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    Figuring Out Financial Regulation

    Jul 18 • Businesses, Economic Debates, Economic History, Financial Markets, Regulation • 190 Views

    Words cannot describe the 2300 pages of the Dodd-Frank Wall Street Reform and Consumer Protection Act. In a way, because it says so much, it tells us very little. Still though, after looking at the bill and several news summaries, I wanted to share some main ideas.

    At first, “risk” and “protection” were the two words that came to mind. Risk: Lawmakers want to manage the impact of the risks taken by financial institutions. Protection: Lawmakers hope to protect consumers from making unwise financial decisions.  

    Then, I discovered a second approach that made sense to me at WSJ.com where they described the basics of the bill through four categories: 

    1) Government: Its powers will grow in order to preserve financial stability. Starting with the Federal Reserve, countless government regulatory agencies will be transformed.

    2) Banks: Financial firms will experience new restrictions on trading different types of complex securities.

    3) Consumers: A new bureau to protect consumers will be established. Its responsibilities will impact a plethora of financial activities. 

    4) Investors: Different investing groups such as hedge funds, people who give investment advice, insurance companies, and those who create securities packages will have new constraints.

    Essentially then we have four groups responding to a Congress that hopes to control financial risk and expand financial protection. With 2300 pages of text, mathematically, the ways in which the four groups can respond and then interact create countless permutations. 

    The Economic Lesson

    Passed in 1932 and 1933, the Glass-Steagall Act separated investment and commercial banking, changed the structure of the Federal Reserve, and created the FDIC. Although it was formally repealed in 1999, regulators permitted financial institutions to violate its spirit beforehand. When I read the act, I was surprised to see language that was as tough to follow as the current financial reform bill. However, as 34 pages of legislation, it had fewer variables and appeared to cover many of the necessary regulatory details.  

     

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    Blowing Bubbles

    Jul 17 • Economic History, Financial Markets • 234 Views

    In The Big Short, Michael Lewis explains the subprime bubble mentality through a quote about CNBC media coverage. “…they weren’t in touch with reality anymore. If something negative happened, they’d spin it positive. If something positive happened, they’d blow it out of proportion..” A page turner that clearly and capitvatingly describes the subprime believers and doubters on Wall Street, The Big Short is a perfect story of a bubble.

    In addition to the subprime bubble and the tech bubble, there once was a bowling bubble. In 1936, Gottfried Schmidt invented the first automatic pinsetter. With machines replacing pin boys, after World War II, bowling boomed and Wall Street responded. As a young Charles Schwab said, “Compute it out–180 million people times two hours per week, for 52 weeks. That’s a lot of bowling.” The result was soaring stock prices in firms such as AMF and Brunswick and the bowling bubble. By 1963, though, following the path of all bubbles, the market reversed and prices plunged to 20% of their all time highs.

    In The Wisdom of Crowds, New Yorker columnist James Surowiecki says that crowds can usually make decisions that are more accurate than individuals. In markets, crowds accurately price sodas and broccoli and tennis lessons. Studies demonstrate that crowds’ guesses cluster around the true number of jelly beans in those huge glass jugs. Similarly, bubbles are an example of crowd behavior. Here though, we have “collective decision-making gone wrong”.

    The Economic Lesson

    Usually investors have “long” positions. They buy a stock (ownership in a company), wait for its price to rise (hopefully), and then sell it.

    Selling before they buy, short sellers want prices to decline. How can you sell something you do not own?  Short sellers borrow a stock or some other type of security and then they sell it. Weeks, months, or years later, they buy the security and return it to the owner from whom they borrowed it. For example, assume you borrow something and sell it for $10; then, weeks later you buy something identical for $5 and return it to the lender. You have made $5.

    In The Big Short, a very small number of people, rather like the boy in “The Emperor’s New Clothes”, realized the folly of buying subprime related securities and instead shorted them.

     

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    Post Hoc Ergo Propter Hoc?

    Jul 16 • Economic Debates, Government, Macroeconomic Measurement • 191 Views

    Ed Koch, former mayor of NYC used to ask, “How am I doing?” We can ask the same question about economic stimulus spending. By going to recovery.gov, you will see that there were 682,370 new recipient reported jobs between January 1 and March 31, 2010. Correspondingly, the July 14 Council of Economic Advisors’ Report (CEA) estimates that stimulus spending created, to date, somewhere between 2.5 and 3.6 million additional jobs. 

    Yes? Maybe. I wonder whether we can be sure that stimulus money created jobs. Perhaps they would have been there anyhow.

    In a recent blog post, economist N. Gregory Mankiw questions the CEA’s conclusions. Sympathizing with their assigned task, he says it is very difficult to ascertain the impact of the stimulus program through their model:

    1) He describes their Keynesian model as assuming that “no matter how bad the economy got, the inference is that it would have been even worse without the stimulus.” Consequently, whether the numbers go up or down, stimulus spending has to have had a positive impact.

    2) He points out that the CEA presents data confirming that the economy improved after the stimulus passed. How he asks, though, can we know if the stimulus was the reason the economy improved with so many other variables also having an impact. His basic point? “Post hoc ergo propter hoc.”

    All of this started me thinking about Paul the psychic octopus. As you probably recall, Paul accurately predicted 2010 World Cup Soccer results by the food receptacles he selected. Not quite “post hoc ergo propter hoc, ” but close.

    The Economic Lesson

    Most of us know whether we support more government or less as the thrust of macroeconomic policy. None of us though can statistically prove that we are right.

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    Animal Emissions

    Jul 15 • Thinking Economically • 631 Views

    As most of us know, cow burps add to global warming. According to the NY Times, animal methane emissions account for 10% of Australia’s contribution to greenhouse gasses. The solution? The kangaroo. Like cows, kangaroos are “foregut fermenters”. However, because their digestive system uses a different microbe, they produce harmless acetic acids instead of methane. If researchers could discover how to give cows the kangaroo microbe, then bovine emissions would be less harmful.

    IPCC researchers predict that global warming will result in temperature increases that might average 4 degrees Celsius during the next century. As a result, warmer temperatures would diminish economic growth by 1% to 5%. In other words, the world economy will continue growing but just not as much. (You might want to look at a good debate on the topic at The New Republic.)

    Enter Congress. Pending legislation includes proposals for electricity producers using qualifying fuels, creating cap and trade programs and carbon taxes, studying carbon capture, subsidizing auto makers’ efforts to create more fuel efficient cars, providing loans for clean energy projects, and nuclear power incentives. They have also suggested a big battery contest.

    The Economic Lesson

    Using CBA (cost/benefit analysis), economists would compare marginal (extra) cost and marginal (extra) benefit. Next, they would conclude that as long as the extra cost does not exceed the extra benefit that results, the policy should be implemented. Here though, I wonder whether it is possible to assess the marginal cost and marginal benefit of congressional initiatives. Even for animal emissions, because the entire Australian beef industry would be affected by diminishing cattle methane, can we accurately assess the impact?

    And therein lies our dilemma. Will the current cost of diminishing greenhouse emissions which may be incalculable be worth a potentially indefinite future benefit?

     

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    “LeBronomics”

    Jul 14 • Thinking Economically • 243 Views

    Called “LeBronomics” by NPR’s Planet Money, LeBron James’ decision to go to Miami was about much more than $99 million. Instead, the key issue was “utils”.

    Whenever economists want to quantify satisfaction, they use the “util”. If LeBron had selected Chicago, local residents might have felt 10 extra utils every time they watched their team play. (I just chose 10. The number does not matter.) Choosing New York, though, would have resulted in many more utils. 2009-2010 was a 50-loss, disappointing season for Knicks fans. Consequently, just seeing LeBron at every game would have generated lots of extra happiness for many New Yorkers.

    By contrast, according to the Planet Money people, selecting Miami created the least extra happiness in the United States. Because Miami already has other superstars, adding a third would not create very many more utils. We could compare this to the utils we get from the first bite of a chocolate chip cookie and the 15th bite. We get much more pleasure at the beginning before adding lots more.

    The Economic Lesson

    Getting less extra satisfaction from each additional unit is called diminishing marginal utility.

    We might add that LeBron James did not experience diminishing marginal utility when he added to his income because Florida tax rates are among the lowest in the country.

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