Free College Tuition

Let’s suppose for a minute that you are not a fiery participant in any wing. That is, you are not easily swayed by slogans and finger-pointing. You are from Missouri the so-called “show me” state. Let’s suppose that no matter what a candidate or a member of government proposes you would at least try to look at all sides of the proposal. Wow. This is already sounding crazy. Where is my JD?  Is there anyone left who thinks that way? Just in case the answer is yes, let’s move on.

Why does Hillary Clinton want to propose free college tuition? In fact, why free anything? Recall that economics teaches that us that stuff usually costs something to make. A My Pillow is the best pillow ever invented. If you watch TV ads you know why.  You don’t expect to get such a pillow for free. Why?  Because its inventor had to make it and all that activity costs money. It seems fair to give Mr. Pillow some money in exchange for his My Pillow. It seems fair too since your life will be totally changed by having a My Pillow (or two of them for the price of one). Imagine how sexy you will look and all the attention you will receive after sleeping on your My Pillow. Clearly it must be worth the asking price.

Why doesn’t Hillary Clinton want to make My Pillows free? I can’t answer that question but let’s now flip over to things the government loves to give away for free. Highways are usually free. You just jump on good old Interstate 5 and go anywhere from San Diego to Seattle. What a deal! No wagon ruts there. I won’t go into a long list of other free items because some of you might get inflamed. But the point is made. The government provides things to us free.

You are scowling. Highways are not free. It costs money to design, build and operate them. Tax payers send checks to local, state, and federal governments to pay for all so-called free stuff, whether it is for highways, schools, or for free drug needles to addicted persons.

Okay, since nothing is really free the main question here is whether you want to pay for stuff directly to a capitalist or to a government. Do you want business people to provide all these things through a market economy or do you want government making the decisions? And now all you Wingers are getting your guns loaded. You lefties don’t trust business people to give us a fair shake. You righties think government is equivalent to robbery. But since we are trying to be non-wingers for a little while today, let’s keep exploring this fascinating topic –more fascinating than a Matt Lauer and Al Roker wrestling match. 

Market economists believe that in some situations markets fail and it is possible that governments should intervene. Any microeconomics text book has a chapter called market failures. You don’t have to be Paul Krugman or Bernie Sanders to believe in market failure. All of us believe! I won’t rewrite the chapter here because a vivid example of market failures comes when two parties transact (you and the makers of Tide) and somehow you pollute other people (who live down the stream where your dirty water flows). Those other people are not represented when you buy Tide, wash your clothes, and dump the water into the stream. Thus those other people have to incur costs to undo the harm you did to them. Those costs escape the economic system unless the government intervenes and makes you and Tide pay for them.

Make sense? It does to me. A similar story relates to highways. Joe’s Highway Company comes to you and asks if you will pay $10 for a nice highway between Bloomington and Lake Lemon. You are a smart cookie and you say no. That’s because you know that Peter and Charles will say yes and then pay. And when they pay, you get to ride the highway for free. This is called the free-rider problem and it can result in not enough highways being built unless government decides that lots of people will benefit and taxes them. Thus more money is raised and more highways gets built.

Enough you say! Okay – government gets to do a few things. But what about free education? Free education satisfies the free rider issue. We all benefit from an educated population. We want our kids to be educated and we want people to pay for it through taxes. While most of us would agree that K-12 gives citizens the basic skills necessary to be good citizens, there is more debate about higher education advancing our kiddies beyond the the necessary levels of reading, writing, and arithmetic. States have subsidized advanced education for their citizens but the question remains as to how much more society benefits from courses and degrees after high school graduation.

College education might simply advance the skills of the person who encounters a degree—and not so much his or her neighbor’s welfare. In that case it makes sense for only the individual to pay for the education.

But what about people who can’t afford a college education? That’s a stickier wicket. We help people with low incomes in many ways. We reduce or eliminate their income taxes and we give them subsidies. We make them eligible for food and housing and heat and medicine and so on. But we don't buy diamond rings or even entry level Fords Fiestas for poor people. Free stuff to the poor has limits. Where exactly does a free college education fit in to that? Is it more like a diamond ring or a chicken in a pot?

Finally, a few more words about unintended effects. Prices are about value. When you say something is free – it is bound to reduce its value.  I worry that free college education will harm one of the strongest industries in the USA – higher education. Free higher education may attract some of the wrong people. Already higher education spends a lot of money and time on things unrelated to education. I fear that making it easier for people to attend will exacerbate those trends. We hear people complaining that college is more about having fun and socialization than about gaining knowledge and skills. Do we really want to spend the people’s money on fun and socialization?

Larry, you don’t give a fig about those young people who are dying to get a college education but can’t afford it. But that is exactly who I do care about. I want them all to attend college. They will be willing to put some skin into the game. Show me how Hillary’s proposal will differentiate between those who will be truly helped and those who will go along for a nice free ride.  Imagine how much more we could devote to those who really want/need the help if we make that distinction. Hillary's proposal includes any household with incomes below $125,000. I wouldn't call a family that makes $125,000 per year poor. Would you? Or is this just about doing something to get Bernie’s supporters to vote for her? Or maybe a backdoor means for government to control costs of higher education?

From Each According to his Ability to Each according to his Needs

Though it stems from former socialist writers, the statement in today’s title has been widely attributed to another famous socialist Karl Marx. A broader statement would include these three points which I stole from Wikipedia (https://en.wikipedia.org/wiki/From_each_according_to_his_ability,_to_each_according_to_his_needs )

I. Nothing in society will belong to anyone, either as a personal possession or as capital goods, except the things for which the person has immediate use, for either his needs, his pleasures, or his daily work.
II. Every citizen will be a public man, sustained by, supported by, and occupied at the public expense.
III. Every citizen will make his particular contribution to the activities of the community according to his capacity, his talent and his age; it is on this basis that his duties will be determined, in conformity with the distributive laws.

While all of us would agree that this statement is highly utopian it does express some values that we all might share. It is nice to think of us giving what we are cable of giving and taking only what we need; sharing the rest. It is like the experience of being on a college basketball team. Clearly some guys are taller than others; some faster; some better shots. They each contribute in different ways. They each get a similar scholarship. They share in the glory when they win. Go team!

From this start you might think that this posting is about socialism. But it isn’t directly. In our seemingly reasonable request to make things more fair today we have lost sight of another dimension of society. Fairness and equity are critical as are clean air and freedom from fear. This list of social desirables is important and long. But in focusing so hard on these requirements of society we sometimes forget and perhaps do not even know about the main lessons and real constraints of economics.

Yes, economists are probably at fault for not teaching and spreading their ideas better. So let me give it a try. I am out of JD and I need to do something.

Let’s start with that college basketball team. The team and its many loud and obnoxious supporters,  followers and mascots want to win. Players do not put in all those practice hours and risk life and limb for the fun of it. They want to win. And to win they have to play like a team. And that means they should make use of the best talents of all their players. But it does not usually mean that all players get treated exactly alike. The star gets dates with the best looking cheerleaders and sometimes gets a free steak or expensive automobile from an overzealous fan. In some schools the star player forgets to attend classes and somehow all that is overlooked despite being labelled a “student”. 

The best high school players are recruited and while they love to play basketball, being on a winning team is what the best ones desire. They want to be stars and get all that goes along with that.

Glad I got that off my chest. You might be wondering how this relates to economics. Imagine that you were one of the first persons to see the world and there were no stores and no factories and no means to easily get things. Yet, you have to live. You have to survive. So you and your buddies design a system so you can eat, have shelter, warmth, protection, watch porn channels, and so on. This is the challenge that economics deals with. How do people get what they need and want? There are a bunch of resources lying around out there. Like the basketball team players you want to find the best way to achieve these goals. You want to get the most consumption with the least amount of effort and/or cost. In other words, why be wasteful? Get what we need in the best possible way.

Economists call this efficiency. And like Marx, economists concerned with efficiency want people to use their highest skills. But unlike Marx, market economists do not assume that people will employ their skills fully unless they are rewarded to do so. If society wants more bananas, then we want more pickers working on banana trees and fewer working on guava trees. If most of them are hanging around the guava fields (or Truffles Bar), an announcement that they would earn more income picking bananas reallocates pickers to bananas away from other work options. Firms can pay these workers more because they can pass along the higher labor costs to the consumer who is willing to pay a higher price to get more bananas. Workers do not usually do this and undergo all the costs of change out of the goodness of their hearts.

Let’s suppose workers hate banana trees or that they have to undergo special training to pick bananas. Inasmuch it might take large increase in wages (or benefits) to attract the resources into bananas. Accordingly prices of bananas would have to push even higher.

Later, when we decide we want to have i-phones, a similar process attracts more labor and capital into producing funny little devices that allow us to tweet inane messages as we peel bananas…at the expense of perhaps fewer hoppy beers.  

Notice that as long as workers (and other resources) are freely mobile and firms are free to switch products and keep the proceeds of their labors, this process works – and it works fluidly. It does not take any one single person to make it work. Hey dudes, Charlie’s Banana Farm is looking for workers and they are giving your kids free kindergarten if you work for Charlie. If information is free and if firms and workers are free this system is on autopilot.

This quick discussion of economic efficiency has two points related to our economy. First, efficiency does not require a central planner. Second, the process of efficiency demands unequal rewards.

There is a lot more to say but let’s stop here with one more point. No, market efficiency does not always work perfectly. Evil lurks in capitalism But whatever the negatives arising from such evil they must be compared against the mistakes made by sometimes evil and misguided central planners. Fairness sells in the political marketplace. Efficiency puts the food on the table. 

Mutual Interdependence Admits Relative Contribution

 The latest useless debate between Obama and Romney has to do with whether or not business owners or other successful business people did it on their own. Obama says that we all benefit from some help from somewhere. Romney interviewed business execs who pointed out how much they sacrificed to get where they are. This is like them debating whether my mother or my father was responsible for my birth. Geez guys, this is a no-brainer – this is another red herring (no offense to smoked kipper) to keep our eye off the ball.

No business executive could honesty say that he/she never got any help from anyone. We can be bright and driven but surely somewhere along the way a lion pulled a thorn from our paw. At the same time, in addition to friends and luck, success usually requires long and hard hours and family sacrifice. People who put in the time often get rewarded. People who don’t work so hard or who choose less risky occupations get less rewarded. Mentors often tell you that you have to be in the right line if you are going to receive the benefits of luck. You have to buy that lottery ticket if you are ever going to win the lottery. Young people find it hard to see why learning math is worth all that effort. Parents tell them to keep working because someday that effort will pay dividends. Those who do not follow that advice take themselves out of the math benefits line. 

While it is true that both sides are correct, the question is which one is “more-correct” when it comes to influencing the economy. That is, if you want to improve employment and output, where do you aim most of your policy? Here I am going to say a few things that seem very practical and normal to me – but I may stir the beast in some of my friends and family. But what’s a blog for if not to lose friends and gain enemies? J

An accounting or a snapshot of a mature business firm finds it with owners, managers, machines, real estate, and labor and 6,000 lawyers. There are a lot of components to make a business tick. Each is critical to the outcome. If one part fails to do its job then the business suffers. The human body has a lot of parts. If one loses a hand or foot then the whole body performs less well. This snapshot suggests that we all rise and fall together.

But depending on the specific company, there are parts that are more or less important when it comes to the overall functioning of the business. Some small firms in some lines of business may not need a lawyer. Those firms can get by with someone who wears a coat and tie, bathes daily, and looks and smells like a lawyer.

Other firms need an inventor or entrepreneur to get started and to continue being competitive. Let’s face it there are many lines of business today whose continued existence is based on staying ahead of the competition. In that kind of firm, a particular plant site or machine might not be so important. To stay alive that firm needs a particular kind of scientist or engineer or manager. Lose that professional and the firm and all its parts go under. Losing a machine or administrative assistant means a challenge. Losing a key professional means losing the firm.  

Many start-ups would have never gotten started without a capitalist. A capitalist is a saver who decides to take an equity or ownership position in a new company. This capitalist believes there is a chance that the new company will succeed but understands that it might not. Most new companies fail. Capitalists also provide money for existing companies and the equation is the same. They give their money for a return not knowing in advance how big that return might be. Capitalists are indispensable. Talented professionals and high tech machines matter little if the firm cannot adequately buy or finance them.

Am I putting you to sleep? Good. I am told that a lot of my friends don’t get enough sleep. I am happy to help. Now where was I?

You hopefully are getting my drift that depending on the company some components are more critical or important than others. Most basketball teams need five players but let’s face it – Lebron and Wade get paid more and are more important than the others.  Somehow the other members of the team get this fact and are not insulted by this reality.

Now we get back to Obama and Romney. Obama is right that it takes a village to help a company succeed. So we should pay attention to all the parts. But let’s not mistake the fact that many companies exist and survive because someone took the financial and personal and family risk. A worker or manager in that company is important but it is usually much easier to find another assembler or industrial engineer than it would be to replace the guy or gal who spent endless hours and gallons of perspiration getting the company started to begin with. To ignore this basic intuition is to put logic on its ear. It not only puts the cart before the horse but it puts the horse in the cart! And that makes the horse very uncomfortable.

This point applies to many companies—large or small, new or old. Betty asks me what I do all day now that I am retired. Much of what I do is read the FT and the WSJ as I sip a nice JD – and learn about companies. Okay I also fume about Paul Krugman’s latest brain-fart but I spend a lot of time reading about companies. Every time I do that I thank my lucky stars that at age 21 I decided to never work in a business. I don’t have the nerve or the stomach to run a business. It is a dogfight out there folks. Ask the owners at Nokia or Research in Motion how they are doing financially. Ask the guy who just started a new restaurant in your town how much he is raking in.

 

Some workers are lucky. All they have to do is come to work and follow the company manual and not smoke funny cigarettes in the parking lots at lunch time. They have an "investment" in their company and they depend very much on that employment but in no way does that compare to what others put in. Some distant and rich investor might have a billion dollars tied up. The entrepreneur may have planned, dreamed, and put his/her life on hold for years to get the company up and running.

Note: I recognize that some firms are run by incompetents. Some of you read the last paragraph and fumed about the fact that you are a key employee and if given the chance you would run the company better after you fired the existing management. You might be right. My point in no way supports the existing management.  My point underscores that some productive inputs are more effective and important than others. When firms get this backwards then they do not succeed. You are proving that point. It must be very frustrating to work in a company like that. Luckily you have the freedom to argue your point or to move on to another company to show that you are right.

While this might seem normal and practical to me some of you are already saying that I have given the working class or the middle class short-shrift. I don’t mean any insult and have tried to say above that all parts are important and valuable to a company. I also fully understand how the income distribution has changed and I know that many middle income Americans have lost ground.  My concern, as is yours, is the best bath to help these Americans improve their lives. It seems backward to help them at the expense of investors, entrepreneurs, and innovators. It seems more sensible to focus on the mutual dependency among the parts. Let’s make sure rewards for entrepreneurial activity are commensurate with the risks. Let’s make sure that our companies can compete as effectively as possible. Let’s improve our education and training. Let’s remove impediments to hiring and firing workers. Let’s take away all those loopholes and stupid illegal and immoral relationships between business and government.

There is a way to move this country out of recession. We do it by valuing mutual dependence with a mature understanding about what it takes to both create and sustain competitive labor and product markets. We all work hard but that does not mean that some are not more vital than others. Our policies should celebrate this fact and not pit one side against the other with inane arguments about whether someone got help or not. 

Bond Markets Will Rule

 Thanks to Buck Klemkosky for being our guest blogger this week. Buck has been the dean of the SKK Graduate School of Business at Sungkyunkwan University, Seoul, since 2004. SKK GSB is the top MBA program in Korea and one of the top programs in Asia. Previously he was a finance professor and served as associate dean and chair of the finance department at the Indiana University Kelley School of Business. He follows the markets closely as a money manager as well. A version of this article in the Korea Times appeared on Dec. 11, 2011.

Recent elections in Europe show popular support for anti-austerity fiscal programs. But the results of elections may not be the final arbitrator of fiscal policies, especially in Europe. As contagion spreads from country to country, it appears as if the bond markets will be the primary force imposing discipline on European governments, central banks and commercial banks.

Two of the primary signals for sovereign debt problems are credit spreads and credit insurance. Investors compare sovereign bond yields to those of Germany or the U.S. to assess the probability of sovereign debt default or some sort of restructuring. As credit default spreads widen, the market places a higher probability on potential default. Investors also pay attention to how much it costs to insure against sovereign debt default in the credit default swap market.

Of course, politicians don’t like discipline, especially market-imposed discipline. Their first reaction is to blame higher bond yields on evil speculators. But politicians lose sight of what markets do. One of their primary functions is to process information and set prices for financial assets. For bonds with fixed coupon rates, the bond price determines the yield to maturity, if investors buy today and hold the bond to maturity. Once the coupon rate is set, if investors want a higher yield because of higher default risk, they can get it only by buying the bond at a discounted price. So there is an inverse relationship between bond yield and bond price. Bond investors also do not have to buy the bond and hold to maturity. They can anticipate or speculate on changed in yield and hold for time period less than maturity.

Burt the basic question is: Should you trust the markets? If you believe that the bond market for sovereign debt efficiently processes information, then bond prices do reflect public and private information. This is referred to as the Efficient Market Hypothesis in finance. Informational efficiency is a matter of degree, but research shows that bond markets are fairly efficient at processing information and setting prices and yields.

What does it take to have an efficient bond market, even with speculators? Foremost, you need a large number, not all, of investors who are rational and compete for information to value bonds. The incentive to search for and analyze information comes from trying to maximize returns for a given level of risk. Markets can also be efficient even with speculators present as long as they have diversity of opinion, independence of thought and use multiple sources of information. Speculators invest their own capital and assume risk, so they have a big incentive to get it right. So speculators do not necessarily separate the financial markets from the real economy or make prices more volatile than economic fundamentals warrant. Speculation also does not necessarily cause asset bubbles (irrational markets). So the collective wisdom of markets and the self-interests of investors can provide the most efficient prices.

Of course, hindsight shows that asset bubbles do occur:  technology stocks (1996-2000), housing in many parts of the world (1996-2006) and various commodities. But the bond markets have not been as subject to irrational exuberance and collective investor euphoria as other asset classes. If bond yields don’t reflect economic fundamentals in many countries today, it is because central banks have kept interest rates abnormally low as a monetary tool to help slow-growth economics.

Governments have proposed or imposed various rules and regulations to curb perceived speculation: place a tax on financial transactions, ban short selling, put position limits on derivatives contracts and eliminate or curtail the use of some products such as credit default swaps. Most of these are imposed with little empirical evidence as it is easier to blame speculators than to address real economic problems such as deficits, promises that can’t be met and sovereign debt.

What the bond markets are telling us is that the euro zone has massive problems that probably can’t be fixed in the short term. The PIGS (Portugal, Ireland, Greece and Spain) have been replaced by the PIIGS (add Italy). The source of the financial contagion has been the European Central Bank and the politicians doing too little too late.  While politicians in some countries worry about moral hazard by reducing incentives to reduce deficits and restructure economies, others believe that austerity programs will cause recessions and widen deficits and increase the sovereign debt problem.

The interconnectedness of European banks and sovereign debt has created a perfect storm in which investors are losing confidence in some euro zone countries and banks.  Investors realize that some of the countries are too big to fail, but also perhaps too big to save, given what has been proposed thus far. The probabilities of the collapse of the single euro zone currency have increased and will continue until bold actions are taken to stop the contagion. Confidence has to be restored decisively.

So European politicians and bankers have not liked what has been happening in the bond markets. More than one has denounced the markets and stated the need to establish or re-establish the primacy of government policy over the markets. But the bond vigilantes are a tough group. If they could speak with one voice, it would be: “The markets aren’t the problem. It’s the banks and the politicians who caused the mess. If you don’t like what we, the markets, do, don’t borrow money in the bond markets.”

As James Carville, advisor to President Clinton, famously stated, “He wanted to be reincarnated as the bond market so he could intimidate everyone.” Market discipline will work when everything else fails, especially politicians and government.

Limbo, the Maytag Repairman, and Macro Markets

How low can you go? Sometimes when spending seems weak and prices are falling there seems to be no end to that cycle. It’s like we are staring down into a bottomless pit. It seems like there is no end to the fall in prices. But prices never fall without limit and the real world is a little more like the limbo than a bottomless hole in the ground. 

You remember the limbo, right? It is a calypso thing. Two people hold the ends of a long stick and some fool with especially rubbery legs goes under the bar as people sing limbo limbo limbo like me while they drink tall island drinks with colorful parasols. As the bar goes lower some of the contestants no longer can go under the bar and the game ends when there is only one contestant who can go under the bar. For his efforts he is usually awarded discount coupons for orthopedic surgery. Or the game ends when your mom comes home and confiscates the rum you stole from her liquor cabinet.

The point of this post is to raise the question of the relative efficacy of market solutions to government intervention.  After five years we might want to question knee-jerk Keynesianism. To do this we have to take a little venture down supply and demand lane. We will now all hold hands and sing gumbaya.

For those who do not want a refresher in supply and demand you may cheerfully proceed down to the place marked “The Fun Starts Here.”

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Economists torture their students with supply and demand to discuss everything from wart growth to interplanetary travel. We can slap a S&D diagram on a white board or cocktail napkin quicker than you can say diminishing marginal returns. My friend Jimmy can wield a small hammer at limestone and produce a beautiful wall or walkway. My hammer is my set of colored markers that I can use to explain price and quantity changes of anything anywhere at any time.

The invention of the stirrup revolutionized warfare and led to a rapid increase in the price of saddles and horses.  Centuries later technological advances in computer chips led to astronomical declines in the price per unit of power for computers. The stirrup increased the usefulness and therefore the demand for horses and saddles and this caused their prices to rise. Computer chip technology made it possible to increase the supply of power at lower costs which led to declines in the price of computer power.

Supply and demand analysis has found its way into common discussion. Most of us are comfortable with the idea that bad weather which ruins crop yields will reduce supply and causes the price of tomatoes to rise. Of course when worry reduces investor appetite for risk we talk about how the decline in the demand for stocks causes stock prices to fall. You don’t have to be an economist to be familiar with the use of supply and demand concepts and how they come together to help one discuss past, present, or future expected price change. I am not trying to say that supply and demand is as well-known as a Charlie Sheen rant, but we have adopted this economic analysis tool to our everyday lives.

Supply and demand analysis is a pretty remarkable thing that comes up with predictions by making assumptions. For example, one assumption says that prices will change in response to the condition of a market. If the main change in a market is an increase in demand, for example, then in the absence of price change or before a price change can take place – this creates an imbalance in the market. In this example, we would observe demand greater than supply. This imbalance or shortage creates the incentives for both demanders and suppliers to agree to a higher price.  In the opposite case which finds supply much larger than demand, this surplus leads market participants to agree to a lower price.  When the price changes in response to these market imbalances, we say that the price change “clears the market.” Clearing of the market means that the price change brings supply and demand back towards equality. A conclusion of the usual market model is that prices play an important role of restoring balance to markets.

Adam Smith’s “invisible hand” concept explained that if markets were allowed to work then we would not need policy or policymakers or baboons to solve market imbalances. If there is too little or too much demand for a given supply you don’t need a committee of experts to solve the problem. What you need is a market wherein there is strong competition, good information, no impediments preventing actors from expressing market wishes, and no obstacles to prices changing as the market dictates.

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The Fun Starts Here

Those last paragraphs sound like a textbook and even I am getting sleepy. But a big point is that whether it is stirrups, tomatoes or whatever – we tend to adopt supply and demand analysis and use it to explain and predict real world outcomes.

This is why I am so perplexed about our application of these tools to macroeconomic situations.  While it might seem a bit far-fetched to some of you, macroeconomists apply supply and demand to a nation’s economy. Macroeconomists since J.M. Keynes have adopted the idea of national demand for goods and services and policy is often directed to stabilizing undesirable changes in aggregate demand. Accordingly, some macroeconomists believe that part of the solution to our latest recession is downward price adjustments. Since much of what caused the recession was a decrease in the demand for houses and financial assets, an application of supply and demand would argue that falling prices of houses and financial assets should part of the solution to market balance or equilibrium. At the macro level it is interesting that our policymakers were not content to just let Adam Smith’s invisible hand solve the problem. Rather than believe there was some reasonable end to a game of Macro-Limbo, they worried that prices were headed into a dark pit filled with rattle snakes and Rush Limbaugh. To prevent prices of financial, housing, and other assets from declining to the earth’s core, the Fed and the Treasury bought stocks, bonds, and companies like geeks at the introduction of the latest gadget at the Apple Store. To prevent housing prices from falling toward the South Pole the government not only bought houses but put in a whole new team to regulate foreclosures and to oversee an orderly disposition of houses.

Distrusting prices to equilibrate these markets, policymakers essentially stopped the markets from working and it appears in the end that they have drastically slowed the movement towards a new balance. Why did policymakers behave this way?  Why did they not allow market capitalism to function? One can only guess the reasons. One is that while they trusted markets to work for most things on most days, they lost their trust when it came to bigger events. Imagine if doctors decided not to use modern medicine every time they had to treat a really serious ailment! Second, what fun is it being in charge of a country if you don’t do anything but stand around watching prices fall and don’t get any credit when the problem disappears? Let’s call that the Maytag Repairman explanation. Third, perhaps they worried that prices would not move in the right direction. But of course, housing, bond, and stock prices did move in predictable fashion. Fourth, perhaps they worried that prices would fall too much and create too much havoc as they fell. It seems to me that this explains a lot of the mistrust of markets. When policymakers faced the public with sad worried eyes they proclaimed that it was necessary for government programs to forestall a horrible process.

Some policy makers are bragging about recent stock prices but notice that with all the merriment, the stock indexes are now only regaining a peak reached during the recession and still have a long way to go before reaching highs attained before the crisis. It has been half a decade of no real stock price growth. But with housing prices still falling, one has to wonder if the real truth of the intervention is that it simply stretched out the eventual adjustment. Prices were going to fall to clear the market but the government made sure the price change took years and years and years.

Geithner and Bernanke would say that I am a nut job. Letting the economy free fall would surely have caused a larger crash. But while most of my friends will agree that I am surely a nut job, I will not agree to what we can’t know. How far would prices have fallen and what would have been the side effects?  I suspect that without government’s mucking up expectations, prices of houses would have overshot in a downward direction and would have made housing the bargain of the century. After all – a house has real worth. It is composed of brick and mortar and sweat. That has value. If we overbuilt houses for numerous years the glut would lead to prices at the low end of that fundamental value. But clearly demand plays a role – and with housing prices cheap enough relative to the cost of producing new houses – the demand could come back. But we never let the prices reach those levels and we will never know how the invisible hand might have worked.

Let’s suppose housing or stock prices fell to these low values I proclaim above, wouldn’t that have killed off a lot of mortgages and created a national recession? Probably. But what I am raising here is that we chose to pull the band aid off slowly. Are we sure that the accumulated pain of the last five years of heavily regulated markets is not greater than the quicker and perhaps more intense spike of pain associated with a quick pull of the bandage? The unemployment rate has been high for quite a while and threatens to remain there for some time. Might these unemployed have been better off if that rate had risen even higher in 2008 or 2009 but was back to 6% today? What I do know is that it is now March of 2012 and we still hear our leaders proclaim that they saved the day and that without further stimulus the economy will go back into recession. I am not so sure that a market solution could have been much worse. The recession started in the beginning of 2007 and ended in the middle of 2009. Five years after the recession started and after trillions of dollars of very active policy, US policymakers admit that the economy is still too weak to be trusted. I think it is the policymakers that can no longer be trusted.

Don’t Pick- up that $100 bill. It isn’t really there. Defending Efficient Markets

A guy sees a $100 bill on the sidewalk and walks right by it. A Keynesian comes up to him and asks him why he didn’t pick it up. The guy answers that he believes in the Efficient Market Hypothesis (EMH) – and the bill must not be real or someone else would have already picked it up! This joke is a real knee-slapper for academics. It is meant to demean the EMH. This not only shows why academics are not allowed to mingle with normal people but it also irks me that my fellow academics have too much fun beating a straw horse.

Why defend the EMH?  One reason is because it is 95 degrees and Betty will have me doing tasks in the back yard if I don’t pretend to be doing something in my nice cool basement office/laundry room/ junk room.  The other reason is that it needs defending from people who would use this as part of their rejection of markets and capitalism. Some experts believe that our recent financial crisis proves the EMH is wrong.  Even worse, it gives them a high horse to preach for more stimulus and more regulation.  So I would like to give them a little piece of what is left of my mind.

Before getting into the particulars we should take a step back and think about the whole idea of learning and hypotheses. You don’t have to have a PhD  to see the importance of hypotheses. As a young parent you believe that you should keep a close eye on your two-year-old. You have a hypothesis that if you completely ignore your child, a problem could arise – perhaps even something terrible could happen. I remember when we once saw our neighbor’s child on the roof of their house. They blinked one minute and somehow he was on the roof. It scared the crap out of all of us. Hypotheses like this one lead to action items or policy prescriptions. If the hypothesis is true, then you need to have rules for vigilance. You need to be a very active parent. We usually frown on leashes for children but I know of some parents who have resorted to such things.

Financial economists have a hypothesis about the prices of assets like stocks and bonds – and houses. The hypothesis states that the price you observe in the market for GM stock or for the average of all stocks is the result of buyers and sellers searching for all the relevant information, analyzing it, and then using it in their sales and purchases. This is not very sophisticated stuff. It just says we are not a bunch of LAZY LOSERS. Most of us – before we buy a refrigerator or a car or a share of stock – try to figure out what it is worth or at least find some information that would support our buying the item at a particular place and time. Suppose you do a little research and you are ready to buy the latest I-Phone when your mother comes in and says she heard that I-Phones cause pimples. But the Droid does not cause pimples… So you look in the mirror and pop a few – and then make your decision based on all the information.

This is not a crazy hypothesis to say that people try to buy as well as they can! Would you rather assume that most people are really lazy and ignorant and dumb and they just buy stuff regardless of price or other relevant information? I hope not. My father would spin in his urn.

Okay – so people – both buyers and sellers – gather and utilize information when trading various assets. This implies that the current market price, which is determined by the interactions of buyers and sellers, REFLECTS THE STATE OF RELEVANT EXISTING INFORMATION. It makes no sense that people would totally ignore pertinent information that was out there.

Basically this is what the EMH says – that current prices embody current information. It also implies that it is difficult for someone to make gains in the market that are not available to everyone else. If prices register all the current information, then it is difficult for one person to profit from the information.  If the EMH is true, it stands to reason that it is hard to “beat the market”. EMH friends advise me that I should buy an index fund and just hold it. Trying to pick individual stocks and to time the market (buy low and sell high) is virtually impossible if information is abundant.

Another implication of the EMH is that government intervention into markets is unnecessary. If prices are being driven by information flows about fundamental factors, then prices are playing their appropriate roles in a market system. Consider the recent bubble in asset prices. At the time Alan Greenspan did not think the Fed could or should do anything about rapidly rising housing and stock prices. Presently the government doesn’t talk much about a bond price bubble. Why? Because Greenspan and Bernanke believe that asset prices are being determined by fundamental factors.  They may not like these fundamental factors but by their very nature they are not easy to change or remediate with policy.

But notice that if the EMH is wrong, then perhaps phantoms or something or someone terrible is behind price changes and something should be done about it.  This creates a stronger role for government intervention – if the EMH is false. So is it true or not?

One piece of information being used these days is to point to Hedge Funds and to acknowledge that some of them have made a ton of money choosing stocks and timing the market. If you have not already, you should read Sebastian Mallaby’s “More Money than God”.  But just because there are examples of Hedge Funds or other investors who made a lot of money, this does not necessarily disprove EMH. How many Hedge Funds lost money trying to pick stocks and time markets? How many funds made a lot of money trading only to eventually lose it using the very same models and approaches? All it takes is a few very successful and very lucky pickers to get the attention of the press. A few successes do not, however, make a rule. If 10,000 monkeys are given computers and 10 monkeys print out the line – Davidson should receive a Nobel Prize – then would you nominate me for the award next year?   Hopefully the outputs of the 9,990 monkeys would have some sway with you.

Furthermore, the EMH never said that it is impossible for some people to know more than others for a time and it never said it was impossible for unscrupulous people to contrive means to fool the public. The EMH only says that ability to corner the market on information should not go on forever and once information becomes public prices will reflect fundamental forces.  

Finally, there is the paradox that if EMH is true, how is it possible that asset price changes could look so much like bubbles? You have heard all the stories of rapid price appreciation – and people wondering just how long it would keep up. In the meantime, people were buying houses and stocks at prices that seemed drastically out of line with reality. How can a story about rationality and efficiency explain buying $100,000 condos for $300,000?

The answer lies in what you consider to be the appropriate price. Should the appropriate market price consider future expectations?  You are considering buying a nice condo. Last year similar condos were selling for $100,000. Today you learn that oil has been discovered on the property and all condo owners are expected to receive $500,000 in future royalties. What would you pay for that condo today? That lovely little property that was worth $100,000 yesterday is worth more like $600,000 today. Is that irrational? That’s a big change—but it can be explained by expectations about the future. What would the condo be worth if scientists found that the property was being built on top of a former electronic factory and that the land was giving off cancerous fumes?

I hope you are getting the point that the EMH is perfectly compatible with extreme changes in price. Now, let’s apply this to recent events. There were plenty of reasons to explain why housing and stock prices were rising before 2008. No one can know the future so there were many thoughtful discussions that led many people to conclude that the fast pace of house and stock prices made some sense. There were also many people warning that the prices could not sustain such a rapid pace. All opinions were out in the public and all we can say in retrospect is that people operated with an expectation that prices would continue to rise. That expectation made more people willing to buy and willing to buy at a higher price. The expectations were self-fulfilling. At least they were until the correction came. While this suggests that bubbles do pop or corrections do come – this does not in any way disparage the EMH. EMH simply says people use information in transactions. When expectations about the future are strongly and passionately held – this is part of the information. Those prices that today seem so out of pace with reality – were efficient guesses three years ago. They used all the information.

Today we have a different set of expectations and a different and depressed level of prices. These are efficient prices for today’s information. And this leads us to the final point – what can or what should be done. Let’s not throw away the EMH – rather let’s use it to decide what to do. It seems to me that what went wrong were two things. First, regulators didn’t do their jobs. The whole credit chain fell apart as EVERYONE justified their expectations by leveraging in dangerous and illegal ways.  And the regulators let them. Second, policymakers helped to sustain the fundamental factors that led to a desire for more leverage and for higher asset price inflation. Greenspan didn’t see how low policy-induced interest rates induced a desire to take more risk in markets.  The Fed stoked the fires.  And Fannie/Freddie fanned the flames.

Now the expectations are that prices will continue to fall. That means there is a good way and a bad way for policymakers to act now. The bad way is to try to grease the wheels of credit expansion. That just gets up back into the same garlic pickle.  The good way is to approach the fundamentals. People will believe that the worst is over when policymakers earnestly address what was wrong. To do this they need to do sensible things that reduce our need to leverage ourselves beyond our ability to pay.  Regulation and policy should be addressed to sensible use of borrowing by the government and the private sector. Until they do that it is hard to see an end to the current economic slowdown. Now where did that $100 bill go?