwards.  They thought that home ownership led to responsible behavior.  In reality, responsible behavior leads to home ownership.

Second, math and stats geeks started building financial models on Wall Street and folks believed they were far smarter than than really were.  Folks thought this new era of financial modeling could reduce the risk of making risky loans.  It turns out they were wrong.

Third, as Russ Roberts points out in his paper, government had established a history of bailing out financial institutions deemed too important to fail.  This led to a moral hazard that caused the leaders of such institutions to take risks they may not have otherwise taken — thus lending to folks that they would not have lent to 20 years earlier.

As Roberts has been known to say, Capitalism is a profit and loss system.  Profits encourage risk taking.  Losses encourage prudence.  Take away the losses (or spread them across everyone) and prudence goes away.

The absence of  prudence was the market distortion that led to the crisis.

These three things all contributed to reducing prudence — or the fear of loss.  They distorted the signals in the housing industry causing it to “heat up”.  It turns out incentives do matter.  If politicians thought owning sandwich shops was a good idea and backed loans on sandwich shops, it’s not hard to imagine that we would get many more sandwich shops that we need and most would eventually go belly up.

That’s what happened with housing.  With these distorted signals, we wound up with many more homes than we needed.


Enlightening Aggregation

I typically think that looking at things like the economy in terms of aggregates is not helpful.  GDP, for example, is an economic aggregate, or a sum of several different categories of spending that is used as a gauge on the health of the economy.

GDP can be useful for visualization, comparison and analysis.  For example, it’s fair to use GDP per capita to compare the relative living conditions of the U.S. and Zimbabwe, or folks living today and folks living in the U.S. fifty years ago.

The danger comes when those in power believe it is something they need to micro manage.

The following passage provides an example of an author who used aggregation to create an effective visual.  I read it years ago, and every now and then it bubbles back to the surface.  I think it may be especially timely now with the debt limit debate in DC (emphasis added).

Wm. Rickenbacker editor of the Rickenbacker report and author of a recently published “Savings & Investment Guide” has pointed out that 28.6 mil.  Americans depend on gov’t retirement and disability programs.  Then you add in recipients of survivor programs — almost 9 mil, unemp. benefits to 6 mil., Military 3-1/2 mil., civilian emps. & dependents and you come up with a total of 81.3 mil. people dependent on tax dollars for their year round living.

All of those tax dollars must come from 70.2 million Americans working & earning in the private sector.  Ah! but you say govt. workers pay taxes too. And so they do. But all their inc. & therefore the portion they pay in taxes comes originally from tax dollars so they are just returning to gov’t. tax money already pd. by the worker in the pvt. sector.

The 70.2 mil. private sector workers have 62.1 mil. personal dependents, so we’re talking about a private sector of 132.3 mil. sharing their income with an additional 81.3 mil.

To sum it up roughly 70 million Americans provide a living for themselves and 143.4 [million] additional people.

Now, don’t take this as meaning there should be no recipients of tax dollars or that all who work in gov’t are parasites.  Obviously, we want to provide for the needy & disabled.   Just as obviously we must have & are happy to have in the military those who provide for our security.  This goes also for policemen and firemen & all those who provide services we want & need.

The point I’m making is that somewhere there must be a figure beyond which we can’t go in the growth of gov’t without wimping out those in the private sector who pick up the tab.

The plain truth is every effort to slow gov’t growth or reduce gov’t costs has failed.  In the last 20 yrs. corp. profits have risen 105%–wages have gone up 213%–govt. costs have risen 340%.  There is one sensible, long overdue answer; fix in the constitution a limit on the share of earnings govt. can take without becoming a drag on the economy.

These words are from the book Reagan: In His Own Hand.   They were written as a manuscript for a Paul Harvey-esque radio spot that Reagan gave in those days.  This one aired on radio on November 16, 1976.

I thought this was an interesting way of looking at the economy.  Wealth must first be created in the private sector before it can be used by government.  Government doesn’t divine wealth out of thin air.  It lives off the wealth created in the private sector.  And the ratio of folks living of that wealth is high.  Someday I might try to update these numbers to see if the ratio has changed.

The reason we transitioned from hunter-gatherers — folks who spent most of their time providing the essentials — to where we are now is through private sector trading that allowed us to free up time amongst ourselves and others.  That freeing up of time allows us to use some of our produce to fund things like government.  It allows some people to not produce much at all and do things like occupy government positions.

While people have many different ideas about what wealth is, wealth derives from this savings of time.  How much time does it take to feed ourselves compared to our hunter-gatherer ancestors?  Much less.  If it didn’t, we couldn’t afford government.

I think it’s good to keep that in mind as some of those in government seem awfully preoccupied with biting the very hand that feeds them.


In his column this week, Thomas Sowell makes the very connection I mentioned in my previous post that most people miss:

Having gotten all the political credit for the money he has showered on his favorites from coast to coast, he now seeks to share the blame for the resulting financial crisis with Republicans, by maneuvering them into a position where they have to help solve the debt crisis that Obama created.

The whole column is worth a read.

Star Wars Geek Friday


Tyrants aren't often this ugly

Those familiar with the Star Wars universe know that episodes 4 through 6 were produced and released in the 70s and 80s and episodes 1 through 3 were released in the late 90s and 00s, making for an interesting way to tell a story.

As I’ve watched the whole series over again and again with my Star Wars-crazed kid, I’ve noticed some elements worth mentioning because they bear some resemblance to real life.

First, the story of Palpatine’s ascent to tyrant and his consolidation of political power is really well done and vastly under appreciated.  He led both sides in a war meant to soften political opposition to his consolidation of power.

He used the war he created to get the other Senators to vote him emergency power, promising to return it when the conflict was over.  He never relinquished that power.

I was reminded of this storyline this week when I heard talks of granting the President emergency power to raise the debt limit.  The parallel is stark.  Palpatine created the emergency to get the Senate to grant him emergency power.  Obama created the spending emergency, both by spending a bunch and by waiting until the debt limit was about to be reached before trying to do something about it, to get politicians talking about giving the President emergency powers to raise the debt limit.  Though few people draw this connection.

In fact, when the Senate does vote to give Palpatine those emergency powers and applauds his acceptance speech, the unwitting pawn that granted Palpatine’s first step of his ascent, Padme Amidala says:

So this is how liberty dies…with thunderous applause.

Second, if you watch the series from Episodes 1 through 6 in order, you will notice that Episode 4, Star Wars, picks up about 25 or 30 years after Episode 3.   In Episode 3, Palpatine and Vader take control of the galaxy and begin their reign.  Episode 4 begins after 25 or 30 years of that reign.

You will also notice that the technology in Episode 4 is rudimentary compared to the technology in Episode 3.  This is a common criticism of the series.  Star Wars was 30 years after Revenge of the Sith and the technology looks so bad.  After all, the fastest ship in the galaxy, the Millienium Falcon, was a bucket of bolts.  I personally think that criticism is unfounded.

While the appearance of the technology is a natural artifact of producing Episode 4 twenty years before Episode 3, it also bears a striking parallel to reality.

Once the galaxy comes under top-down control, there’s a really good chance that the state of technology would go backwards.  In his book, The Rational Optimist, Matt Ridley wrote this about China:

China went from a state of economic and technological exuberance in around A.D. 1000 to one of dense population, agrarian backwardness and desperate poverty in 1950.  According to Angus Maddison’s estimates, it was the only region in the world with a lower GDP per capita in 1950 than in 1000.  The blame for this lies squarely with China’s governments.

To be clear, China’s governments became top-down empires, much like George Lucas’ Empire (except they didn’t have space ships).  So, even though the lapse of technological innovation derived from the production schedule of the movies, it fits.

Warren Buffett IS wrong on taxes

I agree with Stephen Moore’s Op piece in today’s Wall Street Journal.  I hope I may have helped inspire it.

I wrote about a stark inconsistency in the way Buffett values businesses owned by Berkshire Hathaway, the successful holding company he runs, and how he views the taxes paid by these companies here.   In my opinion, the inconsistency is so stark that he deserves the title of hypocrite.

Stephen Moore makes the same point by including the taxes paid on Buffett’s behalf by the company he owns a great deal of, Berkshire Hathaway, something Buffett does not do.

Perhaps I inspired Moore’s view on this.  I wrote to Stephen Moore shortly after Buffett’s 2003 Washington Post article (the text from that email appears below the fold).

Moore writes:

So how does Mr. Buffett arrive at such a low personal tax rate? He may have been referring to a 2010 IRS study of the 400 richest American taxpayers, a list he’s probably on. It showed those people paid an effective federal income tax of 18.1% in 2008.

Yet that study crucially omits the corporate income tax, which is mostly borne by the owners of companies.

Mr. Buffett owns about one-quarter of his investment company Berkshire Hathaway, and his shares are worth about $38 billion. This wealth is mostly stored in what are technically called “unrealized capital gains.” Eventually when those gains are converted into income, he will pay a capital gains tax. Even so, in 2008 Berkshire paid $3 billion in corporate taxes. And since Mr. Buffett is the principal owner, he shoulders a big share of that tax.

Moore goes further to point out that Buffett is wrong on the rates too, higher income folks paid a rate nearly twice as high as middle class families.

According to the Congressional Budget Office (CBO), middle-class families in 2007 (earning between $34,000 and $50,000) paid an effective 14.3% of their income in all federal taxes. The top 5% of income earners paid 27.9% and the top 1% paid 29.5%. And what about the highest earners? Americans with annual incomes above $2 million paid an average 32% of their income in federal taxes in 2005 (the most recent year for which data are available).

Moore also points out that Buffett has been a critic of one aspect of Obama’s tax proposals.

To his credit, Mr. Buffett has criticized President Obama’s near-obsessive calls for higher taxes on corporate jets.  As Mr. Buffet correctly noted, the writeoffs companies take for capital expenditures such as jets are legitimate business expenses.

Buffett’s view here is not surprising.  Berkshire Hathaway owns NetJets, a major provider of corporate jet services.  Hmmm…

One of Warren Buffett’s cardinal investing rules is to not invest in things he doesn’t know much about.  This is understandable.  He has learned through experience that this can be costly.  Apparently, it’s not nearly as costly for him to talk about things he doesn’t know much about.

My 2003 email to Stephen Moore appears below:

Continue reading

The hard sell

I recently stayed in a timeshare.  I rented it.  I don’t “own”, as they call it.  I’m not interested in “owning” timeshare, but I liked what the property had to offer for this vacation.  I was satisfied with the property, felt it was worth the price and would recommend it to others.

Upon check-in, though, I had to deal with a pushy salesman whose job was to get me to schedule a sales tour using some hard selling techniques.  He was not successful.

That got me thinking about the hard sell.  Car, life insurance, investments and timeshares are some industries that tend to employ hard selling tactics.

I wonder if it’s effective.

It’s not effective on me.  It turns me off and I go elsewhere. But, I could be in the minority or maybe just in a different target market.  Maybe some folks need the hard sell.


We do

A family member told me that he recently spoke to a friend of his from Mexico.  His friend works in an auto plant and said that he makes a fraction of what autoworkers make in the U.S., though he still makes more than he would make at most other jobs in Mexico.

My family member asked me, who keeps the difference from the lower wages car companies pay to Mexican workers and the higher wages they pay to workers in the U.S.?  The companies?  Management?

I said, believe it or not, we do.  The cost savings means we pay less for our cars than we would have otherwise, which leaves us with more to spend on other things, which in turn keeps the people who make those things busy.

He wasn’t so sure how that worked.

I said that the auto company managers would love to keep the cost savings, but they have competitors doing the same thing — building cars in Mexico to save on wages — and who will decide to pass the cost savings to the consumers in the form of lower prices to sell more cars.   So, the managers will match that. Which means we pay less.

He seemed to understand that.

Debt limit

As a free market advocate, I don’t think government should have a debt limit.  Such a limit is a good example of a non-market-based, government interference that produces bad unintended consequences.

We’re seeing one of those consequences play out now as the debt limit is used by all sides as a political bargaining chip to pick winners and losers.

The debt limit is phony.  It has no bearing on reality.  It is not tied to the actual fiscal health of government finance.  It says nothing about whether lenders would continue lending to the US government or whether the government has ample funds to service its obligations.

It’s just an arbitrary limit, that can be changed.  It was set by previous politicians so they could claim to support fiscal responsibility in their campaign speeches.  As with many such political actions, they only give rise to political theater down the road.

I don’t believe the government should borrow ad infinitum.  I do believe the government should exercise good fiscal discipline.  But I believe credit markets are more effective than Congress at regulating borrowing.  I also believe voters should be more effective at voting in candidates that will support fiscal responsibility.

Bill Gates is wrong on education

In the Wall Street Journal Opinion Weekend, Jason Riley asks Bill Gates, Was the $5 billion Worth It?

Bill Gates, through his charitable foundation, has sought ways to improve education for 10 years and has failed to produce results.

In this paragraph, Gates seems to rely on some data to back his position:

“We have heavy union states and heavy right-to-work states, and the educational achievement of K-12 students is not at all predicted by how strong the union rules are,” he says. “If I saw that [right-to-work states like] Texas and Florida were running a great K-12 system, but [heavy union states like] New York and Massachusetts have really messed this up, then I could draw a correlation and say it’s either got to be the union—or the weather.”

Immediately following, however, is this paragraph:

Mr. Gates’s foundation strongly supports a uniform core curriculum [i.e. one-size-fits-all] for schools. “It’s ludicrous to think that multiplication in Alabama and multiplication in New York are really different,” he says. He also sees common standards as a money-saver at a time when many states are facing budget shortfalls. “In terms of mathematics textbooks, why can’t you have the scale of a national market? Right now, we have a Texas textbook that’s different from a California textbook that’s different from a Massachusetts textbook. That’s very expensive.”

And later:

Nor does he see the need for competition among state standards. “This is like having a common electrical system. It just makes sense to me.”

So, with unions he relies on data to see if they have any effect on quality.  Yet he seems to want to whack out competition and innovation of curriculum without evidence to support that this would actually drive improvement in education quality.  It just makes sense to him.

I’ve seen quite a few decisions made by folks that just made sense.  They learned shortly thereafter why it didn’t make sense.

I was disappointed the article didn’t mention Gates’ involvement with the Khan Academy.  Ultimately, as with any other market that has evolved over the past few centuries to deliver amazing products, bottoms-up innovation and competition is what drove it.  Khan Academy is disruptive.

Top-down innovation rarely works and often causes massive failures.

The article made it appear like Gates kind of knows this, but he’s too timid to upset the existing rent-seeking constituencies in the education establishment.

Notes from the road

With the budget talks this week, someone asked me what that’s all about. Here’s how I summed it up.

The side that wants to raise the debt limit is saying that they want to spend more of our money and avoid making tough choices about government spending.

That side also told us a couple years back that if they spent more of ours and our children’s money the economy would improve and we’d get a payback on that spending. By the way, their current actions of wanting to get more of our money is evidence their plan didn’t work.

The other side at least wants to start entertaining tough choices on spending and they’re not that interested in spending more of our money.